Commercial Solvents Corp. v. Comm'r of Internal Revenue, Docket Nos. 87814

• Decision Date: 28 May 1964
• Docket Number: Docket Nos. 87814,1574-62.
• Citation: 42 T.C. 455
• Parties: COMMERCIAL SOLVENTS CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

42 T.C. 455

COMMERCIAL SOLVENTS CORPORATION, PETITIONER,
v.
COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket Nos. 87814

1574-62.

Tax Court of the United States.

Filed May 28, 1964.

[42 T.C. 455]

Gilbert I. Falk, for the petitioner.

Warren S. Shine, for the respondent.

1. Held, certain income received by petitioner during all the years here involved from a Japanese corporation (Kyowa) under an agreement dated August 6, 1951, was taxable to petitioner as ordinary income rather than as long-term capital gain.

2. In 1955 petitioner, on the accrual basis, entered into an agreement with a Canadian corporation (Northwest) to manage Northwest's business for an annual fee. The few was to commence when commercial production of Northwest began. The latter occurred on December 1, 1956. On December 31, 1956, petitioner had a fixed and unconditional right to receive its fee. Beginning in 1957, Northwest was in financial difficulties. During 1957 it borrowed approximately $4,500,000 from a bank. The bank, as a condition for granting the loans, required petitioner to agree not to collect its fee as long as Northwest was indebted to the bank. On December 31, 1957, Northwest still owed the bank over $2,300,000. Held, (1) the fee for December 1956 was accruable as income taxable to petitioner in 1956, and (2) the fee for the calendar year 1957 was not accruable as income taxable to petitioner in 1957.

ARUNDELL, Judge:

In these consolidated proceedings the respondent determined deficiencies in income tax for the calendar years 1951 and 1954 through 1957 in amounts as follows:

+--------------------------+
                ¦Year¦Docket No.¦Deficiency¦
                +----+----------+----------¦
                ¦1951¦87814 ¦$6,437.50 ¦
                +----+----------+----------¦
                ¦1954¦1574-62 ¦21,419.58 ¦
                +----+----------+----------¦
                ¦1955¦1574-62 ¦26,344.98 ¦
                +----+----------+----------¦
                ¦1956¦1574-62 ¦26,078.76 ¦
                +----+----------+----------¦
                ¦1957¦1574-62 ¦329,456.44¦
                +--------------------------+
                

Two issues are presented: (1) Whether during all the years here involved petitioner received capital gains or ordinary income as the result of a contract entered into with Kyowa Fermentation Industry Co., Ltd., on August 6, 1951; and (2) whether petitioner realized management fees subject to tax in the amount of $50,833.33 in 1956 and $616,666.67 in 1957 from Northwest Nitro-Chemicals, Ltd.

The parties filed a stipulation of facts to which was attached 45 exhibits. There was no oral testimony.

FINDINGS OF FACT

The stipulated facts are so found and are incorporated herein by this reference.

[42 T.C. 456]

Petitioner is a corporation organized in 1919 and existing under the laws of the State of Maryland with its principal office in New York, N.Y. Its returns for the years here involved were filed with the district director of internal revenue in Upper Manhattan (now Manhattan), New York, N.Y.

Petitioner's common stock is traded on the New York Stock Exchange. It was organized to manufacture, import, export, sell, purchase, and generally deal in and with chemicals, solvents, fertilizers, paints, varnishes, dyes, colors, pigments, and all kinds of merchandise entering into the manufacture of same, and all products and byproducts thereof. Petitioner used the accrual method of accounting, and it used the specific chargeoff method for bad debts during the years in issue.

Since its organization and until some time during February 1957 petitioner was a producer of acetone, butyl alcohol, and ethyl alcohol by the bacterial fermentation process described in the second following paragraph below.

Petitioner began manufacturing operations in May 1920 producing acetone, butanol (sometimes described as butyl alcohol or n-butyl alcohol), and a small amount of ethyl alcohol by a bacterial fermentation process using a corn mash. The process was developed and patented by Chaim Weizmann, an eminent British scientist. Exclusive rights to the use of this process were acquired by petitioner, and petitioner was the sole producer of acetone and butanol by bacterial fermentation until the rights expired in 1936 when others entered the field.

Acetone and butyl alcohol are produced by the action of bacteria on starches and sugars. A mash of carbohydrates of either amylaceous (starchy) or saccharine (sugary) nature is prepared by mixing nutrient material with water. Examples of amylaceous carbohydrates are maize, kaffir corn, wheat, and oats. Examples of saccharine carbohydrates are blackstrap molasses, hydrol, wood sugars, and xylose. After the carbohydrate material is mixed with water, it is subjected to a cooking process for the purpose of sterilizing the material and breaking it down into a form more easily acted upon by bacteria. After sterilization the mash is cooled and inoculated with a culture of butyl alcohol and acetone-forming organisms. The mash is then allowed to ferment. After fermentation, the products, consisting essentially of butyl alcohol, acetone, and ethyl alcohol, in approximately the proportions by weight of 6:3:1, are separated and recovered by fractional distillation.

During 1922 the bacteria used by petitioner in the fermentation process suddenly and mysteriously ceased to function. Some fermentations yielded one-tenth of the normal amount of acetone and butyl alcohol, and many fermentations yielded none at all. Research and

[42 T.C. 457]

experimentation led to the discovery that alien bacteria lurking in the factory piping had infected the fermentation bacteria with a disease that made the cultures impotent. As a result, petitioner developed an effective method of steam sterilization. This experience caused petitioner to increase the size of its laboratory and expand its research staff. A research and development program was begun which continued for many years. As a result of its research and development work, petitioner learned how to vary the yields of acetone, butanol, and ethyl alcohol from the fermentations through the employment of different strains of bacteria which it discovered and cultivated. Petitioner also discovered how to use cheaper raw materials in place of corn. Between August 7, 1934, and October 21, 1941, 26 U.S. patents were issued to petitioner on the fermentation process with respect to bacterial cultures, raw materials, equipment, and treating materials. The 26 patents are attached to the stipulation as Exhibit 1-A and are incorporated herein by this reference. They describe: (1) The increased yields of solvents as a percent of sugar contained in the fermentation mash, and (2) the increased yields of butyl alcohol as a percent of total solvent yield, which resulted from petitioner's research and development work. Petitioner never applied for or received any Japanese patents on the acetone-butanol-ethanol fermentation process.

Kyowa Fermentation Industry Co., Ltd. (now known as Kyowa Hakko Kogyo), hereinafter sometimes referred to as Kyowa, was organized under the laws of Japan on July 1, 1949, as successor to Kyowa Gangyo K. K., which was the successor to Toa Chemical Industry Co., Ltd., originally established in March 1943 at Hofu, Yamaguchi Prefecture, for the purpose of manufacturing aircraft fuel for the Japanese Army. Kyowa's principal office during the years in issue was located in Tokyo, Japan.

Kyowa was the first company in Japan to produce acetone and butanol through the utilization of waste molasses on a commercial basis. By February 1959 it became the largest producer of solvents in Japan, with an annual production of 15,600 tons.

On September 15, 1950, Benzaburo Kato, as president of Kyowa, wrote a letter to Thomas S. Carswell, a vice president of petitioner, in which Kato stated that his company would be interested in obtaining petitioner's technical know-how with respect to the production of butanol and acetone by fermentation and gave the reasons therefor. In this letter Kato also stated:

If the percentage of butyl alcohol in the total solvents is increased by introducing into our process certain techniques and cultures used by Commercial Solvents Corporation, it may aid materially in increasing the percentage of butyl alcohol in our fermentations. If this should prove to be true, we will be able to pay some part of the additional profit accruing to our Company to Commercial

[42 T.C. 458]

Solvents in the form of royalties. As to the amount of royalties, how to calculate and how to pay such royalties and other details connected with same, I am ready to discuss and negotiate with my utmost sincerity.

Petitioner's cultures produced a yield of butyl alcohol higher than the 3,000 long tons produced by Kyowa as set forth in Kato's letter.

Negotiations were thereafter carried out between petitioner and Kyowa, and an agreement, hereinafter sometimes referred to as the agreement, was entered into on August 6, 1951, as a result thereof. A copy of the 13-page agreement is attached to the stipulation as Exhibit 3-C and is incorporated herein by this reference. The pertinent parts of the agreement are paraphrased in these findings.

Petitioner, as first party to the agreement, was referred to as Solvents, and Kyowa, as second party, was referred to as Kyowa. Solvents represented that it had developed and was the owner of processes, know-how, and cultures (collectively referred to as processes) relating to the production of n-butyl alcohol, acetone, and ethyl alcohol by the fermentation of molasses-containing fermentation media. Kyowa represented that is was producing annually 6,600,000 pounds of solvents (n-butyl alcohol, acetone, and ethyl alcohol) by the fermentation of molasses-containing fermentation media, the solvents yield being about 29 percent of the amount of fermentable sugar in the molasses and consisting of 58 to 62 percent n-butyl alcohol, 27 to 33 percent acetone, and 7 to 12 percent alcohol. Kyowa also represented that it was desirous of acquiring the said processes (processes, know-how, and cultures) from Solvents ‘for the territory of Japan’ for the purpose of...