Podd v. Commissioner
This text of 1998 T.C. Memo. 231 (Podd v. Commissioner) is published on Counsel Stack Legal Research, covering United States Tax Court primary law. Counsel Stack provides free access to over 12 million legal documents including statutes, case law, regulations, and constitutions.
Opinion
Decisions will be entered under Rule 155.
MEMORANDUM FINDINGS OF FACT AND OPINION
WELLS, Judge: Respondent determined deficiencies, additions to tax, and penalties in petitioners' Federal income taxes as follows:
STEPHEN D. PODD, DOCKET NOS. 20225-93, 6212-94:
| Penalties | ||
| Year | Deficiency | Sec. 6662(a) |
| 1988 | $ 463 | -- |
| 1989 | 12,654 | $ 2,530.80 |
| 1990 | 61,674 | 12,355.00 |
VICTOR I. PODD, DOCKET NOS. 20226-93, 6211-94:
| Penalties | ||
| Year | Deficiency | Sec. 6662(a) |
| 1988 | $ 951 | -- |
| 1989 | 12,065 | $ 2,413 |
| 1990 | 135,094 | 27,019 |
VICTOR T. PODD, DOCKET NOS. 20227-93, 6210-94:
| Additions to Tax | Penalties | |||
| Year | Deficiency | Sec. 6653(a)(1) | Sec. 6661 | Sec. 6662(a) |
| 1988 | $ 48,402 | $ 2,402 | $ 12,101 | -- |
| 1989 | 475,634 | -- | -- | $ 95,127 |
| 1990 | 68,637 | -- | -- | 13,727 |
JULIA PODD, DOCKET NO. 6213-94:
| Penalties | ||
| Year | Deficiency | Sec. 6662(a) |
| 1990 | $ 52,277 | $ 10,455 |
POWERTEX, INC., DOCKET NOS. 20228-93, 6214-94:
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| Year | Defi- | Free access — add to your briefcase to read the full text and ask questions with AI STEPHEN D. PODD, ET AL., 1 Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent. Podd v. Commissioner Tax Ct. Dkt. No. 20225-93. Docket Nos. 20226-93, 20227-93, 20228-93, 20229-93, 6209-94, 6210-94, 6211-94, 6212-94, 6213-94, 6214-94. T.C. Memo 1998-231; 1998 Tax Ct. Memo LEXIS 233; 75 T.C.M. (CCH) 2575; T.C.M. (RIA) 98231; June 30, 1998, Filed *233 Decisions will be entered under Rule 155. Kevin M. Flynn and WELLS, JUDGE. WELLS MEMORANDUM FINDINGS OF FACT AND OPINION WELLS, Judge: Respondent determined deficiencies, additions to tax, and penalties in petitioners' Federal income taxes as follows: STEPHEN D. PODD, DOCKET NOS. 20225-93, 6212-94:
VICTOR I. PODD, DOCKET NOS. 20226-93, 6211-94:
VICTOR T. PODD, DOCKET NOS. 20227-93, 6210-94:
JULIA PODD, DOCKET NO. 6213-94:
POWERTEX, INC., DOCKET NOS. 20228-93, 6214-94:
Respondent *234 determined deficiencies in, and additions to, Powertex, Inc.'s withholding tax as follows: Powertex, Inc., docket Nos. 20229-93, 6209-94:
Table Continued
Pursuant to amended answers, respondent asserts increased deficiencies, additions to tax, and penalties in petitioners' Federal income taxes. 2*235 *236 Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure. STATEMENT OF ISSUES After concessions, 3*237 the issues remaining for decision are: 1. Whether petitioner Powertex, Inc., is entitled to deduct certain royalty payments paid to certain individual petitioners, or whether an adjustment under 2. whether consulting fees paid by Powertex, Inc., to Special Commodities Services, Inc., are ordinary and necessary business expenses deductible under 3. whether amounts deducted by Powertex, Inc., as management fees paid to Powertex Plus International, Inc., are reasonable payments for services rendered; 4. whether the individual petitioners received constructive dividends; 5. whether petitioner Victor I. Podd was a resident of the United States during 1990; and 6. whether petitioners are liable for certain additions to tax and penalties as determined by respondent. For convenience and clarity, we have divided our opinion into separate segments. The first segment sets forth general findings of fact applicable to all of the issues in the instant case. Each of 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. 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. 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. From 1977 through 1992, Mr. Podd was the president, chief executive officer and largest shareholder of Powertex, and Mrs. Podd was its corporate secretary and treasurer. From 1983 through 1990, their children, Victor I. Podd (Victor, Jr.), and Stephen D. Podd (Stephen), served as vice presidents of Powertex. From 1977 through 1990, all of the outstanding stock in Powertex was owned by Mr. Podd, Victor, Jr., Stephen, and Mrs. Podd. From 1977 through 1990, Mr. Podd and his two sons (collectively, the Podds) and Mrs. Podd were Canadian citizens. Today, *239 Powertex is a manufacturer of several products used in the shipping industry. The core products sold by Powertex are intermodal container liner systems, used to transport such dry bulk flowable products as rice, corn, sugar, carbon black, and PVC resins. Intermodal cargo containers come in either 20-, 35-, or 40-foot lengths, and can carry up to 24 tons of cargo. An intermodal container liner is a plastic liner placed inside a shipping container for the purpose of protecting the contents from loss and contamination during shipment and to prevent corrosion of the container itself. Essentially, the liner is a large plastic bag which conforms to the interior dimensions of the intermodal container. The liner is attached to a bulkhead which acts as a sidewall and holds the cargo in the container, and which contains a portal through which the cargo is loaded and unloaded. After installation and inflation of the liner system inside the container, cargo can then be conveyed into the container. The container is then transported by rail, truck, or ship. Powertex currently manufacturers sic three principal types of intermodal container liner systems. One of Powertex's earliest products *240 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 On May 21, 1980, Mr. Podd licensed *241 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 exchange for royalties of 5 percent during the initial six-year term of the license and 7-1/2 percent during any extensions of the license. The license agreement was renewed on November 30, 1985, for an additional 6-year term. On October 26, 1970, and February 9, 1972, Bert A. Bodenheimer, an employee of Sea-Land, filed patent applications for what would eventually come to be known as the Sea Bulk container liner system. During the 1970's and through May 1983, Sea-Land licensed the exclusive rights to manufacture, market, and sell products covered by the Sea Bulk patents to Tri-Wall Containers *242 (Tri-Wall). The terms of the license agreement provided that Tri-Wall would pay royalties to Sea-Land at an initial rate of 8 percent of net sales of Sea Bulk liners for the first year of the agreement, 9 percent for the second year, and 10 percent thereafter. In March 1981, Raymond Stopper founded Insta-Bulk, Inc., (Insta-Bulk) in Houston, Texas. Insta-Bulk, like Powertex, was engaged in the business of manufacturing and selling intermodal container liners for use in the transportation industry. During 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 *243 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, 7-1/2 percent for the next 2,500, and 5 percent for all units over 7,500. On February 21, 1986, the agreement was again amended, this time to provide that Powertex would pay royalties quarterly at *244 the rate of 5 percent of net sales of Sea Bulk liners. On May 26, 1983, Powertex entered into a sublicense agreement with Insta-Bulk for use of the Sea Bulk patents. The agreement allowed Insta-Bulk to manufacture, market, and sell liners covered by the Sea Bulk patents in Louisiana and Texas. The agreement provided that Insta-Bulk would pay royalties to Powertex at the rate of 18 percent of net sales of Sea Bulk liners for use in the ocean container industry for the first year, and at the rate of 20 percent of net sales thereafter. For liners sold for use outside of the ocean container industry, Insta-Bulk was required to pay Powertex $20 for each Sea Bulk liner sold. On May 27, 1983, Insta-Bulk and Sea-Land settled their litigation, with Insta-Bulk agreeing to the validity and enforceability of the Sea Bulk patents and to infringement of one or more of the claims of the patents. Effective January 1, 1989, the royalty rate for the Insta-Bulk sublicense was reduced to 13 percent. On March 15, 1991, Powertex terminated its sublicense agreement with Insta-Bulk. During mid-1985, Gene Rakar of Amoco Chemical Company (Amoco) approached Mr. Podd concerning the feasibility *245 of using intermodal container liners to transport pure terephthalic acid (PTA), a fine, white powder used to make polyester fiber. In the fall of 1985, Mr. Podd invited Mr. Rakar, Frank Hall (Amoco's Marketing Product 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 *246 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. During early 1986, Amoco asked Powertex to develop a liner and bulkhead compatible with Amoco's loading and unloading equipment and to modify the liner bulkheads to display the words "Amoco" and "PTA". On January 3, 1986, and March 5, 1986, Mr. Sommer sent letters to Powertex recommending changes in the dimensions for the inlet and outlet openings located in the liner bulkhead. From March 1986, through the following several months, Amoco and Powertex personnel continued to test and modify the liner. During that period, the liner was modified by attaching the triangles to the rear bulkhead. The size and dimensions of the triangles were *247 subsequently modified to facilitate the discharge of the PTA. On April 22, 1986, Mr. Podd, as president of Powertex, wrote to Attorney Kenneth L. King of the law firm Scully, Scott, Murphy & Presser in Garden City, New York, to request that the firm represent him and Powertex in filing patent applications for the inventions resulting from the modifications which had been made to the Sea Bulk liner in order to ship PTA. During June 1986, further changes were made to the liner based upon tests conducted at Amoco's Belgium plant, which included improving the triangular diagonals to ensure that the liner fell into place against the walls and floor of the container, installing bungee cords on the sides of the liner, and adding bracing at the rear bulkhead to prevent it from bulging upon discharge. During July 1986, Powertex supplied Amoco with 2 or 3 modified liners which were loaded with PTA and shipped to Amoco's customers in Taiwan. Upon unloading, however, the liners completely failed, 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 *248 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 *249 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 cardboard triangles which bowed under the weight of the product, thereby leaving approximately 150 pounds of PTA in the liner corners. After that test, additional improvements were made to the liner to meet the needs of Amoco's customers, including modifying the bracing system, outlet spout, and size and slope of the triangles. During August 1987, Amoco chose Powertex as its sole source of intermodal container liners because (1) Powertex and Amoco had developed a good working relationship; (2) Powertex sold its liners at a reasonable price; and (3) Powertex had agreed to build a facility near Amoco's Cooper River plant, thus ensuring an alternative supply source should production become impaired at the Rouses Point facility. During March 1988, Amoco and Powertex discussed entering into a purchasing agreement for Amoco's liner requirements and the opening of a second manufacturing facility near Amoco's Cooper River plant. On February *250 22, 1989, Powertex and Amoco executed a blanket purchase agreement. In the agreement, Amoco agreed to purchase liners for its Cooper River plant exclusively from Powertex during the 2- year period commencing January 1, 1989. The agreement was renewable by Amoco for four 1-year periods, provided estimates of Amoco's 1989 liner requirements, set forth guaranteed prices, and imposed manufacturing specifications. The agreement also allowed Powertex to supply Amoco with liners at the end of the initial 2-year period at matching prices, if a competitor offered to sell non-infringing liners at lower prices. During 1990, the Podds incorporated PowertexSouth 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. PowertexSC 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 *251 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, 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 its corporate tax returns, the expenses and fees were either claimed as deductions or capitalized. Powertex sued Insta-Bulk for infringement of the Amoco patents. 5 On December 22, 1994, in settlement *252 of the litigation, an agreement was executed which provided that Powertex would grant Insta-Bulk a "limited, exclusive, non-transferrable license" to make and sell to Union Carbide Corporation intermodal bulk container liners using the Amoco patents and their foreign counterparts. In exchange for such license, Insta-Bulk agreed to pay a royalty of 11 percent of the gross sales of such liners. The agreement also provided that Powertex is granted a "limited, exclusive, non- transferrable license" to make and sell to Amoco intermodal bulk container liners having inflatable air corner bags using patents owned by Raymond Stopper of Insta-Bulk. In exchange for such license, Powertex agreed to pay a royalty of 11 percent of the gross sales of such liners. During late 1986, sales of Amoco liners became an increasingly significant portion of Powertex's total sales, with net profit margins for these sales increasing to 50 percent by 1989. Sales of Amoco liners accounted for the following *253 percentages of Powertex's overall business:
Sales of Amoco liners contributed to significantly increased profits for Powertex, as shown below:
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 *254 checks to Mr. Podd in the amounts of $617,430.26 and $ 477,973.35, respectively. Such amounts represented the amounts deducted by Powertex for royalties on its Federal corporate income tax returns, less a 10-percent withholding tax payment. Each of the Podds reported one third of the amount which Powertex deducted as royalty expenses as royalty income on their individual Federal income tax returns (Forms 1040NR). Powertex created a ledger entitled "Royalties Payable to Victor T. Podd" in order to keep track of the royalties payable on sales of the Amoco liners. On September 27, 1990, respondent mailed an audit letter to Powertex indicating that its 1989 Federal income tax return was being audited. After respondent's audit had begun, Powertex changed the ledger's title to "Royalties Payable to Victor T. Podd, Victor I. Podd and Stephen D. Podd" and provided a copy to respondent. During 1990, Mr. Podd and Mr. Plante began drafting a licensing agreement for the Amoco patents, using the Sea-Land agreement as a model. A written license agreement was not executed, however, until after respondent's audit had begun. During late December of 1990 or January of 1991, the Podds, individually, *255 and Mrs. Podd, as secretary of Powertex, executed a document entitled "Tri-Podd License Agreement" which was dated "as of May 23, 1988". At the same time, the parties executed an amendment to that document dated "as of May 24, 1989". Subsequently, a The Tri-Podd License Agreement provided for royalty payments to the Podds of 15 percent of Powertex's net sales of Amoco liners in 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: Podd hereby grants to Powertex, for the full term of 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, including the marketing *256 and sale of AMOCO STYLE units for uses outside of the ocean container industry. 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 jurisdiction of last resort shall render a final adjudication holding that the AMOCO STYLE United Stated sic Patents (numbers 4,799,607 and 4,884,722) are invalid. The agreement indicated that the specific patents covered were contained in Exhibit A. Exhibit A, however, was not created until 1996, and was first *257 provided to respondent during March 1996. The FINDINGS OF FACT 1. RESPONDENT'S NOTICES OF DEFICIENCYIn the notices of deficiency, respondent disallowed deductions claimed by Powertex for royalty expenses on its Federal income tax returns for the years ending May 31, 1989, and *258 May 31, 1990, in the amounts of $ 686,034 and $531,082, respectively. Respondent determined that such amounts were not ordinary and necessary business expenses under 2. THE EXPERTS' POSITIONSa. 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. *259 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 corporate officer completely dominates the affairs of the corporation. A corporation could also derive an ownership interest where there is an implied contractual relationship for the inventor/employee to assign an interest in a patent to the corporation. Additionally, when an employee is specifically hired to devote his efforts to a particular problem, any invention that results from the performance of that work belongs to the employer pursuant to the "hired to invent" doctrine. Finally, although not as strong as an actual ownership interest, a corporation that has gained "shop rights" in an invention is entitled to a royalty-free, nonexclusive license to practice the invention; *260 i.e., where an employee conceives and perfects an invention during the hours of employment, working with the employer's materials and appliances. After examining the relevant facts, Mr. Lutzker determined that Powertex owned the Amoco patents because of the obligations of the Podds as corporate officers, because the Podds agreed to assign the patents, and because the Podds were hired to invent. Alternatively, Mr. Lutzker determined that Powertex at least had shop rights in the patents which allowed it to use the patents without paying any royalties. Turning to the issues of validity and enforceability, Mr. Lutzker explained that a patent is invalid if the claimed invention is not new or it is obvious in light of the knowledge in the technical art which existed at the time that the claimed invention was conceived. He also stated that a patent will be unenforceable where the patent applicant has engaged in inequitable conduct before 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 *261 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 *262 such patents. He determined that, due to such factors, Powertex received nothing of value pursuant to the Tri-Podd license agreement and that the appropriate royalty rate should be zero percent. As an alternative position, Mr. Goldscheider determined that a 2-percent royalty may be reasonable. He arrived at that figure by starting with the 5-percent royalty rate he determined was applicable under the Sea- Land/Powertex license of the Sea Bulk patents as of May 23, 1988. He then described a hypothetical noninfringing alternative to the Amoco liner and reasoned that, because the Amoco patents could be easily circumvented by such an alternative, the royalty rate should be less than half of the 5-percent rate applicable under the Sea- Land/Powertex license of the Sea Bulk patents. b. PETITIONER'S EXPERTS i. DONALD S. CHISUM Professor Chisum currently teaches at Santa Clara University School of Law. From 1969 through 1996, he was a member of the faculty at the University of Washington School of Law. Since 1970, he has regularly written and lectured on the subject of intellectual property and patent law, and he is the sole author of a multiple volume reference treatise, Patents: A Treatise *263 on the Law of Patentability, Validity and Infringement. He is also "of counsel" to the law firm of Morrison & Foerster in San Francisco. Professor Chisum's expert report and his rebuttal report were limited to the issue of the ownership of the Amoco patents, as between Powertex and Mr. Podd. Professor Chisum began his analysis with the general proposition that the actual human inventor owns the 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. *264 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 Tax Regs. He determined that under the Tri-Podd license agreement, Powertex received "a can't lose, practically risk free, patent protected, competitive sic free, fully developed, commercially successful and a higher priced, high profit product together with a built-in, ready to purchase, large consumption customer." He concluded that a "high royalty" was warranted. Mr. Parker calculated a reasonable rate by hypothesizing that the parties *265 to a licensing agreement would initially determine a starting value for the royalty rate. The approach he used to determine the starting value was (1) to evaluate the royalty with reference to rates for similar patents in similar circumstances, and (2) to treat the royalty as a direct function of forecasted profits to be derived from the sale of Amoco liners. Under the first approach, Mr. Parker considered the Powertex/Sea-Land license regarding the Sea Bulk patents and the Powertex/Insta-Bulk sublicense regarding the Sea Bulk patents to be comparable to the Amoco patents. He concluded, however, that the Tri- Podd license agreement gave many special advantages not found in the license agreements regarding the Sea Bulk patents, and, therefore, a "much higher royalty" was justified. Under the second approach, the parties to the license agreement would determine a royalty rate by determining a reasonable division of profits anticipated through exploitation of the licensed technology. Mr. Parker noted that, because a licensee typically assumes greater financial risk in commercializing technology, a conservative rule of thumb in royalty negotiations allocates 25 percent of the anticipated *266 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*267 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 examination process performed by a patent examiner trained in the particular technical field to which the patent application is directed. He noted that an issued patent is presumed to be valid and that one who challenges validity must prove by clear and convincing evidence that the patent is invalid. Mr. Thomas then performed a detailed analysis of each claim of the Amoco patents, and, after comparison to other patents issued for intermodal container liners, concluded that both patents were valid. Next, Mr. Thomas analyzed the enforceability of the patents. He noted that, because of the ex parte nature of a patent application, a patent applicant has a duty to act with candor, good faith, and honesty in dealing with the U.S. Patent and Trademark Office and must disclose all prior art known to the applicant which is material to the patent application. *268 If that duty is breached, a patent may be held unenforceable because of the inequitable conduct. In order to prove such inequitable conduct, one challenging a patent must prove (1) materiality of prior art, (2) knowledge by the patent applicant of prior art and its materiality, and (3) failure to disclose the prior art to the U.S. Patent and Trademark Office with intent to mislead or deceive. Applying the foregoing standard to the facts of the instant case, Mr. Thomas concluded that the Amoco patents could not be held unenforceable for inequitable conduct. Finally, Mr. Thomas calculated a royalty rate applicable to the licensing of the Amoco patents. He began by stating that the license of the Amoco patents to Insta-Bulk in settlement of the litigation with Powertex was evidence of what a reasonable royalty 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 OPINION 1. ANALYSIS OF ARM'S-LENGTH ROYALTIES FOR USE OF INTANGIBLESa. Section 4826 6 gives respondent broad authority to allocate income, deductions, credits, or allowances between commonly controlled organizations, trades, or businesses if respondent determines that the reallocation is necessary to prevent the evasion of taxes or clearly to reflect the income of the controlled entities. The purpose of The Commissioner's authority to make allocations under 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. b. THE REGULATIONS IN GENERAL An arm's-length consideration is defined specifically as "the amount that would have been paid by an unrelated party for the same intangible property under the same circumstances." Sec. 1.482- 2(d)(2)(ii), Income Tax Regs. The best indication of such arm's- length consideration generally is transfers by the same transferor to unrelated parties for the same or similar intangible property under the same or similar circumstances. Id. If a sufficiently similar transaction involving an unrelated party is unavailable, the arm's- length consideration is determined by evaluating various facts and circumstances. The relevant factors identified in section 1.482- 2(d)(2)(iii), Income Tax Regs., for determining the amount of an arm's-length consideration where an adequately similar transaction is absent are: 8*275 *276 (a) The prevailing rates in the same industry or for similar property, (b) The offers of competing transferors or the bids of competing *274 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, (f) Value of services rendered by the transferor to the transferee in connection with the transfer within the meaning of paragraph (b)(8) of this section, (g) Prospective profits to be realized or costs to be saved by the transferee through its use or subsequent transfer of the property, (h) The capital investment and starting up expenses required of the transferee, (i) The next subdivision is (j), (j) The availability of substitutes for the property transferred, (k) The arm's length rates and prices paid by unrelated parties where the property is resold or sublicensed to such parties, (l) The costs incurred by the transferor in developing the property, and (m) Any other fact or circumstance which unrelated parties would have been likely to consider in determining the amount of an arm's length consideration for the property. c. THE COURT'S HOLDING AS TO THE ARM'S-LENGTH ROYALTY RATE We must decide whether the record contains a sufficiently similar transaction involving an unrelated party. Petitioners point to the license agreement entered into between Powertex and Insta- Bulk in settlement of their litigation as a sufficiently similar transaction involving an unrelated party. Respondent disagrees, primarily because the license was *277 granted in settlement of litigation. We agree with respondent. Although we agree that the Powertex/Insta-Bulk license agreement covering the Amoco patents represents a transfer involving "the same or similar intangible property," we do not believe that the transfer occurred under "the same or similar circumstances" as the transfer in issue in the instant case. We believe that the cross- license agreements which Powertex and Insta-Bulk entered into represent nothing more than the price at which those parties were willing to discontinue their litigation and do not necessarily 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 Having found that the record does not contain a sufficiently similar transaction *278 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. We have carefully scrutinized the experts' reports and the clarifying testimony given at trial by each expert as to his respective report. We are not constrained to follow the opinion of any expert when the opinion is contrary to our own judgment. We may adopt or reject expert testimony, whichever in our judgment is most appropriate. We find significant errors in the approach of each of the parties' experts in determining a reasonable royalty rate. For example, Mr. Parker proceeded under the assumption that a prospective licensee would have no doubts as to the validity, enforceability, and ownership of the Amoco patents. He made no attempt to quantify the differences between the licenses of the Sea Bulk patents and the license of the Amoco patents. Mr. Thomas *280 relied on the license of the Amoco patents by Powertex to Insta-Bulk in settlement of their litigation as a sufficiently similar transaction involving an unrelated party. As 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 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 Consequently, we will evaluate the appropriate factors set forth in In arriving at our conclusion, we begin by considering the prevailing royalty rates for intermodal container liners as established by the record. The only liner for which we have data concerning licenses granted to unrelated third parties is the Sea Bulk liner. 10 The record reveals that the license agreements for use of the Sea Bulk liner patents have provided many different royalty rates. Sea-Land initially licensed the Sea Bulk patents to Tri-Wall Containers in exchange for royalties of 8 percent of net sales for the first year, 9 percent for the second year, and 10 percent for subsequent years. Sea-Land licensed the Sea Bulk patents to Powertex initially for a 10-percent royalty, then included quantity discounts which could reduce the royalty first to 7-1/2 percent and then to 5 percent, *283 and finally for a flat 5 percent for all sales after September 30, 1985. 11Powertex 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 *284 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 Powertex had agreed to build a facility near Amoco's Cooper River plant. The skill and expertise which the Podds had accumulated in designing and manufacturing liners also influenced the profitability of Powertex. Consequently, we do not agree with petitioners that the substantial increase in profits of Powertex is attributable exclusively to use of the Amoco patents. The expert witnesses who appeared in the instant case presented us with an overwhelming amount of information and arguments concerning the validity, enforceability, and ownership of the Amoco patents. In our Order dated December 6, 1996, we *285 stated that the parties were not permitted to introduce evidence to collaterally attack the validity of the patents in this Court, 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 *286 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 From 1983 through 1992, James L. Clark (Mr. Clark) was employed by Sea-Land *287 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 assistance to Powertex during the first year of the agreement, and, subsequently, for using his best efforts to assist Powertex in promoting Sea Bulk liners. As a Sea-Land employee, Mr. Clark negotiated and executed the 1983 license agreement between Powertex and Sea-Land, several amendments to the agreement lowering the royalty rate, Sea-Land's 1989 agreement to sell the Sea Bulk patents to Powertex, and Sea- Land's 1989 agreement to license its Sea Bulk trademark to Powertex. Mr. Clark also approved the sublicense agreement between Powertex and Insta-Bulk. During 1983, Mr. Clark authorized Sea-Land to give free freight to Powertex for the shipment of liners to Powertex customers. Mr. Clark retired from Sea-Land on December 20, 1992. Subsequently, *288 on March 19, 1993, the free freight arrangement for shipment of Powertex liners to customers was terminated by Sea-Land. On July 11, 1983, Mr. Clark incorporated Special Commodities Services, Inc. (SCS) under the laws of the State of New Jersey. Mr. Clark was the president of SCS, and Mary J. Clark was its secretary and treasurer. The outstanding stock of SCS was owned 60 percent by Mr. Clark, 30 percent by Mary J. Clark, and 5 percent each by Dana J. and Mark A. Clark. During or around November 1983, Powertex began making periodic payments to SCS. At some point, Mr. Podd and Mr. Clark executed an agreement "dated as of November 18, 1983" concerning these payments which provided: WHEREAS, SCS, Inc. was, in part, instrumental in Powertex's obtaining that exclusive license the Sea-Land license through consultations with Powertex during and subsequent to the negotiations between Powertex and Sea Land * * * WHEREAS Powertex and SCS, Inc. believe it to be in their mutual best interests for Powertex to continue to receive marketing and technical advice on the manufacture, marketing and sales of Sea Bulk units * * * * * * * * * * Powertex hereby grants to SCS, Inc. for the full term of Powertex's *289 exclusive licensing agreement with Sea Land Service on the SEA-BULK units and any extension thereof, this Consulting Agreement to utilize SCS, Inc.'s, technical expertise in the manufacturing, marketing and sale of the SEA BULK units throughout the world. The 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 2-1/2 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 3-1/2 percent of net sales of Sea Bulk liners, and, for sales by Insta-Bulk, the commission remained at 2-1/2 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, *290 conspiracy, and breach of fiduciary duties in order to recover the payments made to SCS. The suit sought damages and demanded that SCS return the payments made by Powertex. The relevant portions of the complaint stated: 17. Unbeknownst to Sea-Land, in or about the time the Patent Licensing Agreement was negotiated and entered into between Powertex and Sea-Land, James Clark and Podd negotiated an additional compensation arrangement. In exchange for James Clark's insuring the "success" of the Patent Licensing Agreement, Podd agreed to pay James Clark a bribe or kickback equal to 2-1/2 of the sales of Sea-Bulk liners by Powertex. Upon information and belief, the kickbacks to James Clark were increased to 3-1/2% of sales in or about mid 1987. 18. In an effort to conceal the kickbacks paid to James Clark, Podd and Clark entered into a "consulting agreement" between Special Commodities Services, Inc. ("SCS") and Powertex. The consulting agreement was dated November 18, 1983 and executed by James Clark as the President of SCS, Mary Clark as the Vice President, Secretary and Treasurer of SCS, and Victor Podd as President of Powertex. 19. Upon information and belief, SCS was a shell corporation *291 established by James Clark for the sole purpose of concealing the kickbacks paid by Victor Podd and Powertex to James Clark. Upon information and belief, James Clark provided no consulting services, or services of any kind, to Powertex or Victor Podd. All of James Clark's activities regarding Powertex were in his role as an employee of Sea-Land. The lawsuit was settled in or around December 1996, with respect to Mr. Clark, Mary Clark, and SCS, and during or around January 1997, with respect to Powertex and Mr. Podd. The terms of the settlements were not submitted in evidence. In the notice of deficiency, respondent disallowed the $219,289 deduction claimed by Powertex for "consulting fees" paid to SCS for the fiscal year ending May 31, 1990. Respondent determined that the fees were neither ordinary and necessary business expenses nor expended for the designated purpose. Respondent did not assert that the deduction for payments to SCS should be disallowed under 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. In general, an expense *293 is ordinary if it is considered "normal, usual, or customary" in the context of the particular business out of which it arose. The test of deductibility of payments made for services is whether the payments are reasonable and are in fact payments purely for services which are actually rendered. Petitioners contend that SCS "rendered continuous, substantial, and valuable consulting services to Powertex" and consulted with Powertex on "marketing, advertising, business planning, customer development, new products, finance, etc." Petitioners, however, submitted no records in evidence reflecting services *294 performed by SCS. Mr. Podd testified that he would call Mr. Clark at all hours of the day and night seeking "direction, leadership, and knowledge of the industry". Neither party called Mr. Clark to testify at trial. Respondent contends that petitioners' failure to call Mr. Clark allows us to conclude that his testimony would not have supported their arguments. If a witness is equally available to both parties and neither party calls that witness at trial, then no adverse inference is warranted. 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 *295 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 necessary business expenses. See Based on the record before us, we conclude that petitioners have not established that Mr. Clark (individually or through SCS) provided any services to Powertex beyond those he provided in his capacity as an employee of Sea-Land. Consequently, we hold that Powertex may not deduct the payments to SCS in 1990 in the amount of $219,289 as an ordinary and necessary business *297 expense. 13 FINDINGS *298 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 Victor, Jr. each owned 24 percent. Mr. Podd was its president, Mrs. Podd was its secretary, and Stephen and Victor, Jr. were vice presidents. The Podds and Mrs. Podd were also the only employees of Plus during this time period. A "Management Agreement" dated June 1, 1983, and executed by Victor, *299 Jr. as vice president of Powertex, and Mr. Podd as president of Plus provided that Plus would "operate" Powertex for the period from June 1, 1983, to May 30, 1984, in return for "compensation" of $120,000. The agreement provided that it could be terminated by mutual agreement and otherwise would be automatically renewed for successive 3 year terms. Mr. Podd and Victor, Jr. prepared three amendments to the management agreement increasing the "compensation" payable to Plus to $125,000 for fiscal year 1985, $175,000 for fiscal year 1987, and $250,000 for fiscal years 1988 through 1990. Although the amendments stated that they were executed on May 10, 1984, May 22, 1986, and May 11, 1987, they were not actually executed until late 1990 or early 1991. Powertex made payments to Plus as follows:
During the fiscal years ending May 31, 1984, through May 31, 1990, Powertex claimed deductions on its Federal corporate income tax returns for payments to Plus in the following amounts:
During *300 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:
In the notices of deficiency, respondent adjusted the income of Powertex by disallowing the deductions claimed for management fees paid to Plus for the fiscal years ending *301 in 1988 through 1990. Respondent determined that such amounts were neither ordinary and necessary business expenses nor expended for the purpose designated. 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. 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. Management *302 expenses are among the items included in business expenses. Petitioners argue that the amounts labeled as management fees paid from Powertex to Plus are deductible under Respondent contends that the fees paid to Plus are not deductible because *303 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 IV. ISSUE 4: WHETHER INDIVIDUAL PETITIONERS RECEIVED CONSTRUCTIVE DIVIDENDSRespondent determined that the Podds and Mrs. Podd received constructive dividends from a variety of sources. 14*304 Respondent determined that Mr. Podd, Victor, Jr., and Stephen each received constructive dividend income of $228,678 during 1989 and $177,027 during 1990, which amounts are 1/3 of the disallowed royalty expenses claimed by Powertex of $686,034 during 1989 and $531,082 during 1990. Additionally, in accordance with respondent's determination that the $250,000 management fee expenses paid by Powertex to Plus for the 1988 through 1990 taxable years were not ordinary and necessary business expenses, respondent determined that such payments constituted constructive dividends. Initially, respondent determined in the notices of deficiency that Mr. Podd received $250,000 of constructive dividend income for 1988 and 1989, and that the Podds and Mrs. *305 Podd received $250,000 of constructive dividend income for 1990. By way of amended answers, respondent also determined that Victor, Jr. and Stephen each received $250,000 of constructive dividend income for 1988 and 1989. A dividend is a distribution of property by a corporation to its shareholders out of its earnings and profits. The only *306 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 expenses. Consequently, the excess is nondeductible expenditures made by Powertex for the personal benefit of its shareholders and constitute constructive dividends to the Podds. See With regard to the $250,000 management fee expenses paid by Powertex to Plus for the 1988 through 1990 taxable years, we held above that such payments were ordinary and necessary business expenses pursuant to Victor, Jr. is a Canadian citizen. Beginning in 1970, the Podd family resided at their home at 255 Beverly Avenue, Mount Royal, Montreal, Canada. During 1984, Victor, Jr. was granted an H-3 Visa by the United States. On July 6, 1987, Victor, Jr. filed an application for resident alien immigration status with the Immigration and Naturalization Service (INS). On July 7, 1987, Victor, Jr. obtained a United States resident alien green card from the INS entitling him to resident alien status. From July 7, 1987, through December 31, 1990, Victor, Jr. held resident alien immigration status with the United States. During January 1989, Victor, Jr. met Ann Cohen, a resident of 6217-2 Bay Club Drive, Fort Lauderdale, Florida. Victor, Jr. and 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*308 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 which were registered in Montreal and garaged at his parents' home. Many of *309 his personal belongings remained in his parents' home. He maintained bank accounts at four Montreal banks in 1990. During 1990, he also received personal services from a doctor, a dentist, a hairdresser, and a tailor in Montreal. For purposes of the Federal income tax, an alien individual will be treated as a resident alien of the United States with respect to any calendar year if, at any time during such calendar year, the individual is a lawful permanent resident of the United States. 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. 15*312 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 is a resident of both Contracting States, then his status shall be determined as follows: (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 *311 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 (centre of vital interests); (b) If the Contracting State in which he has his centre of vital interests cannot be determined, he shall be deemed to be a resident of the Contracting State in which he has an habitual abode; (c) If he has an habitual abode in both States or in neither State, he shall be deemed to be a resident of the Contracting State of which he is a citizen; and (d) If he is a citizen of both States or of neither of them, the competent authorities of the Contracting States shall settle the question by mutual agreement. (Convention Between the United States of America and Canada with Respect to Taxes on Income and on Capital, Sept. 26, 1980, art. IV, par. 2, T.I.A.S. No. 11,087, Paragraph 1 of the treaty defines the term "resident" as follows: 1. For the purposes of this Convention, the term "resident of a Contracting State" means any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management, place of incorporation or any other criterion of a similar nature, but in the case of an estate or trust, only to the extent that income derived by such estate or trust is liable to tax in that State, either in its hands or *313 in the hands of its beneficiaries. Canada Convention, art. IV, par. 1. 16 Consequently, for the "tie-breaker" rules to apply, it must be shown that, in addition to being a resident of the United States, Victor, Jr. also is treated as a Canadian resident under Canadian law for the 1990 taxable year. Victor, Jr. has introduced evidence tending to show his physical, social, and personal nexus with Canada. Neither party, however, has introduced any evidence of the Canadian law concerning residence. In the absence of any evidence regarding the Canadian *314 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 Respondent determined additions to tax for negligence under 1. UNDERPAYMENT DUE TO NEGLIGENCE2. SUBSTANTIAL UNDERSTATEMENTFor purposes *317 of 3. FAILURE TO FILE TAX RETURN4. FAILURE TO MAKE DEPOSIT OF TAXESPetitioners argue that they are not liable for any of the penalties and additions to tax because they reasonably relied on the advice of competent tax experts. If a taxpayer reasonably relies in good faith upon the advice of a competent tax professional in the preparation of the taxpayer's return, the penalties and additions to tax such as those in issue in the instant case may be inapplicable. See The individual petitioners were Canadian *319 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 *320 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 Although petitioners' C.P.A., Ronald Plante, testified at trial, he did not state whether he was provided any information with respect to the SCS consulting fees issue. Under the circumstances, we hold that Powertex has failed to establish that it furnished Mr. Plante with *321 necessary and relevant information with regard to the consulting fees paid to SCS and that the incorrect treatment of this issue was due to his mistakes. Accordingly, we hold that Powertex is liable for the To reflect the foregoing, Footnotes
RelatedWhitney v. Robertson 124 U.S. 190 (Supreme Court, 1888) Rude v. Westcott 130 U.S. 152 (Supreme Court, 1889) Welch v. Helvering 290 U.S. 111 (Supreme Court, 1933) New Colonial Ice Co. v. Helvering 292 U.S. 435 (Supreme Court, 1934) Bogardus v. Commissioner 302 U.S. 34 (Supreme Court, 1937) Helvering v. National Grocery Co. 304 U.S. 282 (Supreme Court, 1938) Deputy, Administratrix v. Du Pont 308 U.S. 488 (Supreme Court, 1940) Commissioner v. Heininger 320 U.S. 467 (Supreme Court, 1943) Commissioner v. Lincoln Savings & Loan Ass'n 403 U.S. 345 (Supreme Court, 1971) United States v. Boyle 469 U.S. 241 (Supreme Court, 1985) Irving Sachs v. Commissioner of Internal Revenue 277 F.2d 879 (Eighth Circuit, 1960) Reginald G. Hearn and Mary L. Hearn, Husband and Wife v. Commissioner of Internal Revenue 309 F.2d 431 (Ninth Circuit, 1962) United Draperies, Inc. v. Commissioner of Internal Revenue 340 F.2d 936 (Seventh Circuit, 1965) Cornelius G. Noble and Pansy H. Noble v. Commissioner of Internal Revenue 368 F.2d 439 (Ninth Circuit, 1966) Frederick Steel Co. v. Commissioner of Internal Revenue 375 F.2d 351 (Sixth Circuit, 1967) Georgia-Pacific Corporation v. U. S. Plywood-Champion Papers Inc. 446 F.2d 295 (Second Circuit, 1971) Phillip B. Hardin v. United States of America, Hardin's Bakeries Corporation v. United States of America, (Two Cases) 461 F.2d 865 (Fifth Circuit, 1972) Your Host, Inc. v. Commissioner of Internal Revenue, Chef Foods, Inc. v. Commissioner of Internal Revenue 489 F.2d 957 (Second Circuit, 1973) Seymour Silverman v. Commissioner of Internal Revenue 538 F.2d 927 (Second Circuit, 1976) Panduit Corp. v. Stahlin Bros. Fibre Works, Inc. 575 F.2d 1152 (Sixth Circuit, 1978)
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