Before MARIS, GOODRICH and HASTIE, Circuit Judges.
This is a petition by the Commissioner of Internal Revenue to review a decision of the Tax Court holding that in determining the taxpayer's income, excess profits and declared value excess profits tax liability for the years 1942, 1943 and 1944 certain royalty payments made by the taxpayer to Mrs. Bertha E. Thomas during those years were ordinary and necessary business expenses deductible under Section 23(a)(1) (A) of the Internal Revenue Code, 26 U.S.C. The principal question presented to us on review is whether the taxpayer was estopped by a prior adverse decision of the Tax Court filed May 31, 1944, and affirmed by this court, 158 F.2d 828, which involved the tax years 1939, 1940 and 1941, from claiming that the royalty payments in question were deductible as ordinary and necessary business expenses.
The basis of the Tax Court's 1944 decision denying the deductions for the earlier years may be summarized as follows: By virtue of certain agreements of January 6, 1920 and March 20, 1920 entered into between the taxpayer, a manufacturer of flexible couplings, and Mrs. Thomas whereby she had assigned to the taxpayer certain patents on coupling devices which she then owned, as well as all improvements upon the inventions therein described, the taxpayer was already the owner of the two improvements on coupling devices when Mrs. Thomas on October 26, 1939 assigned her patent applications on those improvements to it. Accordingly the royalties in question which the taxpayer paid to Mrs. Thomas during 1939, 1940 and 1941, as the consideration for the assignment of the patent applications pursuant to an agreement between them of November 26, 1939 were merely voluntary payments and, therefore, not deductible for federal tax purposes as ordinary and necessary business expenses. 3 T.C.M. 620.
On November 26, 1943, a few months after the hearing by the Tax Court of the merits of the prior proceeding Mrs. Thomas and the taxpayer entered into a contract which was entitled a "Supplemental Agreement", effective retroactively as of July 1, 1943. By this agreement the taxpayer reassigned to Mrs. Thomas its rights in the improvement Patents Nos. 2,182,711 and 2,251,722 which had been assigned to it by her on October 26, 1939. In turn, Mrs. Thomas granted an exclusive license to the taxpayer to manufacture and sell flexible couplings under these patents. The parties furthermore agreed that the royalties provided for in the agreement of November 26, 1939 had proved to be greater in amount than they had contemplated and they provided for a lower basis of royalty payments, the minimum royalty provisions of the November 26, 1939 agreement to continue in effect and the maximum royalties not to exceed $80,000 per year.
In April, 1945 Mrs. Thomas filed a petition for a declaratory judgment in the Court of Common Pleas of Warren County, Pennsylvania, to determine the rights and obligations of the parties under the agreements of November 26, 1939 and November 26, 1943. In the petition Mrs. Thomas alleged that on March 21, 1945 the taxpayer advised her that because of the Tax Court's decision it would refuse to pay further royalties under the agreements of November 26, 1939 and November 26, 1943 and demanded return of all royalties paid since May 1, 1939 and a reassignment to the taxpayer of the patents it had assigned pursuant to the agreement of November 26, 1943. The Court of Common Pleas sustained the claims of Mrs. Thomas, holding that the agreements of 1939 and 1943 were supported by valid, adequate and legal consideration, that Mrs. Thomas was the owner of the improvement patents in question and that she was entitled to judgment against the taxpayer for the amounts due her under the agreements. On appeal to the Pennsylvania Supreme Court, the judgment was affirmed, one justice dissenting on the ground that there was no real controversy between the parties. Thomas v. Thomas Flexible Coupling Co., 1946, 353 Pa. 591, 46 A. 2d 212.
On the subsequent review of the Tax Court's 1944 decision by this court, this judgment of the Pennsylvania state courts was brought to our attention at argument. This court, nonetheless affirmed the Tax Court's decision. 158 F.2d 828, certiorari denied 329 U.S. 810, 67 S. Ct. 624, 91 L. Ed. 691.
We come then to the facts of the case before us: Pursuant to the terms of the agreement of November 26, 1939 the taxpayer paid Mrs. Thomas $170,833.16 in royalties for 1942 and $236,323.73 for the first half of 1943. Under that agreement, as modified by the agreement of November 26, 1943 royalty payments of $40,000 were paid for the second half of 1943 and $80,000 for the year 1944. The Commissioner disallowed the deduction of these payments from the taxpayer's gross income as ordinary and necessary business expenses under Section 23(a)(1)(A) of the Internal Revenue Code on the ground that the prior decision denying such deductions to the taxpayer for the tax years 1939, 1940 and 1941 estopped it from making the claimed deductions for the tax years here involved. On appeal the Tax Court reached the contrary conclusion, holding that its former decision was not res judicata as to the present proceeding. The court held that the royalty payments made during the tax years 1942, 1943 and 1944 pursuant to the agreements of 1939 and 1943 were deductible as ordinary and necessary business expenses, limited, however, to the gross amount of $80,000 a year. Five members of the court dissented on the ground that the doctrine of res judicata should have been applied. 14 T.C. 802.
On this petition the Commissioner contends that it was error on the part of the Tax Court to hold that the taxpayer was not estopped from deducting the payments to Mrs. Thomas as ordinary and necessary business expenses. He points out that the court, contrary to its findings in these proceedings, had found in the prior proceedings that the assignment of October 26, 1939 by Mrs. Thomas of the two improvement patents, Nos. 2,182,711 and 2,251,722, was in fulfillment of an obligation on her part to do so under the terms of the 1920 agreements, and, therefore, did not afford a basis for her receipt under the November 26, 1939 agreement of new compensation for the transfer in the form of the royalty which that agreement provided for. He contends that it was error for the Tax Court to hold that under the 1939 agreement Mrs. Thomas was entitled to royalties for the tax years involved contrary to the decision of the Tax Court, affirmed by this court, in the prior proceedings. Although the Commissioner concedes that the 1943 agreement was not involved in the prior proceedings, he contends that no different conclusion is required with regard to that contract because it was before the Pennsylvania state courts and this court during the prior proceedings and was, therefore, ruled upon in those proceedings.
On the other hand the taxpayer strongly urges that the Tax Court in the present proceeding rightly held that the decision of the Pennsylvania Supreme Court has authoritatively determined that Mrs. Thomas was not legally obligated in 1939 to assign the patents in question to the petitioner, that the assignment which she made in that year was, therefore, a legal consideration for the taxpayer's promise to pay the royalties provided under the contract of November 26, 1939 and that the taxpayer was accordingly legally obligated to make the royalty payments which it did make during the years 1942, 1943 and 1944.
The royalty payments which are involved in this case fall, as we have seen, into two groups - those paid under the contract of November 26, 1939 for the year 1942 and the first half of the year 1943, the first 18 months of the period of three years in question, and those paid under that contract as modified by the contract of November 26, 1943 for the second half of the year 1943 and all of 1944, the last 18 months of the period. The impact of the doctrine of res judicata is not the same with respect to the payments for these two periods and we shall accordingly consider them separately, considering first the payments for the last 18 months which were made under the 1943 agreement.
Since tax claims for successive years do not involve the same cause of action the aspect of res judicata which is applicable is that known as collateral estoppel. In such cases the judgment in a suit with respect to tax liability for one year is conclusive between the parties to the suit with respect to similar tax liability for a later year only as to those matters in issue and points controverted which were actually litigated and decided in the prior suit. Tait v. Western Md. Ry. Co., 1933, 289 U.S. 620, 53 S. Ct. 706, 77 L. Ed. 1405. In Commissioner v. Sunnen, 1948, 333 U.S. 591, 599600, 68 S. Ct. 715, 720, 92 L. Ed. 898, the Supreme Court stated the rule as follows:
"And so where two cases involve income taxes in different taxable years, collateral estoppel must be used with its limitations carefully in mind so as to avoid injustice. It must be confined to situations where the matter raised in the second suit is identical in all respects with that decided in the first proceeding and where the controlling facts and applicable legal rules remain unchanged. Tait v. Western Md. Ry. Co., supra. If the legal matters determined in the earlier case differ from those raised in the second case, collateral estoppel has no bearing on the situation." Applying this rule the Supreme Court in the Sunnen case said, 333 U.S. at page 602, 68 S. Ct. at page 721:
"For income tax purposes, what is decided as to one contract is not conclusive as to any other contract which is not then in issue, however similar or identical it may be." The court accordingly held in that case that the tax status of royalty payments growing out of certain license contracts was not settled, under the doctrine of collateral estoppel, by a prior decision of the Board ...