Victor T. Podd, Petitioner

FILES T.C. Memo. 1998-231 UNITED STATES TAX COURT STEPHEN D. PODD, ET AL.,1 Petitioners y. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket Nos. 20225-93, 20226-93, 20227-93, 20228-93, 6209-94, 20229-93, 6211-94, 62 0-94, 6212-94, 6213-94, 6214-94.

Filed June 30, 1998.

Kevin M. Flynn and Julian W. Dority, for petitioners.

John Aletta, Elise Frost Alair, and Bradford A. Johnson, for respondent.

The following cases are consolidated herewith for purposes ¹ of trial, briefing, and opinion: Victor I. Podd, docket No. 20226-93; Victor T. Podd, docket No. 20227-93; Powertex, docket No. 20228-93; Powertex, Powertex, 6210-94; Victor I. Podd, docket No. 6211-94; Stephen D. Podd, docket No. 6212-94; Julia Podd, docket No. 62s13-94; and Powertex, Inc., docket No. 6214-94.

Inc., docket No. 6209-94; Victor T. Podd, docket No.

Inc., docket No. 20229-93; Inc., SERVED JUN 3 0 1996 Respondent determined deficiencies in, and additions to, Powertex, Inc.'s withholding tax as follows:

Powertex, Inc., docket Nos. 20229-93, 6209-94:

Tax Year Ended Deficiency 6651 6653 (a) 6653 (a) (1) (A) 6653 (a) (1) (B) 6656 6661 Additions to Tax Under Section Penalties Sec. 6662 (a) 5/31/85 5/31/86 $412,425 5/31/87 5/31/88 5/31/89 5/31/90 - - 48,206 487,975 245,882 - $103,776.50 - 12,454 - - - - - $2,410.30 - - - $20,621.25 - - - - - - - ¹50 percent of the interest due on the deficiency.

41,510.60 $103,106.25 4,981.60 50,106.90 24,588 - - 12,051.50 - - $100,213.80 49,176 - - - - Pursuant to amended answers, respondent asserts increased deficiencies, additions to tax, and penalties in petitioners' Federal income taxes.

from respondent's fees paid by Powertex, The increased deficiencies result assertion of additional constructive dividends to the individual petitioners which, correspondingly, results in increased additions to tax and penalties. Specifically, his answers to assert that certain payments deducted as management to Powertex Plus International, Inc. resulted in constructive dividends. amendments to answer assert such constructive dividends against the individual petitioners in addition to those several of against whom constructive dividends were determined in the notices of deficiency. alternative argument dividends, the individual petitioners.

The amendments to answer also raise an that if these payments are not constructive they should be characterized as compensation income to respondent amended Inc.

The Respondent also amended his answers with respect to certain respondent's alternative position was that royalty payments that respondent determined were not ordinary and necessary business expenses pursuant In the notices of deficiency, royalty rate should be adjusted, pursuant percent. appropriate royalty rate pursuant percent. Correspondingly, increase the constructive dividends asserted against several of the individual petitioners.

respondent amended his answers to respondent asserts that the By way of amended answers, to sec. 482 should be O to sec. 482, to sec. 162.

to 5 the Respondent bears the burden of proof with respect to the increased deficiencies, additions to tax, and penalties pleaded in the amended answers. Rule 142(a). In light of our holdings with regard to the issues raised in the amended answers, however, the location of the burden of proof is immaterial.

the segments following our general findings of fact discusses one of the separate issues set forth above and sets forth our findings of fact and opinion concerning the respective issue.

I. General Findings of Fact Some of the facts have been stipulated for trial pursuant to Rule 91.

The stipulations of facts are incorporated herein by reference, and they are found accordingly.

At the time its petition was filed, in the instant case, Powertex, Inc.

(Powertex) was a New York corporation. Powertex's principal corporate office was located at Rouses Point, New York.

At the time they filed their petitions in the instant case, petitioners Victor T. and Julia Podd resided in Mount Royal, Quebec, Canada; petitioner Stephen D. Podd resided in North Hero, Vermont; and petitioner Victor I. Podd resided in Boca Raton, Florida.

A.

Founding of Powertex Powertex was incorporated under the laws of the state of Vermont in 1977 by petitioner Victor T. Podd (Mr. Podd), his wife petitioner Julia Podd (Mrs. Podd), and his brother Alexander Podd.

The original name of the corporation was Powerstrap, Inc., which was subsequently changed to Powertex Corporation, Inc., in 1979 and finally to Powertex, Inc., in 1984.

Powertex was initially formed to be a packaging manufacturer. Powertex began its business operations in Alburg, Vermont, on property owned by Mr. Podd.

In 1984, Powertex expanded its business from the Alburg facility to a new manufacturing plant in Rouses Point, New York.

Powertex currently manufacturers three principal types of intermodal container liner systems.

B.

The Hideliner One of Powertex's earliest products consisted of an intermodal container liner system known as the hideliner. During the 1970's, Mr. Podd became acquainted with several employees of Sea-Land Service, Inc., (Sea-Land), a company engaged in the commercial transportation business.

Sea-Land shipped raw green animal hides packed in salt.

The hides released contaminating fluids which, combined with the salt, had a caustic effect on the containers in which they were shipped.

In response to this problem, Mr. Podd developed the hideliner (also known as the powerliner) to be used for shipping raw green animal hides.

Essentially, the hideliner consists of a base sheet of foam material and a top cover sheet of polymeric material which is bonded to the base sheet, and which extends over at least a portion of the walls of the container.

As designed, it constitutes a liquid impervious liner useful in the transportation of raw animal skins.

Mr. Podd filed a patent application for the hideliner with the U.S. Patent and Trademark Office on August 1, 1978.

On February 5, 1980, the U.S. Patent and Trademark Office issued United States Patent No. 4,186,845 (the '845 patent) covering the hideliner invention.

On May 21, 1980, Mr. Podd licensed to Powertex the exclusive right to manufacture, market, and sell the hideliner.

The terms of the agreement granted Powertex an exclusive 6-year license in 1982, a dispute developed between Insta-Bulk, Sea-Land, and Tri-Wall concerning whether Insta-Bulk was manufacturing and selling liners which infringed upon the Sea Bulk patents. During 1982, Insta-Bulk filed a request for declaratory judgment with the United States District Court in New York alleging that the Sea Bulk patents were invalid and unenforceable and that it was not infringing upon the Sea Bulk patents.

Sea-Land and Tri-Wall counterclaimed for damages resulting from Insta-Bulk's alleged disclosure of Tri-Wall's trade secrets and for infringement of the Sea Bulk patents by Insta-Bulk.

Sea-Land eventually became dissatisfied with Tri-Wall's performance and therefore terminated its license agreement during or around May 1983.

On May 5, 1983, Powertex entered into an exclusive license agreement with Sea-Land for use of the Sea Bulk patents (Sea-Land license agreement).

The Sea-Land license agreement required, for all Sea Bulk liners sold within the ocean container industry, that Powertex pay Sea-Land a royalty of 10 percent of net sales of Sea Bulk liners, and expend a minimum of 10 percent of net sales of Sea Bulk liners for the purpose of marketing, advertising, and promotion of Sea Bulk liners.

For Sea Bulk liners sold outside the ocean container industry, Powertex was required to pay Sea-Land a royalty of $10 for every Sea Bulk liner sold, and to expend $10 for each unit sold for the purpose of research and development of markets outside of the ocean container industry.

The Sea-Land license agreement was amended on January 17, 1985, to provide that Powertex would pay royalties quarterly at the rate of 10 percent for the first 5,000 Sea Bulk liners sold, 7 ½ percent for the next Manager), and Tracy Sommer (an engineer at Amoco) to observe a test loading of a Sea Bulk liner at General Electric, a Powertex customer, in Selkirk, New York. After witnessing the demonstration, the Amoco personnel determined that the Sea Bulk liner was not acceptable for shipping PTA, due to the 2 to 3 hour loading time, which needed to be shortened to approximately 15 minutes.

Additionally, Amoco needed a liner that was moisture sensitive and utilized a center discharge opening in order to be compatible with their customers' unloading equipment.

A short time later, Amoco employees visited another Powertex customer in New Orleans to witness another loading demonstration.

Initial testing of the Sea Bulk liner supplied by Powertex began in late 1985 and early 1986 at Amoco's Cooper River plant.

The Powertex plant at Rouses Point, New York, manufactured the test liner. Mr. Podd worked closely with Mr. Rakar, Mr. Sommer, and Mr.

Hall in testing and modifying the liner in order to meet Amoco's needs.

Initially, the Sea Bulk liner was modified by providing a center discharge opening in order to fit the unloading equipment of Amoco's customers.

The liner was inadequate for unloading PTA, however, due to its poor flow characteristics, which resulted in the product's gathering in the corners and tearing of the liner when discharging.

In order to remedy the problem, Amoco hired contractors to install wooden triangles in the rear corners of the container by nailing them to the bracing attached to the container walls and floor.

resulting in total loss of the PTA shipment. During July and August of 1986, several modified liners supplied by Powertex were loaded with PTA and shipped to Amoco's customers in Hong Kong and Taiwan.

Those liners also failed to unload properly, however, because several hundred pounds of PTA remained inside the container.

In response to such problems, the liner was modified by (1) changing the angles of the triangles to allow the PTA to more easily flow out upon unloading; (2) removing the front bulkhead and replacing it with a wooden nailing strip laminated to the liner; (3) adding "shake-out straps" to assist in removing the PTA; and (4) separating the liner from the bulkhead, thereby allowing the triangles to function without tearing the liner when the PTA was unloaded. Mr. Sommer and other Amoco engineers worked closely with Powertex in determining the proper size and shape of the triangles.

On October 16, 1986, Mr. Podd filed a patent application with the U.S. Patent and Trademark Office for an intermodal container liner system, the key features of which include a prefabricated, collapsible bulkhead that is easily installed in an intermodal container. Another important feature is the provision for hinged, triangular corner members designed to funnel the cargo towards a center discharge opening, thus preventing the product from gathering in the corners of the container upon unloading.

During late 1986, Amoco increased its purchases of the modified liner as the initial testing had been completed. During November 1986, Powertex shipped liners to Amoco's Belgium plant for testing.

Amoco was not satisfied with those liners because they employed During 1990, the Podds incorporated Powertex South Carolina (Powertex SC) in Moncks Corner, South Carolina, which began manufacturing liners for Amoco's Cooper River plant in April of 1990. Eventually, Powertex SC came to sell 50 percent of the liners it manufactured to customers throughout the world. Powertex SC did not pay any royalties to the Podds or Powertex for its sale of the Amoco liners.

On September 27, 1988, Mr. Podd filed a patent application with the U.S. Patent and Trademark Office for certain improvements on the October 16, 1986, application. Although Amoco made several suggestions and requests during the developmental stages of the liner system, Amoco did not assert any ownership rights in the invention.

On January 24, 1989, and December 5, 1989, United States Patent numbers 4,799,607 and 4,884,722, respectively, (the Amoco patents) were issued to Mr. Podd by the U.S. Patent and Trademark Office for the invention.

Subsequently, Powertex filed applications in several countries for foreign counterpart patents concerning the Amoco liner, listing Mr. Podd as the inventor.4 Several foreign counterpart patents were subsequently published as a result of the applications.

Powertex paid the legal expenses and filing fees for both the U.S. and foreign counterpart patents concerning the Amoco liner.

On Petitioners contend that applications for foreign counterpart patents were filed by Powertex because at Canada was not a signatory to the Patent Cooperation Treaty, and, therefore, Mr. Podd could not file for such patents, but Powertex, a United States corporation, could.

time that Fiscal Year 1986 1987 1988 1989 1990 Percentage of Total Sales .

<1 Sales of Amoco liners contributed to significantly increased profits for Powertex, as shown below:

Fiscal Year 1985 1986 1987 1988 1989 1990 Net Taxable Income $1,290,536 1,351,033 1,701,787 4,335,176 6,739',962 7,174,522 During February 1988, Mr. Podd discussed with his accountant, Ronald R. Plante of Peat Marwick, the possibility of licensing the Amoco patents to Powertex.

The discussion was motivated in part by the increasing amounts of taxable income that Powertex was expected to earn from the increased sales of Amoco liners.

In May 1989, at the end of Powertex's fiscal year, Mr. Podd and Mr. Plante again discussed licensing the Amoco patents to Powertex and set the royalty rate at 15 percent of net sales of Amoco liners.

Powertex did not make any royalty payments for use of the Amoco patents during the fiscal years ending May 31, 1986, through May 31, 1988.

On its Federal corporate income tax returns for the fiscal years ending May 31, 1989, and May 31, 1990, Powertex reported paying royalties of $686,034 and $531,082, respectively.

On May 30, 1989, and May 30, 1990,- Powertex issued checks to Mr. Podd in the exchange for the right to use the Amoco patents.

The agreement's term was 6 years, commencing June 1, 1988, and renewable by Powertex if it sold at least 5,000 Amoco liners in fiscal year 1993.

The agreement further provided:

for the full term of Podd hereby grants to Powertex, this Agreement and any extension thereof, the sole and exclusive right and license to manufacture, market and sell AMOCO STYLE units and any and all other devices, methods and processes covered by the patents and patent applications listed in the attached Exhibit A. Said right and license shall be world-wide in scope and shall include the right to use and enjoy said patent rights and permit others to use and enjoy said patent rights, marketing and sale of AMOCO STYLE units for uses outside of the ocean container industry.

including the Under the agreement, the Podds also granted a license to Powertex for the exclusive worldwide right to use the trademark "POWERLINER" in connection with products covered by the licensed patents without an additional royalty.

Powertex also agreed to assume financial responsibility to the extent of $50,000 per year, commencing on June 1, 1988, for costs incurred by the Podds or Powertex in defending and litigating patent infringement claims.

The agreement provided that it would be construed and governed by New York Law.

The agreement failed to identify the patents covered.

The only reference to specific patents was contained in the following clause:

(c) Powertex may terminate this Agreement as of the tenth day following the sending of a notice of such termination to Podd if any court of competent of that the AMOCO STYLE United Stated [sic] Patents (numbers 4,799,607 and 4,884,722) are invalid.

last resort shall render a final adjudication holding jurisdiction purpose designated. Alternatively, respondent determined that Mr.

.

Podd did not engage in the Amoco patent transactions between himself and Powertex at arm's length, and, accordingly, respondent made adjustments pursuant to section 482. Respondent initially determined an alternative adjustment under section 482 using a 5- percent royalty rate, resulting in a disallowance of royalty expenses claimed for the years ending May 31, 1989, and May 31, 1990, in the amounts of $457,356 and $318,649, respectively.

Respondent's answer was amended to assert an arm's-length royalty rate pursuant to section 482 of 0 percent.

2.

The Experts' Positions a. Respondent's Experts i.

Joel E. Lutzker Mr. Lutzker received his B.A.

in physics from New York University and his J.D.

from New York University School of Law.

He has been active in the fields of patents, trademarks, and copyrights for 20 years and is currently a partner in the intellectual property law firm of Amster, Rothstein & Ebenstein.

Mr. Lutzker's reports examined the ownership of the Amoco patents and their validity and enforceability. Mr. Lutzker began by examining several different theories under which Powertex could be found to have an ownership interest in the patents.

He explained that under the "corporate opportunity" doctrine, the fiduciary responsibility of a corporate officer to act in the corporation's best interests could create an obligation to assign a patent.

Such an obligation could also arise under the "alter ego" theory where the U.S. Patent and Trademark Office; i.e., where the applicant breaches the duty of candor and good faith by failing to disclose all material information concerning the patentability of the invention.

After examining the circumstances surrounding the issuance of the Amoco patents, Mr. Lutzker concluded that there was "strong evidence" that both patents were unenforceable due to Mr. Podd's failure to disclose material prior art to the U.S. Patent and Trademark Office.

He further concluded that a "strong argument" could be made that both patents were invalid because certain prior art renders each claim of the patents obvious.

ii. Robert Goldscheider Mr. Goldscheider received his B.S.

in economics from Columbia University in 1951 and his J.D.

from Harvard Law School in 1954.

He has more than 35 years of experience in the licensing field and is a frequent lecturer on problems involving the transfer and commercialization of technology.

Mr. Goldscheider's expert report and his rebuttal report were limited to the issue of a reasonable royalty rate for a license of the Amoco patents.

He indicated that the issues of "patentability and enforceability" of the patents were outside the scope of his expertise and that he would therefore rely on Mr. Lutzker's reports as to those issues.

Essentially, Mr. Goldscheider adopted Mr. Lutzker's conclusions that the Amoco patents were invalid and unenforceable and that Powertex owned or at least had shop rights in such patents.

He patent rights to an invention until those rights are transferred.

He stated that there are several exceptions to the general rule, including an express or implied contract to assign patent rights, the "hired to invent" doctrine, the "corporate opportunity" doctrine, the "alter ego" theory, and the "shop right" doctrine.

Professor Chisum examined the legal framework underpinning each of the exceptions to the general rule.

He determined that none of the exceptions apply to give Powertex an ownership interest in the Amoco patents. Accordingly, Professor Chisum concluded that Mr.

Podd has been the legal and equitable owner of the Amoco patents at all times and that any rights Powertex has in those patents derive solely from the Tri-Podd license agreement.

ii. Gayle Parker Mr. Parker received his B.S.

in industrial engineering from Lafayette College in 1956 and his J.D.

from George Washington University in 1960.

From 1956 to 1957, he worked as a patent examiner in the U.S. Patent and Trademark Office.

From 1958 to 1979, he was the Director of Licensing and patent counsel for the National Aeronautics and Space Administration Headquarters. Since 1979, he has been the president of Technology Licensing Corporation and "of counsel" to a patent law firm, Larson & Taylor, in Arlington, Virginia.

Mr. Parker's expert report and his rebuttal report were limited to examining the reasonableness of the royalties paid pursuant to the Tri-Podd license agreement. Mr. Parker began by analyzing the relevant factors identified in section 1.482-2(d)(2)(iii), Income percent of the anticipated profits to the licensor. Mr. Parker noted, however, that such percentage can be negotiated upward or downward, and, because Mr. Podd brought a "strong arsenal of assets" to the licensing negotiations, he could demand a royalty rate which would entitle him to 50 to 75 percent of the anticipated profits.

Mr. Parker used such an allocation of profits to determine that Mr.

Podd was entitled to royalties in the range of 15.3 to 23.0 percent and that a royalty rate in the range of 12.5 to 15 percent is "definitely reasonable."

In using the allocation of profits to determine a reasonable royalty rate, however, Mr. Parker used actual, rather than projected, sales data in his calculations.

iii. George M. Thomas Mr. Thomas received his B.S.

in mechanical engineering from the University of South Carolina in 1957 and his L.L.B.

from the American University Law School in 1964.

From 1960 to 1964, he worked as a patent examiner in the United States Patent Office in Washington, D.C. Since 1964, he has been continuously engaged in the practice of patent, trademark, and copyright law.

He is currently the senior partner in the firm of Thomas, Kayden, Horstemeyer & Risley in Atlanta, Georgia.

Mr. Thomas prepared two expert witness reports (first and supplemental) which addressed the validity and enforceability of the Amoco patents, and the reasonableness of the royalties paid pursuant to the Tri-Podd license agreement.

Mr. Thomas began his analysis of the validity of the Amoco patents by noting that patent applications are subject to a rigorous would be in an arm's-length transaction.

He then determined that a higher royalty rate was justified under the Tri-Podd license agreement because the rights granted therein did not restrict sales to a single customer and because of the provision including all improvement patents developed by the Podds.

Rather than analyzing the relevant factors identified in section 1.482-2(d)(2)(iii), Income Tax Regs., Mr. Thomas next proceeded to analyze 15 factors set forth in Georgia-Pacific Corp.

v. U.S. Plywood Corp., 318 F.Supp. 1116, 1120 (S.D.N.Y. 1970), modified 446 F.2d 295 (2d Cir. 1971), which dealt with determination of the amount of a reasonable royalty to be paid by an infringer to the patent holder.

Based on his analysis of such factors, he concluded that Mr. Podd could command a royalty in an arm's-length transaction of "greater than the 11% royalty for the restricted license of Insta-Bulk, probably 15%".

OPINION

1. Analysis of Arm's-Length Royalties for Use of Intangibles a. Section 482 in General Commissioner's section 482 determination must be sustained absent a showing that he has abused his discretion. Paccar, Inc. v.

Commissioner, 85 T.C. 754, 787 (1985), affd. 849 F.2d 393 (9th Cir.

1988). Consequently, the taxpayer bears the heavier than normal burden of proving that the Commissioner's section·482 allocations are arbitrary, capricious, or unreasonable.⁷ Your Host, Inc. v.

Commissioner, 489 F.2d 957, 960 (2d Cir. 1973), affg. 58 T.C. 10, 23 (1972); Seagate Tech., Inc. & Consol. Subs. v. Commissioner, supra at 164; G.D. Searle & Co. v. Commissioner, 88 T.C. 252, 359 (1987).

Whether the Commissioner's discretion has been exceeded is a question of fact. American Terrazzo Strip Co., Inc. v.

Commissioner, 56 T.C. 961, 971 (1971).

In reviewing the reasonableness of the Commissioner's allocation under section 482, we focus on the reasonableness of the result, not the details of the methodology employed.

Bausch & Lomb, Inc. v. Commissioner, supra at 582; see also Eli Lilly & Co. v. United States, 178 Ct. Cl. 666, 372 F.2d 990, 997 (1967).

In addition to proving that the deficiencies set forth in the notice of deficiency are arbitrary, capricious, or unreasonable, the taxpayer has the burden of proving satisfaction of the arm's-length standard.

See Sundstrand Corp. v. Commissioner, supra at 354.

to sec. 482, In the instant case, petitioners thus bear the burden of the royalty proving that re.spondent's downward adjustment of rate, pursuant deficiency is arbitrary, capr1clous, or unreasonable. respondent amended his answers to assert that the appropriate royalty rate, pursuant burden of proving that 5 percent rests with respondent. Rule 142(a); see also supra note 2.

to sec. 482, should be O percent, the royalty rate should be adjusted below in the notices of to 5 percent Because the consideration where an adequately similar transaction is absent are:S (a) The prevailing rates in the same industry or for similar property, (b) The offers of competing transferors or the bids of competing transferees, (c) The terms of the transfer, including limitations on the geographic area covered and the exclusive or nonexclusive character of any rights granted, (d) The uniqueness of the property and the period for which it is likely to remain unique, (e) The degree and duration of protection afforded to the property under the laws of the relevant countries, Sec. 1.482-2(d), Income Tax Regs., was effectively superseded by sec. 1.482-4T, Temporary Income Tax Regs., 58 Fed. Reg. 5263, 5287 (Jan. 21, 1993), generally effective for taxable years beginning after April 21, 1993.

Additionally, sec. 482 was amended, for tax years beginning (or license) of to such transfer or license shall be after Dec. 31, 1986, by the addition of the following sentence at the end thereof: "In the case of any transfer intangible property (within the meaning of section 936(h)(3) (B)), the income with respect commensurate with the income attributable to the intangible." Tax Reform Act of 1986, Pub. L. 99-514, sec. 1231(e)(1), 100 Stat. 2085, 2562-2563. The effect of is that we may consider the actual profits realized by the transferee through its use of 99-426, 425 (1985), 1986-3 C.B. not compensation for the intangible be limited to the question of whether it was appropriate considering only the facts in The committee intends existence at the transfer. that consideration also be given the actual profit experience realized as a consequence of the transfer.") the intangible property. H. Rept.

the inquiry as to the appropriate (Vol. 2) 425 ("The committee does intend, however, the amendment to sec. 482 the time of that The statutory amendment to sec. 482 is apparently in Income Tax Regs., which the property may be considered in conflict with sec. 1.482-2(d)(2)(iii)(g), provides that only the prospective profits to be realized by the transferee through its use of the determination of the amount of an arm's-length consideration See (i.e., without consideration of subsequent actual profits). Bausch & Lomb, ("Unlike both respondent and petitioners' experts, we find little relevance in B&L Ireland's actual results of operations during 1981 and 1982. 1980 to a potential which was entered on January 1, 1981."), affd. 933 F.2d 1084 (2d Cir. 1991).

Such information would not have been available in licensee negotiating a license agreement Inc. v. Commissioner, 92 T.C. 525, 601 (1989) establish an arm's-length royalty rate.

License fees negotiated in settlement of litigation may not be indicative of a true arm's- length royalty rate because of the incentive to avoid high litigation costs.

See Rude v. Westcott, 130 U.S. 152, 164 (1889); Panduit Corp v. Stahlin Bros. Fibre Works, Inc., 575 F.2d 1152, 1164 n.¹¹ (6th Cir. 1978). Consequently, we find that the Powertex/Insta-Bulk license agreement covering the Amoco liner was not a "sufficiently similar transaction" as contemplated by section 1.482-2(d)(2)(ii), Income Tax Regs.

Having found that the record does not contain a sufficiently similar transaction involving an unrelated party, we must attempt to construct an arm's-length royalty.

In doing so, we look to the relevant factors identified by section 1.482-2(d)(2)(iii), Income Tax Regs.

We are not completely satisfied with the methodology employed or the results reached by either party.

We conclude that petitioner has shown that the royalty rate advanced by respondent is unreasonably low and therefore is arbitrary, capricious, and unreasonable.

Seagate Tech., Inc. & Consol. Subs. v. Commissioner, supra; Sundstrand Corp. v. Commissioner, supra.

.On the other hand, we believe that the royalty rate advocated by petitioner is unreasonably high for the property involved in this case. We have evaluated all of the arguments raised by the parties.

In reaching our conclusion, we draw on the record as a whole to determine the royalty rate at which we believe unrelated parties, under the facts and circumstances of the instant case, would have arrived for the we noted above, however, the fact that this license was granted in settlement of litigation prevented it from being a sufficiently similar transaction for purposes of section 1.482-2(d)(2)(ii), Income Tax Regs. Additionally, we are puzzled as to his decision to examine the factors found in Georgia-Pacific Corp. v. U.S. Plywood Corp., 318 F. Supp. at 1120, instead of those enumerated in section 1.482-2(d)(2)(iii), Income Tax Regs. Although some of the Georgia- Pacific Corp.

factors are similar to those listed in the regulation, several are not.

For example, the Georgia-Pacific Corp.

factors include the derivative effect of selling the patented product in promoting sales of other products of the licensee and opinions from expert witnesses, factors which are not included in the regulation.

Finally, Mr. Thomas' basic approach was to rely on the Powertex/Insta-Bulk settlement license of the Amoco patents as evidence of a "clearly arm's-length transaction."

He then pointed to the advantages inherent in the Tri-Podd license agreement as justifying a royalty of "greater than * * * 11% * * * probably 15%", with no effort to quantify the effect of the asserted advantages.

As to Mr. Goldscheider, his entire opinion is grounded on Mr.

Lutzker's opinion that the Amoco patents are invalid, unenforceable, and owned by Powertex.

He made no attempt to evaluate the relevant factors identified in section 1.482-2(d)(2)(iii), Income Tax Regs., and his reports added little to what was provided by Mr. Lutzker.

Moreover, we found Mr. Goldscheider's demeanor at the trial to take away from his credibility, as he acted more like an advocate, rather included quantity discounts which could reduce the royalty first to 7 ½ percent and then to 5 percent, and finally for a flat 5 percent for all sales after September 30, 1985.11 Powertex sublicensed the Sea Bulk patents to Insta-Bulk in an agreement providing for 18- percent royalties in the first year and 20 percent thereafter.

The agreement was later amended to provide for royalties at a 13-percent rate,. effective January 1, 1989.

Accordingly, by 1989, the Sea Bulk patents were being licensed at royalty rates of 5 percent and 13 percent. We believe that this range of royalties circumscribes the appropriate royalty rate to be paid for use of the Amoco patents as well.

Petitioners describe the Amoco patents as being superior to the Sea Bulk patents, and therefore capable of commanding higher royalty rates.

We believe, however, that the Amoco patents can best be described as more specialized and designed for a particular use, whereas the Sea Bulk patents were intended for more general usage.

Petitioners also point to the substantial increase in profits of Powertex that resulted from sales of the Amoco liners as a factor to justify a high royalty rate. Although we agree that the Amoco patents were an important factor in generating those profits, we believe that they were not the only catalyst. During 1987, Amoco chose Powertex as its sole source of intermodal container liners, in part because they had developed a good working relationship and Mr. Parker, petitioner's expert, ¹¹ ignored the provision in the agreement requiring Powertex to also pay 10 percent of net sales for the purpose of marketing, advertising, and promotion when he evaluated the royalties payable by Powertex for use of the Sea Bulk patents. We do likewise.

the amount·it is willing to pay."), affd. without published opinion 691 F.2d 508 (9th Cir. 1982).

We believe that an evaluation of the foregoing factors results in a royalty towards the middle of the 5- to 13-percent range we identified above. Using our best judgement, and evaluating the record as a whole, we conclude that a royalty of 9 percent of net sales of Amoco liners is a reasonable arm's-length consideration pursuant to section 482 for the intangibles in issue.¹² III.

Issue 2: Whether Consulting Fees Paid by Powertex to Special Commodities Services, Business Expenses Deductible Under Section 162 Inc. Are Ordinary and Necessary

FINDINGS OF FACT

From 1983 through 1992, James L. Clark (Mr. Clark) was employed by Sea-Land as its Director of Corporate Terminal Operations and Director of Special Commodities Services. His responsibilities included managing the license agreement between Powertex and Sea- Land, and providing technical support, marketing assistance, and advice for assisting Sea-Land's customers in using Sea Bulk liners.

Pursuant to the license agreement between Sea-Land and Powertex, Mr.

Clark was responsible for providing technical advice and marketing Respondent also disallowed the royalty expense deductions claimed by Powertex under sec. 162 on the grounds that not ordinary and necessary business expenses, on the grounds that Powertex actually owned, or at Amoco patents. percent constitutes an arm's-length consideration pursuant sec. 482, such a royalty is deductible pursuant well. (1973) is equally applicable in ascertaining the ordinary and necessary character of a payment is deducted under sec. 162(a)).

See R.T. French Co. v. Commissioner, 60 T.C. 836, 849 (the arm's-length test commonly associated with sec. 482 In light of our holding that a royalty of 9 least had shop rights in, to a related party that to sec. 162 as they were the to license) subsequent * Land * * through consultations with Powertex during and to the negotiations between Powertex and Sea WHEREAS Powertex and SCS, their mutual best receive marketing and technical advice on the manufacture, marketing and sales of Sea Bulk units * * Inc. believe it to be in interests for Powertex to continue to * * * * * * * * Powertex hereby grants to SCS, Inc.

for the full term of Powertex's exclusive licensing agreement with Sea Land Service on the SEA-BULK units and any extension thereof, this Consulting Agreement technical expertise in the manufacturing, marketing and sale of the SEA BULK units throughout to utilize SCS, the world.

Inc.'s, (cid:16)042The agreement provided that notices to SCS should be sent to Mr.

Clark's condominium located at 580 Patten Avenue, Unit #39, Long Branch, New Jersey 07740. Mr. Clark did not purchase the condominium until April 6, 1984.

Pursuant to the agreement, Powertex was required to pay SCS a "commission" of 2 ½ percent of net sales of Sea Bulk liners by Powertex and its sublicensee, Insta-Bulk. Beginning with the quarter ending September 30, 1987, through February 25, 1992, the "commission" was increased to 3 ½ percent of net sales of Sea Bulk liners, and, for sales by Insta-Bulk, the commission remained at 2 ½ percent. During the period from mid-1985 through February 25, 1992, Powertex paid approximately $927,451 to SCS pursuant to the agreement.

On October 26, 1995, Sea-Land filed a lawsuit in the Superior Court of New Jersey against Mr. Clark, Mary J. Clark, SCS, Powertex, and Mr. Podd, based on claims of fraud, commercial bribery, conspiracy, and breach of fiduciary duties in order to recover the payments made to SCS.

The suit sought damages and demanded that SCS respondent's hesitancy to pursue a section 162(c)(2) argument is due to the fact that respondent would bear the burden of proving, by clear and convincing evidence, that the payments were illegal and that the other requirements for disallowance under section 162(c)(2) are satisfied. Brizell v. Commissioner, 93 T.C. 151, 161 (1989); sec. 1.162-18(b)(4), Income Tax Regs.

In any event, in the instant case, we need not examine the legality of the payments to SCS.

Deductions are a matter of legislative grace, and a taxpayer seeking a deduction must meet every condition that Congress has imposed for entitlement to the deduction claimed.

New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).

To qualify as an allowable deduction under section 162(a) an item must (1) be paid or incurred during the taxable year; (2) be for carrying on any trade or business; (3) be an expense; (4) be a necessary expense; and (5) be an ordinary expense. Commissioner v. Lincoln Sav. & Loan Association, 403 U.S. 345, 352 (1971). Whether an expenditure is ordinary and necessary is a question of fact to be decided on the basis of all of the facts and circumstances. Commissioner v.

Heininger, 320 U.S. 467, 475 (1943); Hearn v. Commissioner, 309 F.2d 431, 431 (9th Cir. 1962), affg. 36 T.C. 672 (1961); Brizell v.

Commissioner, supra at 156.

In general, an expense is ordinary if it is considered "normal, usual, or customary" in the context of the particular business out of which it arose. Deputy v. Du Pont, 308 U.S. 488, 495-496 (1940).

An expense is necessary if it is "appropriate and helpful" to the 1972), affg. on this issue and revg. on another issue 51 T.C. 337, 343-344 (1968).

It appears that Mr. Clark could have been subpoenaed by either petitioners or respondent. Accordingly, we draw no inference from the fact that neither party subpoenaed Mr.

Clark.

Nonetheless, several aspects of the relationship between Powertex, SCS, and Mr. Clark cause us to scrutinize the relationships between them. During 1983, Mr. Clark negotiated and executed the license agreement between Powertex and Sea-Land.

During 1983, he also authorized Sea-Land to give free freight to Powertex for shipment of its liners. Mr. Clark also incorporated SCS in 1983 and entered into the "consulting agreement" between SCS and Powertex.

The "consulting agreement" provides that SCS will provide "technical expertise in the manufacturing, marketing and sale of the Sea Bulk units". Mr. Podd, however, admitted that Mr.

Clark had no experience in the liner industry and that his expertise was in the refrigerated container industry.

Mr. Clark left Sea-Land during 1992, and, within 3 months, the free freight arrangement for shipment of Powertex liners was terminated by Sea-Land.

The Sea-Land lawsuit filed in 1995 describes the payments required by the "consulting agreement" as bribes or kickbacks and contends that all of Mr. Clark's activities with regard to Powertex were undertaken in his capacity as an employee of Sea-Land.

A deduction for a kickback has been allowed when the payments were not shown by the Commissioner to be illegal and the taxpayer established that the payments were ordinary and IV.

Issue 3: Whether Amounts Deducted by Powertex as Management Fees Paid to Powertex Plus International, Payments for Services Rendered Inc. Are Reasonable

FINDINGS OF FACT

During the years 1977 through 1990, the Podds and Mrs. Podd were Canadian citizens.

From 1977 through 1983, the Podds and Mrs.

Podd did not hold any immigration status or visa with the United States. During 1977, the Immigration and Naturalization Service (INS) detained Mr. Podd while he was crossing the United States/Canadian border and questioned him about his immigration status and right to work in the United States.

On September 19, 1977, Powertex Plus International, Inc.

(Plus) was incorporated in Canada by Mr. Podd, originally under the name Powerweb Corporation, Ltd. Petitioners' law firm advised Mr. Podd to incorporate and receive wages from Plus in Canada because of the prohibition against a Canadian citizen's working in the United States without a visa.

During the years 1983 through 1990, Mr. Podd owned 28 percent of the outstanding stock of Plus, and Mrs. Podd, Stephen, and liners to the free freight arrangement was terminated ¹³(...continued) to give free freight to Powertex for the shipment of Powertex customers, shortly after Mr. Clark retired from Sea-Land, and thereafter Sea-Land filed suit to recover the payments from Powertex to SCS, the most plausible explanation for the payments is that they were kickbacks to Mr. Clark. Petitioners have obvious reasons for not contending that the payments were kickbacks, and respondent, as noted, may have been reluctant to characterize the payments as illegal kickbacks due to the burden of proof provision in sec. 162(c)(2). record concerning the SCS payments, and it is petitioners' burden to prove that such payments were ordinary and necessary business expenses.

In any event, we are left with a less than adequate Fiscal Year Ending May 31, 1984 May 31, 1985 May 31, 1986 May 31, 1987 May 31, 1988 May 31, 1989 May 31, 1990 Amount $120,000 125,000 125,000 175,000 250,000 250,000 250,000 During the years 1983 through 1990, Plus' place of business was located at 255 Beverley Avenue, Montreal, Quebec, Canada, which was also used as a residence by Mr. Podd, Mrs. Podd, and Stephen during such years. Additionally, Powertex deducted expenses for an office maintained at the 255 Beverly Avenue address on its Federal corporate income tax returns for the fiscal years ending May 31, 1984, through May 31, 1990. During the same period, however, Powertex also maintained offices at the Rouses Point facility for use by the Podds and Mrs. Podd.

During the fiscal years ending May 31, 1989 and 1990, Powertex claimed depreciation deductions on its Federal corporate income tax returns for a desk, chair, and other standard office furniture located at 255 Beverly Avenue. Powertex also paid the Podds' worldwide travel and entertainment expenses. Plus paid the following wages in Canadian dollars:

Year 1988 1989 1990 Mr. Podd Mrs. Podd Victor, Jr.

Stephen $70,000 61,525 100,000 $60,000 61,525 100,000 $35,000 49,215 25,000 $35,000 49,215 25,000

OPINION

In the notices of deficiency, respondent adjusted the income of Powertex by disallowing the deductions claimed for management fees performed, and not the label put on them by the payor and the payee.

Estate of Boyd v. Commissioner, 76 T.C. at 658 (and cases cited therein). Petitioners bear the burden of proving what portion of the fees is allocable to deductible expenses.

Id.

Petitioners argue that the amounts labeled as management fees paid from Powertex to Plus are deductible under section 162 as ordinary and necessary business expenses. Petitioners contend that Plus provided substantial, regular, and valuable management services. Mr. Podd testified that Plus provided Powertex services in the nature of "general guidance" and "direction". More specifically, it was Mr. Podd's uncontroverted testimony that Plus reviewed sales invoices and entertained customers of Powertex.

Respondent contends that the fees paid to Plus are not deductible because they lacked a business purpose and because Plus was merely a holding company which failed to provide any significant services to Powertex.

Respondent does not argue that the management fee payments were not reasonable. At trial, petitioners offered credible testimony that significant services were provided to Powertex through Plus.

On the record before us, we hold that the payments made by Powertex to Plus as management fees during the years in issue were for services actually rendered and that, therefore, they are deductible under section 162.

also determined that Victor, Jr. and Stephen each received $250,000 of constructive dividend income for 1988 and 1989.

OPINION

A dividend is a distribution of property by a corporation to its shareholders out of its earnings and profits.

Sec. 316(a).

Dividends are taxable as ordinary income to shareholders to the extent of the earnings and profits of the corporation.

Sec. 316.

A dividend need not be formally declared or even intended by the corporation. Noble v. Commissioner, 368 F.2d 439, 442 (9th Cir.

1966), affg. T.C. Memo. 1965-84; Commissioner v. Makransky, 321 F.2d 598 (3d Cir. 1963), affg. 36 T.C. 446 (1961); Sachs v. Commissioner, 277 F.2d 879 (8th Cir. 1960), affg. 32 T.C. 815 (1959).

Additionally, the distribution need not be made to a shareholder, but only for the shareholder's personal benefit. Cirelli v.

Commissioner, 82 T.C. 335, 351 (1984); Edgar v. Commissioner, 56 T.C. 717 (1971).

The determination of whether a constructive dividend has occurred is a question of fact which depends on each case. Hardin v. United States, 461 F.2d 865 (5th Cir. 1972).

The only argument petitioners advance with respect to the royalty payments is that the full amount of such payments is deductible as an ordinary and necessary business expense and therefore cannot be a constructive dividend.

As discussed supra, we have found that the appropriate royalty rate for the patents licensed pursuant to the Tri-Podd license agreement is 9 percent.

To the extent that royalty payments were made in excess of 9 percent, such amounts are not ordinary and necessary business Ms. Cohen eventually began dating and were married on August 16, 1991.

During 1990, Victor, Jr. conducted business for Powertex in Florida by contacting and meeting with its Florida customers.

Victor, Jr. utilized a phone, desk, and fax machine located in Ms.

Cohen's apartment for conducting Powertex business. Victor, Jr.

also utilized an automobile owned by Powertex while in Florida during 1990.

On March 26, 1990, Powertex purchased mobile telephone service for Victor, Jr.'s use at Ms. Cohen's apartment. During or around May of 1990, Victor, Jr.

transported a boat that he owned with Stephen from Rouses Point, New York to Fort Lauderdale, Florida, docking it at the marina servicing Ms. Cohen's apartment.

In the insurance policy covering the boat, Victor, Jr.

listed Ms.

Cohen's apartment as his address and the address where the boat is normally kept.

On August 22, 1990, Victor, Jr. obtained a driver's license issued by the State of Florida. Again, Ms. Cohen's apartment is listed as his address. During 1990, Victor, Jr.

incurred charges on his credit card for 160 days in Florida and for 55 days in other locations in the United States.

For the 1990 taxable year, Victor, Jr.

filed a Canadian resident income tax return.

For the 1991 taxable year, Victor, Jr.

claimed that he was a United States resident for income tax purposes and resided in Fort Lauderdale, Florida.

.

During 1990, Victor, Jr. also held a Quebec driver's license and belonged to a health club in Montreal.

He owned two automobiles Accordingly, because Victor, Jr. held a valid green card during 1990, he generally would be treated as a resident alien of the United States with respect to that year.

If, for income tax purposes, Canada also considered Victor, Jr.

to be a resident of that country for 1990, he potentially would be subject to double taxation.

The United States-Canada income tax treaty (the treaty), however, provides a method for alleviating such potential.¹³ The treaty provides a series of so-called "tie-breaker" rules for determining residence where an individual qualifies as a resident of both countries, as follows:

2. Where by reason of the provisions of paragraph 1 an individual status shall be determined as follows:

is a resident of both Contracting States, then his (a) He shall be deemed to be a resident of the Contracting State in which he has a permanent home available to him; if he has a permanent home available to him in both States or in neither State, he shall be deemed to be a resident of the Contracting State with which his personal and economic relations are closer vital interests); (centre of (b) If the Contracting State in which he has his centre of vital interests cannot be determined, he shall United States income tax treaties are on equal ¹³ the Land". domestic law in that both are "the supreme Law of U.S. Const. art. VI, cl. 2; see also sec. 894(a) ("The provisions of this title shall be applied to any taxpayer with due regard to any treaty obligation of taxpayer."); sec. 7852(d)(1) relationship between a provision of a treaty and any law of the United States affecting revenue, neither the treaty nor the law shall have preferential status by reason of law.") the United States which applies to such ("For purposes of determining the its being a treaty or footing with If a treaty conflicts with a Federal law, the later in time will prevail. (1889); Whitney v. Robertson, 124 U.S. 190, 194 (1888); see also Lindsey v. Commissioner, 98 T.C. 672, 676 (1992), affd. without published opinion 15 F.3d 1160 (D.C. Cir. 1994).

Chae Chan Ping v. United States, 130 U.S. 581, 600 Canada. Neither party, however, has introduced any evidence of the Canadian law concerning residence.

In the absence of any evidence regarding the Canadian law for determining residence for income tax purposes, we conclude that Victor, Jr. was not a Canadian resident for income tax purposes in 1990.

See MacLean v. Commissioner, 73 T.C. 1045, 1053 (1980) (petitioner not considered a resident of the United Kingdom where he failed to cite any United Kingdom statutory or case law authority); Afshar v. Commissioner, T.C. Memo. 1981-241 ("where neither party has offered any material with respect to the applicable foreign law, we need not take judicial notice of such law"), affd. without published opinion 692 F.2d 751 (4th Cir. 1982).

Accordingly, the "tie-breaker" rules of the treaty are inapplicable.

Consequently, we hold that Victor, Jr.

is a resident of the United States for 1990 pursuant to section 7701(b)(1) (A)(i).

VII.

Issue 6: Additions to Tax and Penalties

FINDINGS OF FACT

Respondent determined additions to tax for negligence under section 6653(a)(1)(A) and (B), additions to tax for negligence under section 6653(a)(1), additions to tax for substantial understatements under section 6661(a), and accuracy-related penalties for negligence or substantial understatements under section 6662(a). Respondent also determined additions to tax for failure to file tax returns under section 6651(a)(1) and additions to tax for failure to make deposit of taxes under section 6656.

with reasonable cause and in good faith depends upon the pertinent facts and circumstances.

Sec. 1.6664-4(b)(1), Income Tax Regs.

2. Substantial Understatement Section 6661 imposes an addition to tax in an amount equal to 25 percent of the underpayment of income tax if the underpayment is attributable to a substantial understatement. Section 6661 applies to tax returns with a due date prior to January 1, 1990. Section 6661 was repealed with regard to returns having a due date after December 31, 1989, and recodified in section 6662. Section 6662(a) and 03)(2) imposes a penalty in an amount equal to 20 percent of the portion of underpayment which is attributable to any substantial understatement of income tax.

For purposes of sections 6661 and 6662(a), an understatement is substantial if it exceeds the greater of 10 percent of the correct tax or $5,000 or, in the case of a corporate taxpayer, $10,000.

Secs. 6661(b) (1) (A) and (B) , 6662 (d) (1) (A) and (B) .

The term "understatement" is defined as the excess of the amount of tax required to be shown on the return for the taxable year over the amount of tax shown on the return for the taxable year reduced by any rebate. Secs. 6661(b)(2), 6662(d)(2)(A).

In calculating understatements, items for which there was substantial authority or adequate disclosure are not to be considered.

Secs.

6661(b)(2) (B)(i) and (ii), 6662(d)(2)(B)(i) and (ii).

3. Failure To File Tax Return Section 6651(a)(1) provides for an addition to tax of 5 percent of the tax required to be shown on the return for each month or a The individual petitioners were Canadian citizens unfamiliar with the U.S.

tax system.

They sought assistance from a certified public accountant in the United States in order to comply with the provisions of the Internal Revenue Code.

The accountant for the individual petitioners and Powertex, Ronald R. Plante, a C.P.A. with Peat Marwick, testified as to his role in the preparation of petitioners' tax returns. Mr. Plante had a longstanding professional association with Powertex and the individual petitioners, which began around 1977 or 1978. Mr. Plante credibly testified that petitioners sought his advice in order to fulfill their tax obligations in the United States.

It is well documented in the record that petitioners relied upon the advice of Mr. Plante.

It is obvious that Mr. Plante possessed sufficient expertise in the field of tax law, and we believe that, with the exception of the issue concerning the deduction claimed by Powertex for consulting fees paid to SCS, petitioners provided him with the necessary and relevant information to prepare their tax returns. After a careful review of the record, we hold that, based on all the facts and circumstances, except as to the SCS consulting fees issue, petitioners reasonably relied in good faith on the advice of Mr.

Plante and are therefore not liable for the penalties and additions to tax as determined by respondent.

As to the SCS consulting fees issue, we hold that petitioners have not met the requirements of the reasonable cause exception that are necessary to avoid imposition of the section 6662(a) accuracy- related penalty.

If a taxpayer relies reasonably and in good faith