The Coca-Cola Company, and Includible Subsidiaries v. Commissioner

106 T.C. No. 1UNITED STATES TAX COURT
THE COCA-COLA COMPANY, AND INCLUDIBLE SUBSIDIARIES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 299-94. Filed January 4, 1996.
P filed a motion for partial summary judgment
relating to the computation of combined taxable income
under sec. 936(h)(5)(C)(ii), I.R.C., with respect to
syrup and soft-drink concentrate produced by P's sec.
936, I.R.C., subsidiary, Caribbean Refrescos, Inc.
1. Held: Sec. 1.936-6(b)(1), Q&A-12, Income Tax
Regs., governs the computation of combined taxable
income with respect to sales of component concentrate
to unrelated third parties.
2. Held, further, sec. 1.936-6(b)(1), Q&A-12,
Income Tax Regs., requires U.S. affiliate expenses to
be allocated and apportioned to the component
concentrate by applying the production cost ratio to
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all expenses allocable and apportionable to the
integrated product; i.e., bottle and can soft drink.
3. Held further, sec. 1.936-6(b)(1), Q&A-12,
Income Tax Regs., requires U.S. affiliate expenses
allocable and apportionable to the integrated product,
i.e., bottle and can soft drink, to be determined under
sec. 1.861-8, Income Tax Regs., as described in sec.
1.936-(6)(b)(1), Q&A-1, Income Tax Regs.
4. Held, further, P may net interest income against
interest expense in determining the amount of the
interest deduction to be allocated and apportioned in
computing combined taxable income under sec. 936,
I.R.C., and sec. 1.861-8(e)(2), Income Tax Regs.
Bowater Inc. v. Commissioner, 101 T.C. 207 (1993).
Charles W. Hall, William S. Lee, Nancy T. Bowen, William
P. McClure, Herman B. Bouma, and Gregory J. Ossi, for
petitioner.
Beth Williams, H. Steven New, and David P. Fuller, for
respondent.
OPINION
WRIGHT, Judge: This matter is before the Court on
petitioner's motion for partial summary judgment filed under Rule
121.1 This case was heard at a motions session held on February
1
Unless otherwise indicated, all Rule references are to the
Tax Court Rules of Practice and Procedure, and all section
references are to the Internal Revenue Code in effect during the
years in issue.
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23, 1995, at Washington, D.C.2 Petitioner's motion was taken
under advisement.
Summary judgment is intended to expedite litigation and
avoid unnecessary and expensive trials. Florida Peach Corp. v.
Commissioner, 90 T.C. 678, 681 (1988). Summary judgment may be
granted with respect to all or any part of the legal issues in
controversy "if the pleadings, answers to interrogatories,
depositions, admissions, and any other acceptable materials,
together with the affidavits, if any, show that there is no
genuine issue as to any material fact and that a decision may be
rendered as a matter of law." Rule 121(b); Sundstrand Corp. v.
Commissioner, 98 T.C. 518, 520 (1992), affd. 17 F.3d 965 (7th
Cir. 1994); Zaentz v. Commissioner, 90 T.C. 753, 754 (1988). The
moving party bears the burden of proving that there is no genuine
issue of material fact, and factual inferences will be read in a
manner most favorable to the party opposing summary judgment.
Dahlstrom v. Commissioner, 85 T.C. 812, 821 (1985). The facts
presented below do not appear to be in dispute, are stated solely
for purposes of deciding the motion, and are not findings of fact
for this case. Fed. R. Civ. P. 52(a); Sundstrand Corp v.
Commissioner, supra at 520.
I. Background
2
In addition, the Court considered an amicus curiae brief
filed by PepsiCo.
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Petitioner owns bottling companies known as company bottling
operations (CBO's), each of which is a domestic corporation owned
or controlled directly or indirectly by petitioner. Petitioner's
principal place of business is Atlanta, Georgia. Caribbean
Refrescos, Inc. (CRI), is a wholly owned subsidiary of
petitioner.
CRI produces soft-drink concentrate in Puerto Rico and
transfers all of the concentrate for the U.S. market to Coca-Cola
USA (sometimes referred to as USA), an unincorporated division of
petitioner. Coca-Cola USA sells concentrate, in unchanged form,
to CBO's and to unrelated independent bottling companies engaged
in producing syrup and selling such syrup to wholesalers. Coca-
Cola USA converts the remainder of the concentrate into fountain
syrup and sells the syrup to unrelated bottlers and CBO's.
Fountain syrup is a combination of concentrate, high fructose
corn syrup, and water. Syrup is mixed with carbonated water at
retail outlets to produce the fountain soft drink sold to
consumers. During the years at issue, the dilution ratio for
Coke, Diet Coke, Caffeine Free Diet Coke, Cherry Coke, and Diet
Cherry Coke was 1:79.26:515. Thus, one unit of concentrate is
processed into 79.26 gallons of syrup, which is further processed
into 515 gallons of soft drink. Regardless of the form of the
product sold, each sale involves exactly one unit of concentrate.
The CBO's that purchase concentrate from Coca-Cola USA
convert the concentrate into fountain syrup and sell the syrup to
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unrelated retailers. The CBO's that purchase fountain syrup sell
the fountain syrup to unrelated retailers.
CRI is both the possessions corporation and the electing
corporation within the meaning of section 936. Under section
1504(b), a section 936 possessions corporation is required to
file a separate U.S. corporate return and is therefore ineligible
to join in the parent corporation's consolidated return.
The issues before us for partial summary judgment arise out
of the section 936 tax credit, which is designed to encourage
investment and employment in Puerto Rico and other possessions of
the United States. The amount of the credit is derived from the
amount of the "combined taxable income" (sometimes referred to as
CTI) derived from the "possession product". The primary dispute
in the instant case involves the dividing of income and expenses
between related parties. More specifically, the dispute involves
whether the use of a formulaic calculation, or rather a
calculation based upon factual relationships, is mandated in
order to obtain the proper allocation and apportionment of
expenses to the gross income derived from the sale of a component
possession product by a U.S. affiliate.
Petitioner filed its Federal income tax returns for taxable
years 1983 through 1986 relying in part on section 1.936-6(b)(1),
Q&A-12, Income Tax Regs. (Q&A-12). Respondent issued a
deficiency notice to petitioner in 1991 for taxable years 1983
and 1984. Petitioner filed a motion for partial summary judgment
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in that prior case, docket No. 17171-91, similar to the one filed
in the instant case. Respondent thereafter conceded the prior
case in November 1992. On November 10, 1992, the Commissioner
opened a regulation project with respect to the computation of
combined taxable income under section 936(h). In October 1993,
respondent issued the notice of deficiency in the instant case,
determining deficiencies in petitioner's Federal income taxes for
1985 and 1986 in the amounts of $30,504,383 and $42,640,008,
respectively. Respondent determined that petitioner was not
entitled to the amount of the section 936 tax credit claimed on
its returns for the years at issue. The petition in the instant
case was filed January 4, 1994. On January 12, 1994,
respondent's proposed amendment to Q&A-12 was published in the
Federal Register. See infra note 5.
A secondary dispute in the instant case involves the
treatment of interest expense with respect to computing combined
taxable income under section 936. We are asked to decide whether
petitioner may net interest income against interest expense in
determining the amount of interest deduction to be allocated and
apportioned in computing combined taxable income. Respondent
contends that interest netting violates section 1.861-8(e)(2),
Income Tax Regs., and petitioner must allocate and apportion the
amount of its gross interest expense in determining combined
taxable income. As a preliminary matter, we summarily reject
respondent's argument and find, without further analysis, on the
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basis of Bowater Inc. v. Commissioner, 101 T.C. 207 (1993), that
petitioner may net interest income against interest expense in
determining the amount of interest deduction to be allocated and
apportioned in computing combined taxable income under section
936 and section 1.861-8(e)(2), Income Tax Regs. See also General
Portland Cement Co. v. United States, 628 F.2d 321 (5th Cir.
1980).
II. Discussion
A. Section 936 and Section 1.936-6(b)(1) Q&A 1 & 12, Income
Tax Regs.
Under the statutory scheme of section 936, a U.S.
corporation, such as CRI, which elects the application of section
936 and meets certain requirements with respect to operating in a
possession, is entitled to a credit against the U.S. tax on
certain possession-related income. Section 936 provides the
following:
SEC. 936(a). Allowance of Credit.--
(1) In General.-- * * * if a domestic corporation
elects the application of this section * * * there
shall be allowed as a credit against the tax imposed by
this chapter an amount equal to the portion of the tax
which is attributable to the sum of--
(A) the taxable income, from sources without
the United States, from--
(i) the active conduct of a trade or
business within a possession of the United
States, or
(ii) the sale or exchange of
substantially all of the assets used by the
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taxpayer in the active conduct of such trade
or business, and
(B) the qualified possession source
investment income.
* * * * * * *
(d) Definitions and Special Rules.--For purposes of
this section--
* * * * * * *
(2) Qualified Possession Source Investment
Income.--The term "qualified possession source
investment income" means gross income which--
(A) is from sources within a possession of
the United States in which a trade or business is
actively conducted, and
(B) the taxpayer establishes to the
satisfaction of the Secretary is attributable to
the investment in such possession (for use
therein) of funds derived from the active conduct
of a trade or business in such possession, or from
such investment,
less the deductions properly apportioned or allocated
thereto. [Emphasis added.]
Section 936(h) provides the following:
SEC. 936(h). Tax Treatment of Intangible Property
Income.--
* * * * * * *
(3) Intangible property income.--For purposes of
this subsection--
(A) In general.--The term "intangible
property income" means the gross income of a
corporation attributable to any intangible
property * * *
(B) Intangible property.--The term
"intangible property" means any--
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(i) patent, invention, formula,
process, design, pattern, or knowhow;
* * * * * * *
(iii) trademark, trade name, or brand
name;
(iv) franchise, license, or contract;
(v) method, program, system,
procedure, campaign, survey, study, forecast,
estimate, customer list, or technical data;
* * *
* * * * * * *
which has substantial value independent of the services
of any individual.
* * * * * * *
(5) Election out.--
* * * * * * *
(C) Methods of computation of taxable
income.--If an election of one of the following
methods is in effect pursuant to subparagraph (F)
with respect to a product or type of service, an
electing corporation shall compute its income
derived from the active conduct of a trade or
business in a possession with respect to such
product or type of service in accordance with the
method which is elected.
* * * * * * *
(ii) Profit split.--
(I) General rule.--If an election
of this method is in effect, the
electing corporation's taxable income
derived from the active conduct of a
trade or business in a possession with
respect to units of a product produced
* * *, in whole or in part, by the
electing corporation shall be equal to
50 percent of the combined taxable
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income of the affiliated group (other
than foreign affiliates) derived from
covered sales of units of the product
produced * * *, in whole or in part, by
the electing corporation in a
possession.
(II) Computation of combined
taxable income.--Combined taxable income
shall be computed separately for each
product produced * * *, in whole or in
part, by the electing corporation in a
possession. Combined taxable income
shall be computed (notwithstanding any
provision to the contrary) for each such
product * * * by deducting from the
gross income of the affiliated group
(other than foreign affiliates) derived
from covered sales of such product * * *
all expenses, losses, and other
deductions properly apportioned or
allocated to gross income from such
sales * * * and a ratable part of all
expenses, losses, or other deductions
which cannot definitely be allocated to
some item or class of gross income,
which are incurred by the affiliated
group (other than foreign affiliates).
* * *
* * * * * * *
(7) Regulations.--The Secretary shall prescribe
such regulations as may be necessary or appropriate to
carry out the purposes of this subsection * * *
[Emphasis added.]
In the simplest terms, section 936(a) allows for a tax
credit. The amount of this credit is equal to the portion of tax
attributable to the "taxable income" derived from conducting
business in a possession. Section 936(h) determines the
treatment of intangible property income. Intangible property is
broadly defined in section 936(h) and includes, of relevance
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here, formulas, processes, trademarks, trade names, brand names,
franchises, licenses and contracts, methods, programs, systems,
procedures, campaigns, surveys, studies, forecasts, customer
lists, and technical data. Sec. 936(h)(3)(B)(i),(iii), (iv),
(v). The formula for beverage bases or concentrates for various
soft drinks and syrups is considered intangible property under
section 936(h)(3)(B). See also sec. 1.936-5(a), A-6, Example
(1)(A), Income Tax Regs.
In the absence of an election under section 936(h)(5),
intangible property income is taxed to the U.S. shareholders of
the possessions corporation. If a possessions corporation makes
a valid election, its active trade or business income with
respect to the product for which the election is made is computed
in accordance with the method elected. CRI elected the "profit-
split" method under section 936(h)(5)(C)(ii).
Under the profit-split method, the taxable income of the
"electing corporation", with respect to a product produced in a
possession, is deemed to be 50 percent of the "combined taxable
income" of the "affiliated group" derived from sales of the
product to nonaffiliates or to foreign affiliates.3 The
3
The term "electing corporation" means a domestic
corporation for which an election under sec. 936 is in effect.
Sec. 936(h)(5)(E). The term "affiliated group" means the
electing corporation and all other organizations, trades, or
businesses (whether or not incorporated, whether or not organized
in the United States, and whether or not affiliated) owned or
controlled directly or indirectly by the same interest, within
(continued...)
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remaining 50 percent of the combined taxable income is allocated
to, and treated as, the taxable income of the appropriate U.S.
affiliate or affiliates. Sec. 936(h)(5)(C)(ii)(I), (III).
Combined taxable income equals the gross income of the section
936 corporation and its U.S. affiliates derived from sales of the
possession product to nonaffiliates or foreign affiliates less
the expenses of the section 936 corporation and the U.S.
affiliates allocated and apportioned to such gross income. Sec.
936(h)(5)(C)(ii)(II). Thus, the section 936 credit equals the
tax attributable to 50 percent of the combined taxable income
figure.
Congress recognized in enacting section 936(h) that some
section 936 corporations produce products that are not sold as
such to unrelated parties, but rather are transferred to
affiliates and used as component parts in the production of other
products that are then sold by the affiliates to unrelated
parties. Congress directed the Secretary of the Treasury to
write the rules with respect to such component products. Section
936(h)(7) requires the Secretary to prescribe such regulations as
may be necessary and appropriate to carry out the purposes of
section 936(h).
Section 1.936-6, Income Tax Regs., provides the following:
3
(...continued)
the meaning of sec. 482. Sec. 936(h)(5)(C)(i)(I)(b).
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(b) Profit split option--(1) Computation of
combined taxable income.
Question 1: In determining combined taxable
income from sales of a possession product, how are the
allocations and apportionments of expenses, losses, and
other deductions to be determined?
Answer 1: (i) Expenses, losses, and other
deductions are to be allocated and apportioned on a
"fully-loaded" basis under § 1.861-8 to the combined
gross income of the possessions corporation and other
members of the affiliated group * * * The amount of
research, development, and experimental expenses
allocated and apportioned to combined gross income is
to be determined under § 1.861-8(e)(3). * * * Other
expenses which are subject to § 1.861-8(e) are to be
allocated and apportioned in accordance with that
section. For example, interest expense * * * is to be
allocated and apportioned under § 1.861-8(e)(2). With
the exception of marketing and distribution expenses
discussed below, the other remaining expenses which are
definitely related to a class of gross income shall be
allocated to that class of gross income and shall be
apportioned on the basis of any reasonable method, as
described in § 1.861-8(b)(3) and (c)(1). Examples of
such methods may include, but are not limited to, those
specified in § 1.861-8(c)(1)(i) through (vi).
* * * * * * *
Question 12: If the possession product is a
component product or an end-product form, how is the
combined taxable income for such product to be
determined?
Answer 12: (i) In computing combined taxable income,
the sales price of the component product * * * is
determined as follows. With respect to a component
product, an independent sales price from comparable
uncontrolled transactions must be used if such price
can be determined in accordance with sec. 1.482-
2(e)(2). If an independent sales price of the
component product from comparable uncontrolled
transactions cannot be determined, then the possessions
corporation must treat the sales price for the
component product as equal to the same proportion of
the third party sales price of the integrated product
which the production costs attributable to the
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component product bear to the total production costs
for the integrated product. * * *
(ii) * * * The possessions corporation will determine
its costs * * * attributable to the possession product and
its expenses allocable and apportionable to the possession
product under sec. 1.861-8, as described in question and
answer 1 * * *
Each member of the affiliated group that is a
United States person, other than the possessions
corporation, shall determine its costs (other than
costs incurred for materials purchased from a U.S.
affiliate) attributable to the possession product, and
its expenses allocable and apportionable to the
integrated product under sec. 1.861-8, as described in
question and answer 1 of this paragraph (b)(1). Each
such United States person (other than the possessions
corporation) shall apportion to the possession product,
on the basis of the ratio of the production costs for
the possession product to the total production costs
for the integrated product, the expenses that such
affiliate allocated and apportioned to the integrated
product. * * * [Emphasis added.]
For purposes of computing combined taxable income, section
1.936-6(b)(1), Q&A-1, Income Tax Regs. (Q&A-1), governs the
computation of combined taxable income by prescribing rules for
the allocation and apportionment of expenses derived from the
sale of a possession product sold to unrelated third parties in
unchanged form. Q&A-12, on the other hand, appears to govern the
computation of combined taxable income by prescribing rules for
the allocation and apportionment of expenses derived from the
sale of a product sold to unrelated third parties which contains
a component possession product.
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B. Parties' Positions
Respondent first argues that Q&A-1 governs in the instant
case, requiring that all expenses USA incurs and those CBO
expenses that are factually related to gross income from the sale
of concentrate be apportioned in full to such income regardless
of the form in which the possession product is sold. Second,
respondent argues in the alternative that even were Q&A-12
controlling in the instant case, the application of the
production cost ratio contained in Q&A-12 produces absurd
results, and petitioner's motion should be denied on the basis of
Exxon Corp. v. Commissioner, 102 T.C. 721 (1994). Respondent
maintains that the question before this Court is whether Congress
intended the results that flow from petitioner's application of
the production cost ratio (PCR) to the U.S. affiliates' expenses
known to be factually related to the gross income derived from
CRI's component concentrate.
Respondent argues further that the factual relationship test
found in section 1.861-8(b) and (c), Income Tax Regs., is adopted
in section 936(h)(5)(C)(ii)(II) through its overall incorporation
of the standards contained in section 861. Respondent claims
that Q&A-12 must be read in the context of the statute and is to
be applied only as a supplement to Q&A-1, which determines,
according to respondent, the expenses allocable and apportionable
to the possession product in all cases including those cases in
which the possession product is sold in a component form.
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A possession product is an item of property which is the
result of a production process carried on in a possession. Sec.
1.936-5(a), A-1, Income Tax Regs. Possession products encompass
component products, integrated products, and end-product forms.
Id. A component product is a product which is subject to further
processing before sale to an unrelated party. Id. An integrated
product is (1) a product not subject to any further processing
before sale to an unrelated party and (2) a product which
includes all component products from which it is produced. Id.A possessions corporation may treat a component product or an
integrated product as its possession product even though the
final stage or stages of production occur outside the possession.
Id. Further processing includes transformation, incorporation,
assembly, or packaging. Id. For our purposes, the integrated
product is syrup or soft drinks, the component product is
concentrate, and the possession product is the component
concentrate. Again, CRI is both the possessions corporation and
the electing corporation within the meaning of section 936.
CRI incurs costs in producing and shipping concentrate to
the United States. Production costs include direct labor costs
and overhead incident to and necessary for production but do not
include direct material costs and interest. Secs. 1.936-6(b)(1),
Q&A 12, 1.936-5(b)(4), 1.471-11(b), Income Tax Regs. USA and the
CBO's incur expenses in selling the syrup and soft drinks. U.S.
affiliate expenses allocable and apportionable to the integrated
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product, i.e., syrup and soft drink, are determined under section
1.861-8, Income Tax Regs., as described in section 1.936-6(b)(1),
Q&A-1, Income Tax Regs. These expenses include, inter alia,
research and development, experimental, interest, marketing,
distribution, and advertising expenses. Sec. 1.936-6(b)(1),
Income Tax Regs.
We provide the following examples for illustration:
Example 1
When petitioner sells concentrate as concentrate, i.e., in
unchanged form, to unrelated third parties, CTI is determined as
follows:
Item Amount
Gross income from the sale
of concentrate per unit1 $2.24
Total USA expenses (1.48)
Combined taxable income .76
1
Concentrate is sold in units; syrup and soft drinks are
sold in equivalent gallons.
In this example, the PCR is not applicable because the
concentrate is being sold in unchanged form and not as a
component of something larger. Here, Q&A-1 determines the
computation of CTI, requiring that all expenses factually related
to the concentrate be allocated and apportioned in full to the
income derived from the sale of the concentrate as concentrate.
Thus, 50 percent of the CTI is 38 cents per unit, resulting in a
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tax credit equal to the tax attributable to 38 cents per unit of
concentrate sold.
Example 2
When the concentrate is sold as a component of a beverage
product to unrelated third parties, CTI is determined as follows:
Item Amount
Gross income from the sale
of concentrate as a component
of syrup $2.24
Total USA expenses (1.48)
Production costs incurred per
unit of possession product .10
Total production costs
incurred per unit of
integrated product .80
PCR 12.5%
Expense allocation after
applying the PCR (.19)
Combined taxable income 2.05
If the possession product is a component product, as here,
combined taxable income is determined under Q&A-12. The plain
language of Q&A-12 requires (1) the determination of five factors
relating to sales, costs, and expenses and (2) the application of
those factors when using the allocation and apportionment method
provided therein. The five factors to be determined under Q&A-12
are as follows:
(1) The electing corporation must determine the sale price
of the component product. The sale price is derived from either
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an independent sale price from comparable uncontrolled
transactions, or if an independent sale price from comparable
uncontrolled transactions cannot be determined, then the sale
price is determined using a production cost ratio method. This
first requirement is not at issue for purposes of the instant
motion;
(2) the possessions corporation must determine its costs
attributable to the possession product under section 1.861-8,
Income Tax Regs.;
(3) the possessions corporation must determine its expenses
allocable and apportionable to the possession product under
section 1.861-8, Income Tax Regs.;
(4) each member of the affiliated group must determine its
costs attributable to the possession product under section 1.861-
8, Income Tax Regs; and
(5) each member of the affiliated group must determine its
expenses allocable and apportionable to the integrated product
under section 1.861-8, Income Tax Regs.
Finally, Q&A-12 requires that each affiliate apportion to
the possession product on the basis of the ratio of the
production costs for the possession product to the total
production costs for the integrated product, the expenses the
affiliate allocated and apportioned to the integrated product.
In our second example, the total production costs associated
with the integrated product equal 80 cents per unit, and the
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production costs associated with the possession product equal 10
cents per unit, resulting in a PCR of 12.5 percent. The PCR is
then applied to the total expense amount of $1.48 per unit,
resulting in approximately 19 cents per unit expense allocation.
The CTI equals $2.05 per unit, resulting in a tax credit equal to
the tax attributable to approximately $1.03 per unit of beverage
product sold.
In this example, only 12.5 percent of the expenses known to
be factually related to the sale of the integrated product are
allocated and apportioned to the income derived from the sale of
the possession product. This results in an increased CTI figure,
which in turn increases the amount of the section 936 possessions
tax credit. Thus, where production costs at the possession level
are small in relation to the total production costs, as in the
instant case, a low PCR is produced, resulting in the allocation
of a relatively small percentage of the total amount of expenses
to the income derived from the sale of the possession product.
Respondent argues that the application of the PCR in the
instant case results in unapportioned USA expenses totaling
$227,213,515 in 1985, representing approximately 89.84 percent of
the total amount of expenses for that year, and unapportioned
expenses totaling $263,021,507 in 1986, representing 91.7 percent
of the total expenses for that year.
Both parties acknowledge that regardless of the form in
which the concentrate is sold, i.e., one unit of concentrate,
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79.26 gallons of syrup, or 515 gallons of soft drink, petitioner
incurs approximately the same amount of expense with respect to
each product. Petitioner argues, however, that the regulations
under section 936 contain only one provision prescribing the
manner of calculating combined taxable income with respect to a
component product; i.e., Q&A-12. Under the plain meaning of this
regulation, Q&A-12 controls the computation of combined taxable
income with respect to possession products that are component
products, according to petitioner. The concentrate produced by
CRI, which is converted into syrup or into bottle and can soft
drinks before sale to unrelated parties, is a component product.
According to petitioner, under the plain, unambiguous terms of
the regulation, Q&A-12 governs the computation of combined
taxable income with respect to such concentrate, mandating the
application of the production cost ratio.
Petitioner further asserts that the application of Q&A-12 to
component concentrate is consistent with the regulatory scheme in
general. In petitioner’s view, the language in the question
portion of Q&A-12 is broad and unqualified, and nothing in the
regulations under section 936 indicates that any other rules may
apply with respect to component products, according to
petitioner.
Petitioner argues that the language in Q&A-12 clearly states
that the role of Q&A-1, with respect to component products, is to
determine U.S. affiliate expenses at the integrated product
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level; i.e., to determine the aggregate of U.S. affiliate
expenses allocable and apportionable to the gross income from the
integrated product containing the component product. Q&A-12 then
prescribes the PCR as the exclusive basis for allocating and
apportioning those expenses to the component possession product.
Petitioner argues that under the plain meaning of the regulation,
the PCR applies to all U.S. affiliate expenses allocable and
apportionable to the integrated product; i.e., syrup and soft
drinks.
Furthermore, argues petitioner, the example in Q&A-12
confirms this interpretation. In the example, expenses of the
U.S. affiliates are allocated and apportioned to the integrated
product, computers, and then apportioned to the component
product, central processing units, using the PCR. Thus,
petitioner argues, the example provided in Q&A-12 supports the
plain meaning of the regulation.
Respondent contends that on the facts before us, section
936(h)(5)(C)(ii)(II), as interpreted by Q&A-1, requires that all
expenses that USA incurs, and those CBO expenses that are
factually related to concentrate gross income, be apportioned in
full to such income. Respondent argues that Congress did not
intend the results that flow from petitioner's application of the
PCR to U.S. affiliates' expenses known to be factually related
to, and therefore allocable and apportionable solely to, the
gross income derived from CRI's component concentrate. With
- 23 -
respect to expenses incurred by petitioner's corporate and USA
divisions, the amount of expenses apportionable to CRI's
component concentrate gross income can be precisely quantified,
according to respondent. Petitioner concedes, for purposes of
the instant motion, that USA incurred approximately the same
amount of expense, on a per-gallon basis, regardless of whether
USA sold the concentrate to third parties in its integrated form
or in its unchanged form. Thus, respondent argues that USA
expenses factually attributable to the concentrate must be
allocated and apportioned in full to such concentrate regardless
of whether it is sold in an unchanged form or in a component
form.
According to respondent, section 936(h)(5)(C)(ii)(II)
governs all computations of combined taxable income and adopts a
facts-and-circumstances test for apportioning U.S. affiliates'
expenses to the gross income derived from covered sales of a
possession product regardless of the form in which the possession
product is sold.4 Congress mandated this approach, argues
respondent, by enacting language borrowed directly from section
861. Respondent argues that the phrase "properly apportioned or
allocated" is a term of art borrowed verbatim from section
861(b), and enactment of this particular phrase should be
4
The term "covered sales" means sales by members of the
affiliated group (other than foreign affiliates) to persons who
are not members of the affiliated group or to foreign affiliates.
Sec. 936(h)(5)(C)(ii)(IV).
- 24 -
interpreted as a directive from Congress to apply the section
1.861-8, Income Tax Regs., expense allocation and apportionment
regime in performing CTI computations.
The principles under section 1.861-8, Income Tax Regs.,
require that all deductions must be allocated to the class or
classes of gross income to which they are factually related.
Deductions are incurred with respect to activities and properties
that generate particular classes of gross income, or which
generate all classes of gross income, and that are definitely
related to those classes of gross income.
These principles, according to respondent, require that
deductions be apportioned between gross income derived from the
possession product (the statutory grouping) and other gross
income (the residual grouping) using a method that reasonably
reflects the factual relationship between the deductions and the
income assigned to the grouping. Respondent contends that
section 936(h)(5)(C)(ii)(II) adopts a method of apportioning
expenses to possession product gross income which turns upon
factual relationships. Petitioner's alleged misapplication of
the PCR causes gross misapportionments, according to respondent.
Petitioner argues that the plain meaning of Q&A-12 is
consistent with the language and purpose of section
936(h)(5)(C)(ii)(II). Petitioner contends that section
936(h)(5)(C)(ii)(II) provides only general principles for
component products and does not provide specific guidance for
- 25 -
determining the taxpayer's expense, losses, and other deductions
that are properly allocated and apportioned to the gross income
derived from sales of a component possession product. Indeed,
there is no specific reference anywhere in section 936(h) to
component possession products or the computation of CTI with
respect to component possession products, asserts petitioner.
Section 936(h)(7) authorizes and directs the Secretary to
prescribe such regulations as may be necessary or appropriate to
carry out the purposes of section 936(h), and, according to
petitioner, Q&A-12 is the provision the Secretary chose to
prescribe to fill the statutory gap. Thus, petitioner argues,
respondent chose to (1) make Q&A-12 the exclusive procedure for
computing CTI with respect to component possession products and
(2) chose to use a formulary apportionment method in order to
make such computation. Undoubtedly, other procedures for
computing CTI for component possession products could have been
prescribed, and other procedures might be thought by some to
produce "better" results, argues petitioner. The procedures
adopted in Q&A-12 were chosen, however, and are fully consistent
with the language and purpose of section 936(h)(5)(C)(ii)(II).5
5
Other procedures were recommended to the Treasury and IRS,
and another procedure has been proposed by the Commissioner for
taxable years beginning after 1993. Under the proposed
amendment, CTI for a component possession product is determined
by applying the PCR to the CTI for the integrated product
containing the component possession product. See Notice of
Proposed Rulemaking, 59 Fed. Reg. 1690 (Jan. 12, 1994).
- 26 -
Petitioner argues that having prescribed an allocation and
apportionment procedure that could either favor or disfavor a
taxpayer, depending on the circumstances, respondent should not
be permitted to selectively enforce the provision by challenging
its application for particular taxpayers. Petitioner
acknowledges that it obtains favorable results by applying Q&A 12
as written. The results produced by applying Q&A-12, however, do
not justify overriding the plain language of the regulation.
Petitioner contends that a plain and unambiguous provision may be
judicially overridden only if it produces grossly or patently
absurd results.
Respondent argues that petitioner's interpretation of Q&A-12
improperly limits the role of Q&A-1, contrary to clear
indications that Q&A-1 must be accorded a broad scope.
Respondent contends that petitioner's interpretation of Q&A-12 is
plainly at odds, not only with the express broad terms of Q&A-1,
but also with section 936. Q&A-1 is intended to state the
standards by which all expenses attributable to the possession
product must be allocated and apportioned regardless of the form
in which the possession product is sold to the third parties,
asserts respondent. Q&A-1 must be given a broad scope of
application in making allocations and apportionments of expenses
directly to the possession products in all situations where
expenses can be so apportioned using the methods provided in
section 1.861-8, Income Tax Regs. Respondent argues that in
- 27 -
apportioning expenses to component possession product gross
income, the PCR of Q&A-12 plays a complementary and supportive
role, not an exclusive role.
Furthermore, respondent contends that the example in Q&A-12
is merely illustrative and does not authorize petitioner's
interpretation. Illustrative examples must be interpreted so as
to effectuate the statutory language and purpose, according to
respondent, and Q&A-12 must not be interpreted in a manner which
restricts or conflicts with the statute or with Q&A-1.
Respondent contends that if an example in the regulations is
inconsistent with the text of the regulation, the example must
yield and the regulatory text is given effect.
Petitioner argues that the plain meaning of Q&A-12 does not
unduly restrict the scope of Q&A-1. Q&A-12 complements Q&A-1 by
prescribing the method by which CTI is computed for possession
products sold in component form. Q&A-1 provides rules for
allocating and apportioning U.S. affiliate expenses with respect
to sales of possession products in general; Q&A-12 provides rules
prescribing the manner in which U.S. affiliate expenses are to be
allocated and apportioned with respect to component possession
products.
C. Analysis: Legislative Regulations Generally
First, we must determine the roles that Q&A-1 and Q&A-12
play in the instant case. After determining which provision
plays the primary role, we must then determine, under section
- 28 -
936, the manner of computing combined taxable income and the
method by which expenses are to be allocated and apportioned
under the facts of the instant case.
There is no specific reference anywhere in section 936(h) to
component products or the computation of combined taxable income
with respect to component products. The computation of combined
taxable income with respect to component possession products
under the profit-split method is prescribed in Q&A-12. The
formulary apportionment method prescribed in Q&A-12 determines
the manner in which U.S. affiliate expenses are apportioned to
the gross income derived from covered sales of the component
possession product.
Section 1.936-6(b)(1), Income Tax Regs., was promulgated
pursuant to a specific statutory grant of authority under section
936(h)(7). Where the Commissioner acts under a specific grant of
authority, our primary inquiry is whether the regulation is not
contrary to the statute and is not arbitrary or capricious.
Rowan Cos. v. United States, 452 U.S. 247 (1981); Florida
Manufactured Housing Association, Inc. v. Cisneros, 53 F.3d 1565,
1572 (11th Cir. 1995); CWT Farms, Inc. v. Commissioner, 755 F.2d
790, 800 (11th Cir. 1985), affg. 79 T.C. 86 (1982).
Congress' delegation of rulemaking power was expressed in S.
Rept. 960, 70th Cong., 1st Sess. (1928), 1939-1 C.B. (Part 2)
409, 419, as follows:
- 29 -
The Committee believes it to be impractical to attempt
by legislation to prescribe the various detailed and
complicated rules necessary to meet the many differing
and complicated situations. Accordingly, it has found
it necessary to delegate power to the Commissioner to
prescribe regulations legislative in character covering
them. * * *
See also Tate & Lyle, Inc. & Subs. v. Commissioner, 103 T.C. 656(1994).
Section 1.936-6(b), Income Tax Regs., is a legislative
regulation containing substantive rules. As such, the regulation
is entitled to greater weight and deference than an interpretive
regulation issued pursuant to the Commissioner's general grant of
authority to prescribe needful rules and regulations under
section 7805(a). CWT Farms, Inc. v. Commissioner, supra at 800;
Tate & Lyle, Inc. & Subs. v. Commissioner, supra at 666; Perkin-
Elmer Corp. & Subs. v. Commissioner, 103 T.C. 464 (1994).
A legislative regulation is made pursuant to a specific
grant of authority, often without precise congressional guidance,
to define a statutory term or prescribe a method of executing a
statutory provision. Chevron U.S.A., Inc. v. Natural Res. Def.
Council, Inc., 467 U.S. 837, 843-844 (1984); Anderson, Clayton &
Co. v. United States, 562 F.2d 972 (5th Cir. 1977).
In section 936(h)(7), Congress has delegated to the
Commissioner authority to act in an essentially legislative
manner to fill in the gaps of the statute. If the Commissioner's
interpretation is reasonable, it will not be supplanted with our
own. Florida Manufactured Housing Association, Inc. v. Cisneros,
- 30 -
supra at 1571-1572; see United States v. Cartwright, 411 U.S.
546, 550 (1973); RJR Nabisco, Inc. v. United States, 955 F.2d
1457, 1464 (11th Cir. 1992).
In Chevron U.S.A., Inc. v. Natural Res. Def. Council, Inc.,
supra at 842-843, the Supreme Court stated the following:
When a court reviews an agency's construction of
the statute which it administers, it is confronted with
two questions. First, always, is the question whether
Congress has directly spoken to the precise question at
issue. If the intent of Congress is clear, that is the
end of the matter; for the court, as well as the
agency, must give effect to the unambiguously expressed
intent of Congress. If, however, the court determines
Congress has not directly addressed the precise
question at issue, the court does not simply impose its
own construction on the statute, as would be necessary
in the absence of an administrative interpretation.
Rather, if the statute is silent or ambiguous with
respect to the specific issue, the question for the
court is whether the agency's answer is based on a
permissible construction of the statute. [Emphasis
added; fn refs. omitted.]
Our primary inquiry in the case of a legislative regulation
is whether the interpretation or method prescribed therein is
within the delegation of authority. Regardless of whether the
regulation at issue is legislative or interpretive, it is
appropriate to ascertain whether the regulation harmonizes with
the plain language of the statute, its origin, and its purpose in
order to determine whether the regulation carries out the
congressional mandate in a proper manner. United States v. Vogel
Fertilizer Co. 455 U.S. 16, 24-26 (1982); CWT Farms, Inc. v.
Commissioner, supra at 801.
- 31 -
As legislative regulations are essentially substantive rules
of law, the rules of interpretation applicable to statutes are
appropriate tools of analysis. KCMC, Inc. v. FCC, 600 F.2d 546,
549 (5th Cir. 1979); Intel Corp. & Consol. Subs. v. Commissioner,
100 T.C. 616, 630 (1993), affd. 67 F.3d 1445 (9th Cir. 1995);
Phillips Petroleum Co. v. Commissioner, 101 T.C. 78, 97 (1993),
affd. without published opinion ___F.3d___ (10th Cir., Nov. 28,
1995). Statutes are to be construed so as to give effect to
their plain and ordinary meaning unless to do so would produce an
absurd result. Green v. Bock Laundry Machine Co., 490 U.S. 504,
509 (1989); United States v. NEC Corp., 931 F.2d 1493, 1498 (11th
Cir. 1991); Blue Cross & Blue Shield v. Weitz, 913 F.2d 1544,
1548 (11th Cir. 1990); Exxon Corp. v. Commissioner, 102 T.C. 721(1994).
Where a statute is clear on its face, we require unequivocal
evidence of legislative purpose before construing the statute so
as to override the plain meaning of the words used therein.
Halpern v. Commissioner, 96 T.C. 895 (1991). All parts of a
statute must be read together, and each part should be given its
full effect. D. Ginsberg & Sons, Inc. v. Popkin, 285 U.S. 204,
208 (1932); Estate of Dupree v. United States, 391 F.2d 753, 757
(5th Cir. 1968); McNutt-Boyce Co. v. Commissioner, 38 T.C. 462,
469 (1962), affd. per curiam 324 F.2d 957 (5th Cir. 1963).
Unless exceptional circumstances dictate otherwise, when we find
the terms of a statute unambiguous, judicial inquiry is complete.
- 32 -
Burlington N. R.R. v. Oklahoma Tax Commn., 481 U.S. 454, 461
(1987); United States v. NEC Corp., supra at 1498.
Thus, the party who seeks to convince a court to adopt a
reading of a statute which is at odds with its plain meaning
labors under a heavy burden. United States v. NEC Corp., supra
at 1499.
Consistent with the foregoing, we examine the historical
development of section 936 and determine whether the regulation
implements the congressional mandate in a reasonable manner.
D. Analysis: Section 1.936-6(b)(1), Q&A-1 & -12, Income
Tax Regs.
Section 936 has its genesis in section 262 of the Revenue
Act of 1921, ch. 136, 42 Stat. 271, which exempted a U.S.
corporation from Federal taxes on foreign-source income if it
derived at least 80 percent of its income from sources within a
possession and satisfied certain other requirements. The
requirements for exemption from tax as a possessions corporation
were carried forward without material change into section 931 of
the Internal Revenue Code of 1954. In the Tax Reform Act of
1976, Congress eliminated the exemption and in its place enacted
the tax credit mechanism of section 436. Tax Reform Act of 1976,
Pub. L. 94-455, sec. 1051, 90 Stat. 1643.
Congressional intent for section 931 and its predecessors
consistently has been the encouragement of American business
investments in possessions of the United States. American
- 33 -
companies operating in the possessions originally were subjected
to double taxation by the imposition of both the Federal
corporate income tax and the taxes levied by the possessions
governments. Tariff Act of 1913, ch. 16, sec. II, 38 Stat. 166;
Revenue Act of 1918, ch. 18, 40 Stat. 1058.
Congress perceived that the tax burden so created placed
American businesses at a competitive disadvantage when compared
with their British and French counterparts not subject to
taxation upon the profits they earned abroad unless paid back to
the home company. Congress consequently enacted the original
version of section 931 to remove that competitive disadvantage.
H. Rept. 350, 67th Cong., 1st Sess. 1 (1921), 1939-1 C.B. (Part
2) 168, 174.
Section 931 provided corporations an exclusion for
possession-source income if they met the "80-percent source" test
and the "50-percent active trade or business" test.6 Because of
6
Sec. 931 provided as follows:
SEC. 931. INCOME FROM SOURCES WITHIN POSSESSIONS
OF THE UNITED STATES.
(a) General Rule.--In the case of
citizens of the United States or domestic
corporations, gross income means only gross
income from sources within the United States
if the conditions of both paragraph (1) and
paragraph (2) are satisfied:
(1) Three-year period.--If 80 percent or
more of the gross income of such citizen or
domestic corporation (computed without the
(continued...)
- 34 -
the exclusion, and because dividends received by a domestic
corporation from its wholly owned possessions subsidiary were not
eligible for the intercorporate dividends received deductions
under section 246(a)(2)(B), possessions corporations amassed
large amounts of income not repatriated to the United States.
To encourage investment of possessions-source earnings in
the United States, Congress, in 1976, enacted section 936. Tax
Reform Act of 1976, Pub. L. 94-455, sec. 1051, 90 Stat. 1643.
The Tax Reform Act of 1976 revised prior law, providing for a
more efficient system for exemption of possessions corporations
in order to prevent the possessions from losing a significant
source of capital. In place of the exemption mechanism contained
in section 931, section 936 permits a U.S. corporation to elect a
tax credit to offset the U.S. tax on its possessions income.
6
(...continued)
benefit of this section) for the 3-year
period immediately preceding the close of the
taxable year (or for such part of such
period immediately preceding the close of
such taxable year as may be applicable) was
derived from sources within a possession of
the United States; and
(2) Trade or business.--If--
(A) in the case of such
corporation, 50 percent or more of its
gross income (computed without the
benefit of this section) for such period
or such part thereof was derived from
the active conduct of a trade or
business within a possession of the
United States * * *
- 35 -
Thus, the current version of the investment incentive takes the
form of a tax credit rather than an exemption.
It is clear from the legislative record that Congress was
aware of the highly favorable tax benefits afforded U.S.
corporations operating in Puerto Rico. It is equally clear that
Congress intended to retain and reaffirm such tax benefits by
enacting section 936. The Senate Finance Committee and the House
of Representatives Committee on Ways and Means stated the
following, in virtually identical reports:
The special exemption provided (under sec. 931)
in conjunction with investment incentive programs
established by possessions of the United States,
especially the Commonwealth of Puerto Rico, have been
used as an inducement to U.S. corporate investment in
active trades and businesses in Puerto Rico and the
possessions. Under these investment programs little or
no tax is paid to the possessions for a period as long
as 10 to 15 years and no tax is paid to the United
States as long as no dividends are paid to the parent
corporation.
Because no current U.S. tax is imposed on the
earnings if they are not repatriated, the amount of
income which accumulates over the years from these
business activities can be substantial. The amounts
which may be allowed to accumulate are often beyond
what can be profitably invested within the possession
where the business is conducted. As a result,
corporations generally invest this income in other
possessions or in foreign countries either directly or
through possessions banks or other financial
institutions. In this way possessions corporations not
only avoid U.S. tax on their earnings from businesses
conducted in a possession, but also avoid U.S. tax on
the income obtained from reinvesting their business
earnings abroad.
The committee after studying the problem
concluded that it is inappropriate to disturb the
existing relationship between the possessions
- 36 -
investment incentives and the U.S. tax laws because of
the important role it is believed they play in keeping
investment in the possessions competitive with
investment in neighboring countries. * * * [S. Rept.
94-938, at 277-278 (1976), 1976-3 C.B. (Vol. 3) 57,
315-316; H. Rept. 94-658 (1975), 1976-3 C.B. (Vol. 2)
945, 946-947; emphasis added.]
Thus, under both section 936 and its predecessor section
931, possessions corporations are and have been effectively
exempt from tax on income from possessions sources. This
exemption applied to income from intangibles created by such
corporation or acquired from an unrelated party. In 1982,
Congress added subsection (h) to section 936.7 Tax Equity and
Fiscal Responsibility Act of 1982, Pub. L. 97-248, sec. 213, 96
Stat. 452. Subsection (h) was added in order to lessen the abuse
caused by taxpayers claiming tax-free income generated by
intangibles developed outside of Puerto Rico. See H. Conf. Rept.
97-760, at 505 (1982), 1982-2 C.B. 600, 617.
Section 936(h)(1) provides that any income of an electing
corporation attributable to intangible property is deemed to be
the income of, and is taxable to, the shareholders of the section
936 corporation. Where income is derived from the sale of an
intangible possessions product, taxable income generally is
computed under section 936(b)(1)-(4). A section 936 corporation
7
Sec. 936(h) was added to the Code in response to issues
raised in Eli Lilly & Co. v. Commissioner, 84 T.C. 996 (1985),
affd. in part, revd. in part and remanded 856 F.2d 855 (7th Cir.
1988). See H. Conf. Rept. 97-760, at 504 n.* (1982), 1982-2 C.B.
600, 617.
- 37 -
may, however, “elect out” under section 936(h)(5) and choose to
compute its taxable income under one of two methods: (1) The
cost-sharing method; or (2) the profit-split method. Pursuant to
either method, the stockholders of the section 936 corporation
are taxed on a share of the income generated from intangible
assets.
Congress recognized in enacting section 936(h) that some
section 936 corporations produce products that are not sold to
unrelated parties, but rather are transferred to affiliates and
used as component parts in the production of other products that
are then sold by the affiliates to unrelated parties. The
statute, however, does not provide any specific rules for the
computation of combined taxable income in such a case. Rather,
Congress directed the Treasury to write the rules with respect to
such component products. Sec. 936(h)(7). The conference report
accompanying the enactment of section 936(h) instructs the
Secretary to:
prescribe regulations providing for appropriate
treatment in cases where the island affiliate * * *
produces a component which it sells to an affiliate for
incorporation into a product sold to third parties.
[H. Conf. Rept. 97-760, supra at 508, 1982-2 C.B. at
619.8]
We conclude that section 1.936-6(b)(1) Q&A-12, Income Tax
Regs., establishes a permissible method for computing CTI where
8
Sec. 936(h)(7) was redesignated as sec. 936(h)(8) by the
Technical and Miscellaneous Revenue Act of 1988, Pub. L. 100-647,
sec. 1012(h)(2)(B), 102 Stat. 3502.
- 38 -
the possession product is a component product. In evaluating the
regulations under section 936, we are mindful of the Supreme
Court's admonition: "The choice among reasonable interpretations
is for the Commissioner, not the courts." National Muffler
Dealers Association, Inc. v. United States, 440 U.S. 472, 488
(1979). Provided that Q&A-12 is neither unreasonable nor plainly
inconsistent with the statute, it will be upheld. Bingler v.
Johnson, 394 U.S. 741, 750 (1969); RJR Nabisco, Inc. v. United
States, 955 F.2d at 1464.
The legislative history of section 936, as a whole, is
silent on the precise issue before us. The legislative history
does, however, make clear Congress' consistent intention to
maintain the favorable tax benefit of operating in a U.S.
possession, and we find that the application of the PCR in Q&A-12
in the instant case is fully consistent with that intention.
The regulatory scheme under section 936 is technical and
complex, and we find that the Commissioner considered the
treatment of possession products in a detailed and reasoned
fashion before making a final decision.9 Section 936 does not
specifically define the term “CTI”, nor does the statute provide
a clear method for allocating and apportioning expenditures in
9
As is customary, the IRS invited interested members of the
public to submit written comments with respect to proposed
regulations interpreting sec. 936 as amended by the Tax Equity
and Fiscal Responsibility Act of 1982. Numerous comments were
received and considered. See 47 Fed. Reg. 53746 (Nov. 29, 1982).
- 39 -
computing CTI under the facts before us. The term CTI, and the
method for computing such, for purposes relevant here, however,
is defined in Q&A-12. General language of a statutory provision
will not be held to apply to a matter specifically dealt with in
another part of the same enactment; specific terms prevail over
the general. D. Ginsberg & Sons, Inc. v. Popkin, 285 U.S. at
208; Dupree v. United States, 391 F.2d 753, 758 (5th Cir. 1968).
Under the profit-split method, the electing corporation's
taxable income derived from products produced in a possession
equals 50 percent of the combined taxable income of the
affiliated group derived from covered sales of these products.
Sec. 936(h)(5)(C)(ii)(II). Combined taxable income is the gross
income of the affiliated group derived from covered sales of the
possession product less all expenses properly apportioned and
allocated to such income.
Q&A-1 describes the proper allocation and apportionment of
expenses in computing CTI with respect to soft-drink concentrate
produced by CRI and sold by U.S. affiliates in unchanged form to
unrelated bottlers. If, however, the possession product is
simply a component of a final product, then Q&A-12 prescribes the
manner of computing CTI.
Q&A-12 prescribes the method for determining CTI with
respect to component products. Under that method, the expenses
which the affiliated group allocated and apportioned to the
integrated product, i.e., syrup and soft drink, must be further
- 40 -
apportioned to the possession product, i.e., the soft-drink
concentrate. The latter apportionment is based on the ratio of
the production costs for the possession product to the total
production costs for the integrated product.
In using this formulaic method to arrive at CTI, it becomes
clear that the greater the expense allocation to the concentrate,
the lower the CTI, and, thus, the smaller the credit.
Conversely, the lesser the expense allocation to the concentrate,
the higher the CTI, and, thus, the greater the credit. In the
example in Q&A 12, the taxpayer's PCR is 80 percent. This is
because the production costs incurred at the possessions level
are high relative to total production costs. Petitioner,
however, has relatively low PCR's with respect to its component
product, which, as stated earlier, results in a quite favorable
tax benefit. The use of a formula will cut both ways; it will be
beneficial to some and not so beneficial to others. That is the
intrinsic nature of formulas.
Essentially, respondent is arguing that, at each level, the
application of the PCR impermissibly misapportions away from the
component concentrate expenses that are known and admitted to be
factually related to the concentrate, which in turn inflates the
CTI figure, causing the sheltering of post-allocation income. We
find that the focus of respondent's argument appears to center on
the wisdom of the choice between two alternatives; i.e., a
formulaic versus a fact-based approach, rather than on whether
- 41 -
the choice made was a reasonable choice within a gap left open by
Congress.
Q&A-12 contains no mention of "factual relationships" or
"economic consequences". It merely provides a formula used in
calculating CTI in order to determine the amount of credit under
section 936. There is no doubt and no dispute that (1)
petitioner qualifies for the section 936 credit, and (2) CRI made
a valid election to use the profit-split method under section
936.
Currently, in response to the instant case, the Commissioner
has opened a new regulation project regarding the computation of
CTI under section 936(h). The proposed regulation contains,
again, a formulary rather than a factual approach attacking the
issue from the income side as opposed to the expense side. The
proposed regulation makes no mention of factual relationships or
economic reality.
We find that Q&A-12 is clear on its face, and respondent's
strained interpretation of the relationship between Q&A-1 and
Q&A-12 is merely an attempt to persuade this Court to
retroactively revise the regulation. Until the regulation is
changed, reflecting the Commissioner's proposed amendments to
Q&A-12, taxpayers are entitled to the tax benefit generated under
Q&A-12.
Additionally, we find that the formulaic method prescribed
in Q&A-12 is consistent with Congress' intent to encourage
- 42 -
investment in U.S. possessions, and consequently, we find that
Q&A-12 is not inconsistent with any stated congressional intent.
Q&A-12 could have been written to require simply that
expenditures be allocated and apportioned in a manner consistent
with the rules set forth in section 1.861-6, Income Tax Regs.,
but it was not.
The fact that other methods might also be reasonable, or
even preferable, however, does not warrant our overturning a
regulation which itself has a reasonable basis. Brown & Root v.
TVA, 681 F.2d 1313, 1316-1317 (11th Cir. 1982). Even presuming
that we might disagree with the results of applying the PCR in
the instant case, we would not substitute our own construction of
the statute for that of the Secretary where the regulation
implements the congressional mandate in a reasonable manner. See
Florida Manufactured Housing Association, Inc. v. Cisneros, 53
F.3d at 1572-1573. Respondent may not ignore the requirements
set forth in the plain language of the regulations any more than
petitioner or other taxpayers. Intel Corp. & Consol. Subs. v.
Commissioner, 100 T.C. at 630.
We cannot conclude that the regulation at issue presents an
impermissible construction of section 936(h). The Commissioner
was delegated the authority to make choices among reasonable
alternatives in interpreting section 936(h) and did so.
After considering the regulation in light of the language of
section 936(h) and the purpose behind it, we are satisfied that
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section 1.936-6(b)(1) Q&A-12, Income Tax Regs., constitutes a
valid exercise of the Secretary's regulatory authority. We
conclude that Q&A-12 is the controlling provision in the instant
case.
E. Exxon
Respondent argues in the alternative that this Court's
opinion in Exxon Corp. v. Commissioner, 102 T.C. 721 (1994),
provides an independent basis for denying the instant motion as
the application of Q&A-12 to the facts of the instant case would
cause absurd results. Petitioner, citing Abdalla v.
Commissioner, 647 F.2d 487, 497 (5th Cir. 1981), affg. 69 T.C.
697 (1978), contends that the plain and unambiguous meaning of a
provision may be overridden only in rare and exceptional
circumstances where the result of giving the provision its plain
and unambiguous meaning would be so absurd as to "shock the
general moral or common sense" and be against clear legislative
intent.
Petitioner argues that respondent's reliance on Exxon Corp.
v. Commissioner, supra, is misplaced, and that respondent is
essentially asking this Court to rewrite the applicable
regulations. We agree. We find that Exxon Corp. is
distinguishable from the instant case.
Exxon received a known and quantifiable amount of income
from sales of natural gas in 1979. Exxon claimed a 22-percent
depletion allowance on an amount larger than the actual sales
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proceeds from that gas. This larger amount against which the
depletion allowance was taken was derived from determining gross
income under the "representative market" or "field price" method
under the regulations. The issue in Exxon Corp. was the method
of computing “gross income from the property” for purposes of the
depletion allowance. See sec. 613(a). The statute itself was
silent on this issue. The regulation defined gross income in
terms of the representative market or field price, which in that
case produced hypothetical gross income far in excess of actual
gas sales.
The Commissioner argued that Exxon was not entitled to a
percentage depletion deduction based upon a hypothetical "gross
income from the property", which exceeded Exxon's actual gross
income from the sale of gas. The Commissioner maintained that
the "gross income from property", for purposes of percentage
depletion, must not exceed the actual gross income from the sale
of gas, and under those circumstances, the Commissioner was
entitled to employ a net-back methodology in determining "gross
income from the property". Exxon argued that under the plain
meaning of section 1.613-3(a), Income Tax Regs., it was required
to compute its percentage depletion deduction by using the
representative market or field price of the gas.
Section 611 allows a "reasonable allowance for depletion" in
the case of oil and gas wells "according to the peculiar
conditions in each case". Section 613(a) provides for a
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percentage depletion deduction based upon a percentage of a
taxpayer's "gross income from the property". Section 611(a)
provides that reasonable depletion allowance in all cases is to
be made under regulations prescribed by the Secretary.
Although the statute was silent as to the definition of
"gross income from the property" as it related to the facts in
Exxon Corp. v. Commissioner, supra, section 1.613-3(a), Income
Tax Regs., provided that "gross income from the property" is:
the amount for which the taxpayer sells the oil or gas
in the immediate vicinity of the well. If the oil or
gas is not sold on the premises but is manufactured or
converted into a refined product prior to sale, or is
transported from the premises prior to sale, the gross
income from the property shall be assumed to be
equivalent to the representative market or field price
of the oil or gas before conversion or transportation.
Exxon argued that, under the literal terms of section 1.613-
3(a), Income Tax Regs., where the gas is transported from the
premises prior to sale, the Commissioner cannot use a net-back
methodology to determine gross income from the property.
The Commissioner argued that not only was Exxon's
interpretation of the regulation at issue flawed, it also was
inconsistent with the legislative history behind percentage
depletion. Exxon essentially argued that, under the ordinary or
plain meaning rule, the literal terms of the regulation at issue
must be followed without further analysis.
We held that the rules of statutory construction require us
to determine whether the "plain meaning" of a regulation would
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have a nonsensical result. Exxon Corp. v. Commissioner, supra at
728. We held further that the plain meaning rule does not
preclude an examination behind the literal terms of the language
at issue if the lack of such an examination would compel an odd
result. Exxon Corp. v. Commissioner, supra at 728 (citing Public
Citizen v. United States, 491 U.S. 440, 454 (1989)).
We examined the legislative purpose and history of
percentage depletion to ascertain whether and to what extent the
statutory framework was consistent with a literal interpretation
of the regulation at issue. In so doing, we found that the plain
meaning of the regulation, as applied to the facts before us in
Exxon Corp., was against clear and longstanding congressional
intent.
Accordingly, we found that in computing allowance for
percentage depletion, it was unreasonable for Exxon to determine
its 1979 "gross income from the property" for sales of natural
gas, after the gas was transported away from the wellhead, by the
method provided for in the last sentence of section 1.613-3(a),
Income Tax Regs., the representative market or field price
method, where those prices resulted in a "gross income from the
property" five times Exxon's actual contract sales revenue.
In the instant case, however, the only clear and consistent
congressional intent expressed with respect to the possession tax
credit regime is the encouragement of U.S. business operations in
U.S. possessions. We do not find that the application of the
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plain meaning of Q&A-12 in the instant case is inconsistent with
this stated policy. Indeed, no clear, longstanding congressional
intent exists with respect to the issue presented in the instant
case.
Many tax provisions provide for favorable tax results, and
to conclude that a provision as applied is absurd simply because
the tax benefit is substantial is unwarranted. The results that
flow from the use of the PCR in the instant case, while quite
beneficial to petitioner, are not unreasonable or unsound and
certainly do not shock the general moral or common sense.
Respondent argues that applying the PCR to apportion less
than the full amount of the expenses known to be factually
related to the component possession product causes absurd
results. The Commissioner, however, chose to implement a
formulaic method; i.e., the PCR. Formulas by their very nature
are arbitrary, and their use is intended to minimize factual
disputes.
Respondent asks this Court, in effect, to rewrite the
regulations in order to avoid a result which Q&A-12 clearly
requires. Until Congress or the Secretary acts to modify the
result of Q&A-12, we will apply Q&A-12 as written.
We find that Exxon Corp. v. Commissioner, supra, is
distinguishable from the instant case and is therefore not
dispositive of the instant motion.
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III. Conclusion
Accordingly, we find that section 1.936-6(b)(1) Q&A 12,
Income Tax Regs., (1) governs the computation of combined taxable
income with respect to sales of component concentrate produced by
CRI and sold by petitioner to unrelated third parties, (2)
requires U.S. affiliate expenses to be allocated and apportioned
to the component concentrate by applying the production cost
ratio to all expenses allocable and apportionable to the
integrated product, i.e., bottle and can soft drink, and (3)
requires U.S. affiliate expenses allocable and apportionable to
the integrated product, i.e., bottle and can soft drink, to be
determined under section 1.861-8, Income Tax Regs., as described
in section 1.936-6(b)(1), Q&A-1, Income Tax Regs.
We find further, on the basis of Bowater Inc. v.
Commissioner, 101 T.C. 207 (1993), that petitioner is entitled to
offset interest income against interest expense in determining
the amount of interest deduction to be allocated and apportioned
in computing combined taxable income under section 936 and
section 1.861-8(e)(2), Income Tax Regs.
To reflect the foregoing,
An appropriate order
will be issued granting
petitioner’s motion for
partial summary judgment.