LEARNED HAND, District Judge
(after stating the facts as above). I shall decide this case upon the assumption that “nominal capital,” in section 209, means “nominal invested capital,” without, of course, passing upon that question. I shall further assume — and indeed on this point both sides agree — that the secret process of Riddle was “intangible property,” within the meaning of section 207 (a) (3) [144]*144(b) — Comp. St. 1918, Comp. St. Ann. Supp. 1919, § 6336%h. I shall finally assume that the process had only a nominal value in April, 1909, when it was sold to the plaintiff for $2,400 of stock. With these assumptions the question arises whether the money used to develop the process can be regarded as “paid in or earned surplus and undivided profits used or employed in the business” under section 207 (a) (3). On the trial I thought that the plaintiff was right on this point, and for clarity I shall therefore state its argument as strongly as I can. The statute, it says, prescribes that “intangible property” of this kind “shall be included in invested capital at a value not to exceed the actual cash value at the time of such purchase.” Disregarding “paid-in surplus,” of which there is none here, the “earned surplus” is the only item into which the supposed added value of the process can be placed. Now surplus, or at least “earned surplus,” is merely an accountant’s way of saying that the value of the assets is greater than the liabilities. When the statute speaks of “invested capital,” it must be understood to refer to existing property, i. e., “means of production,” and, to use accountant’s language, not because accounts can ever of themselves be the basis of taxation, but because they are the most convenient record of actual values, embodied in property which is alone the proper basis of taxation. “Earned surplus” must therefore represent the value of existing property.
This being true, continues the plaintiff, the only asset of value in 1917 was the perfected process, and we may assume that it had enough value to give more than a “nominal” “earned surplus” above the capital stock, which was the only liability., Therefore, if the asset could be taken at its true value in 1917, section 209 of the statute would not apply. The difficulty with the collector’s position, however, is that section 207 directed us to include the process at no more than its “actual cash value” in 1909, and at that time it had none. The money spent in improving and perfecting the process had, in 1917, no existence at all, save in the process itself. It was spent in machinery or supplies, or Riddle’s living expenses, or salaries. So far as our treasury was concerned, there was nothing now left, except the process. That was, therefore, the only asset which could figure on the credit side of our account to establish any “earned surplus,” and the statute forbade its inclusion at anything but a nominal value. Therefore' we had no “earned surplus,” and only a “nominal invested capital.”
[1] This argument, appears to me unanswerable, if the incompleted process be regarded as the same asset for all purposes when finally developed as when first acquired. The statute must, of course, mean something, and the least that it can mean must be, I think, that any automatic increase in value of a process or “other intangible property” must be disregarded. The “unearned increment,” as economists would call it, will be ignored. Therefore I should altogether disregard any increase in the value of this process, dependent upon general conditions of industry, as, for example, the rise in the price of theobromine, due to the Great War. Furthermore, for the purposes of this case anyway, I may assume that an increase in the value of the process, [145]*145resulting from spending money in advertising or the like, which leaves it unchanged in itself, will fall into the same category. That question can await decision till it arises; I say nothing about it here.
The case at bar is, however, one where money has been spent in changing the property itself, so that, in place of a formula which prescribed one sequence of steps, there emerged another which prescribed a different sequence. Fair analogies appear to me, for example, cattle fed for market, or houses rebuilt or enlarged. It is true that for convenience we speak of such property as always remaining the same, though in fact it is not only different in value, hut that difference results from a change in the objective character of the property itself; but that convenience should not disguise the substantial fact that it is, economically speaking, new properly which appears.
When such changes have resulted from the expenditure of new capital, I see no reason why the statute should be construed as peremptorily directing that they should he disregarded. It is quite true still, as the plaintiff argues, that the “earned surplus” must be found in some assets, and that the only asset in the case at bar still remains the process ; but it is a different process. The limitation of section 207 may be confined, without undue violence to the sense of the words, to such increases in value as arise without the addition of new capital, and it may be, to such others also as involve no objective change in the thing itself.
Indeed, it can. scarcely be supposed that Congress could have had any other purpose than to prevent the taxpayer from crediting his capital account with increases which he had done nothing to produce. If they meant to include also new outlays upon existing capital, no matter how providently made, the statute provides a direct incentive to extravagance. Often, perhaps generally, it is a sound industrial policy to improve existing capital, rather than to scrap it, and invest anew. Yet, if the plaintiff be right, no such investment can ever do more than meet "depreciation, and this would apply as well to “tangibles” as to “intangibles.” The only new values which could he recognized would be in property bought outright after incorporation, and those investments which may have been the means of changing the industrial character and value of existing property, would be totally lost for purposes of taxation. When taxes can be as high as the excess profits tax may he, such inducements may become a patent influence upon industrial conduct, and it cannot be supposed that the result of the plaintiff’s construction was within the purposes of Congress.
Again, it should be a weighty consideration with me that the Tax Bureau has made these allowances in the past in the case of thousands of taxpayers, and has drafted its regulations upon the assumption that the statute permits them. I therefore hold that, when money has been earned and spent in improving a process such as this, its increased value due only to that expenditure may figure as an asset in estimating under section 207 “earned surplus,” if any, as an element of “invested capital.”
[2] It does not follow, of course, in the case at bar, that the value of the process so improved was enough to cause any “earned surplus” [146]*146to emerge. That depends upon whether the assets, so estimated, were greater than the stock, $10,000, by more than a “nominal” amount. Now the value of the “tangibles” must, under section 207, be taken as of January 1, 1914, at which time they had disappeared. Therefore the process must have increased from its nominal value in 1909 to more than $10,000 before any “earned surplus” could begin to appear at all. The value at which the plaintiff carried the process does not definitely appear on its books.
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LEARNED HAND, District Judge
(after stating the facts as above). I shall decide this case upon the assumption that “nominal capital,” in section 209, means “nominal invested capital,” without, of course, passing upon that question. I shall further assume — and indeed on this point both sides agree — that the secret process of Riddle was “intangible property,” within the meaning of section 207 (a) (3) [144]*144(b) — Comp. St. 1918, Comp. St. Ann. Supp. 1919, § 6336%h. I shall finally assume that the process had only a nominal value in April, 1909, when it was sold to the plaintiff for $2,400 of stock. With these assumptions the question arises whether the money used to develop the process can be regarded as “paid in or earned surplus and undivided profits used or employed in the business” under section 207 (a) (3). On the trial I thought that the plaintiff was right on this point, and for clarity I shall therefore state its argument as strongly as I can. The statute, it says, prescribes that “intangible property” of this kind “shall be included in invested capital at a value not to exceed the actual cash value at the time of such purchase.” Disregarding “paid-in surplus,” of which there is none here, the “earned surplus” is the only item into which the supposed added value of the process can be placed. Now surplus, or at least “earned surplus,” is merely an accountant’s way of saying that the value of the assets is greater than the liabilities. When the statute speaks of “invested capital,” it must be understood to refer to existing property, i. e., “means of production,” and, to use accountant’s language, not because accounts can ever of themselves be the basis of taxation, but because they are the most convenient record of actual values, embodied in property which is alone the proper basis of taxation. “Earned surplus” must therefore represent the value of existing property.
This being true, continues the plaintiff, the only asset of value in 1917 was the perfected process, and we may assume that it had enough value to give more than a “nominal” “earned surplus” above the capital stock, which was the only liability., Therefore, if the asset could be taken at its true value in 1917, section 209 of the statute would not apply. The difficulty with the collector’s position, however, is that section 207 directed us to include the process at no more than its “actual cash value” in 1909, and at that time it had none. The money spent in improving and perfecting the process had, in 1917, no existence at all, save in the process itself. It was spent in machinery or supplies, or Riddle’s living expenses, or salaries. So far as our treasury was concerned, there was nothing now left, except the process. That was, therefore, the only asset which could figure on the credit side of our account to establish any “earned surplus,” and the statute forbade its inclusion at anything but a nominal value. Therefore' we had no “earned surplus,” and only a “nominal invested capital.”
[1] This argument, appears to me unanswerable, if the incompleted process be regarded as the same asset for all purposes when finally developed as when first acquired. The statute must, of course, mean something, and the least that it can mean must be, I think, that any automatic increase in value of a process or “other intangible property” must be disregarded. The “unearned increment,” as economists would call it, will be ignored. Therefore I should altogether disregard any increase in the value of this process, dependent upon general conditions of industry, as, for example, the rise in the price of theobromine, due to the Great War. Furthermore, for the purposes of this case anyway, I may assume that an increase in the value of the process, [145]*145resulting from spending money in advertising or the like, which leaves it unchanged in itself, will fall into the same category. That question can await decision till it arises; I say nothing about it here.
The case at bar is, however, one where money has been spent in changing the property itself, so that, in place of a formula which prescribed one sequence of steps, there emerged another which prescribed a different sequence. Fair analogies appear to me, for example, cattle fed for market, or houses rebuilt or enlarged. It is true that for convenience we speak of such property as always remaining the same, though in fact it is not only different in value, hut that difference results from a change in the objective character of the property itself; but that convenience should not disguise the substantial fact that it is, economically speaking, new properly which appears.
When such changes have resulted from the expenditure of new capital, I see no reason why the statute should be construed as peremptorily directing that they should he disregarded. It is quite true still, as the plaintiff argues, that the “earned surplus” must be found in some assets, and that the only asset in the case at bar still remains the process ; but it is a different process. The limitation of section 207 may be confined, without undue violence to the sense of the words, to such increases in value as arise without the addition of new capital, and it may be, to such others also as involve no objective change in the thing itself.
Indeed, it can. scarcely be supposed that Congress could have had any other purpose than to prevent the taxpayer from crediting his capital account with increases which he had done nothing to produce. If they meant to include also new outlays upon existing capital, no matter how providently made, the statute provides a direct incentive to extravagance. Often, perhaps generally, it is a sound industrial policy to improve existing capital, rather than to scrap it, and invest anew. Yet, if the plaintiff be right, no such investment can ever do more than meet "depreciation, and this would apply as well to “tangibles” as to “intangibles.” The only new values which could he recognized would be in property bought outright after incorporation, and those investments which may have been the means of changing the industrial character and value of existing property, would be totally lost for purposes of taxation. When taxes can be as high as the excess profits tax may he, such inducements may become a patent influence upon industrial conduct, and it cannot be supposed that the result of the plaintiff’s construction was within the purposes of Congress.
Again, it should be a weighty consideration with me that the Tax Bureau has made these allowances in the past in the case of thousands of taxpayers, and has drafted its regulations upon the assumption that the statute permits them. I therefore hold that, when money has been earned and spent in improving a process such as this, its increased value due only to that expenditure may figure as an asset in estimating under section 207 “earned surplus,” if any, as an element of “invested capital.”
[2] It does not follow, of course, in the case at bar, that the value of the process so improved was enough to cause any “earned surplus” [146]*146to emerge. That depends upon whether the assets, so estimated, were greater than the stock, $10,000, by more than a “nominal” amount. Now the value of the “tangibles” must, under section 207, be taken as of January 1, 1914, at which time they had disappeared. Therefore the process must have increased from its nominal value in 1909 to more than $10,000 before any “earned surplus” could begin to appear at all. The value at which the plaintiff carried the process does not definitely appear on its books. On January 1, 1917, it had a surplus of $13,088.59, and therefore assets of $23,088.59. Of this, $7,367.64 was in cash, leaving $15,720.95 for other assets, which must be the process and the contract. The contract got its value only from the process, and may be disregarded. The value of the process as of that year would therefore appear to be this sum.
This figure, it is true, does not correspond with other evidence, and apparently is incorrect. In its income tax return for 1916 it valued the process as of March 1, 1913, at $19,716.84, and claimed a deduction for depreciation to date of $7,761.42, leaving a value of about $12,000'as of January 1, 1917. The discrepancy of some $3,700 I have been unable to account for, except upon the hypothesis that there were other assets not shown. Perhaps the cash was greater, because the cash book showed a balance on January 2, 1917, of $11,000, which just about makes up the difference. Assuming that this is the proper explanation, still on the plaintiff’s own admission it had an “earned surplus,” of $2,000, which-in view of the size of the business I should not consider “nominal.”
[3] But the defendant was not bound by the plaintiff’s admission. It was for the plaintiff to prove that it had only a nominal capital. The process was clearly of very substantial value. The contract had 10 years more to run, and there was a minimum royalty of $2,000. Besides this, the plaintiff could call for at least 3,000 pounds of theo-bromine yearly at not more than $2.50 a pound, a right which had been of substantial value in the years before the war began to affect the price. In 1914 this right was worth $525, and the royalty apparently $2,854. Moreover, when the contract terminated, the process would not necessarily become worthless. Indeed, it may have a very substantial value for an indefinite time. The plaintiff has certainly failed to prove that its value in 1917 over $10,000 was “not more than nominal.”
I therefore conclude that the case is not proved, and will direct a verdict for the defendant.