ASAT, Inc. v. Commissioner

108 T.C. No. 11UNITED STATES TAX COURT
ASAT, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 3173-95. Filed March 31, 1997.
P, a wholly owned domestic subsidiary, purchased
assembly services from its parent, a foreign
corporation. During an IRS audit of P's 1991 Federal
corporate income tax return, the IRS notified P that it
would need to be appointed its parent's limited agent
under sec. 6038A(e)(1), I.R.C. P did not obtain the
authorization of agent before R issued a notice of
deficiency. Consequently, pursuant to sec.
6038A(e)(3), I.R.C., which grants the Commissioner the
authority to determine in her sole discretion the cost
of goods sold and deductions arising out of
transactions between a domestic corporation and a
related foreign corporation, R determined that P's cost
of goods sold should be decreased and eliminated a net
operating loss (NOL) carryforward which originated from
P's 1989 and 1990 tax years. In addition, R disallowed
P's deduction for consulting fees paid to an unrelated
domestic corporation and applied the accuracy-related
penalty.
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Held, sec. 6038A, I.R.C., applies to P for the
year at issue. Held, further, P failed to obtain the
authorization of agent required by sec. 6038A(e)(1),
I.R.C. Held, further, R did not abuse her discretion
when she adjusted P's cost of goods sold and NOL under
sec. 6038A(e)(3), I.R.C. Held, further, P may not
deduct the consulting fees as it did not prove that the
expense was ordinary and necessary. Held, further, P
is liable for the accuracy-related penalty.
James E. Merritt, Linda A. Arnsbarger, and Thomas H. Steele,
for petitioner.1
Mary E. Wynne, Michael F. Steiner, and Grace L. Perez-
Navarro, for respondent.
VASQUEZ, Judge: Respondent determined a deficiency in
petitioner's Federal income tax in the amount of $407,592 and an
accuracy-related penalty under section 6662(a)2 of $81,518 for
its taxable year ending April 30, 1991. Although respondent gave
alternative grounds for each adjustment in the notice of
deficiency, her first ground in regard to petitioner's cost of
goods sold and net operating loss was section 6038A(e)(3), which
grants the Commissioner the authority to determine in her sole
discretion the cost of goods sold and expenses arising out of
transactions between a domestic corporation and a related foreign
1
Counsel of record during the trial and briefing of this
case was Martin A. Schainbaum.
2
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
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corporation (the section 6038A issues). As resolution of the
section 6038A issues could negate the need for a trial of issues
involving section 482 (section 482 was an alternative ground for
the adjustments), we conducted a separate trial of the section
6038A issues. With this background in mind, the issues for
decision are:
(1) Whether section 6038A applies to petitioner for its tax
year ending April 30, 1991; and, if so,
(2) whether there was a failure to authorize petitioner as
its parent's agent under section 6038A(e)(1); and, if so,
(3) whether respondent's determination under section
6038A(e)(3), reducing petitioner's cost of goods sold by
$1,494,437, was an abuse of discretion;3
(4) whether respondent's determination under section
6038A(e)(3), eliminating petitioner's NOL carryforward of
$165,147, was an abuse of discretion;
(5) whether petitioner may deduct consulting fees of
$280,922;4 and
(6) whether petitioner is liable for the accuracy-related
penalty under section 6662(a) for negligence.
3
References to "abuse of discretion", unless otherwise
indicated, are in the context of a sec. 6038A analysis.
4
Petitioner's entitlement to the consulting fee deduction
is not a sec. 6038A issue. See infra.
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FINDINGS OF FACT
Petitioner, ASAT, Inc., is a corporation organized under the
laws of California. At the time the petition was filed, its
principal place of business was in Palo Alto, California.
Petitioner's Organizational Structure
From December 22, 1988, to at least June 30, 1992 (a period
which includes petitioner's fiscal year ended April 30, 1991, the
year in issue), petitioner was a wholly owned subsidiary of ASAT,
Ltd., a Hong Kong corporation. During its fiscal year ended
April 30, 1991, ASAT, Ltd., was 85 percent owned by a subsidiary
of QPL International Holdings Ltd. (QPL), a Bermuda corporation
with offices in Hong Kong. Mr. Li Tung Lok (Mr. Li) was chairman
of the board and the largest single shareholder of QPL during
1990 and 1991. Petitioner became 95 percent owned by Worltek
International Ltd. (Worltek), a domestic corporation organized in
California, when Worltek purchased 95 percent of petitioner's
stock directly from petitioner on July 15, 1992. On November 9,
1994, QPL acquired 100 percent of the stock of Worltek. Hence,
petitioner, once again, became an indirect subsidiary of QPL.
Petitioner's Business5
Petitioner located semiconductor companies (customers) that
wanted their semiconductor dies put into an assembly package.
These customers contracted with petitioner for assembly services
5
Unless otherwise indicated, descriptions of petitioner's
business pertain to its fiscal year ending Apr. 30, 1991.
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to be provided by ASAT, Ltd., petitioner's foreign parent.
Customers provided the product by drop shipment directly to ASAT,
Ltd., in Hong Kong, for assembly. Petitioner coordinated the
transaction, sometimes handling the freight forwarding. ASAT,
Ltd., invoiced petitioner, which then invoiced its customer for
the agreed upon purchase price (the contract price). After the
customer paid petitioner the contract price, petitioner paid the
invoice received from ASAT, Ltd., by remitting 94 percent of the
contract price to ASAT, Ltd., retaining 6 percent for itself.6
During the fiscal year immediately prior to the year in issue,
petitioner paid ASAT, Ltd., 100 percent of the amounts collected
from petitioner's customers.7 Petitioner reported its receipt of
the contract price on its 1991 Federal corporate income tax
return (tax return) as "Gross receipts or sales". Petitioner
reported its payments to ASAT, Ltd. for assembly services under
"Cost of goods sold".8
6
The 6-percent retained portion of the contract price will
sometimes be referred to as the "gross profit spread" for
convenience. Petitioner and respondent referred to the gross
profit spread as a "commission" and to the 6-percent amount as
the "commission rate" at trial and on brief for convenience.
Although the gross profit spread is similar to a commission, we
are dealing with respondent's determination of the proper amount
of petitioner's payments to its parent, not with the proper
amount of a commission paid by the parent to petitioner.
7
The reason petitioner remitted the entire contract price
to ASAT, Ltd., in the tax year ending Apr. 30, 1990, is not in
the record.
8
The characterization of the payments in question as cost
of goods sold rather than as a deduction does not affect the
(continued...)
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ASAT, Ltd., had no sales people located in the United States
during its fiscal year ended April 30, 1991. Petitioner made
purchases on behalf of ASAT, Ltd. There were no written
agreements between petitioner and ASAT, Ltd., regarding the
purchases petitioner made on ASAT, Ltd.'s, behalf. Petitioner
paid for all advertising in the United States for itself and
ASAT, Ltd.
Internal Revenue Service (IRS) Audit of Petitioner
Respondent's examination of petitioner's tax year ending
April 30, 1991 (hereinafter the examination), began when a
notification of the examination was sent to petitioner on July
17, 1992. The examination continued until December 21, 1994, the
date the statutory notice of deficiency was issued. Nanette
Alexander Hamilton was the International Examiner who examined
petitioner's tax return for the tax year ended April 30, 1991.
During the examination, Ms. Hamilton met with petitioner's tax
counsel, Martin Schainbaum, and with Fe Maliwat, Robert Borawski,
and Conrad Chapple, all representatives of petitioner. Ms.
Maliwat was petitioner's controller from April 13, 1991, to
December 31, 1992. In addition to providing documents to Ms.
Hamilton, Ms. Maliwat responded to inquiries and explained
certain aspects of petitioner's business operations. Mr.
Borawski was petitioner's counsel and corporate secretary during
8
(...continued)
outcome of this case.
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the examination. Mr. Chapple has been petitioner's chief
financial officer and senior executive vice-president from
January 1, 1993, to the present. Prior to 1993, Mr. Chapple was
president of Worltek.
During the examination Ms. Hamilton issued 11 Information
Document Requests (IDR's) to petitioner. Ms. Hamilton asked for
the agreements and the basis of how the pricing, commissions, and
service rates were established between petitioner and ASAT, Ltd.,
as well as agreements between petitioner, ASAT, Ltd., and
unrelated parties. Petitioner never provided these documents,
though petitioner provided copies of invoices to show actual
pricing. By letter dated October 23, 1992, Ms. Hamilton advised
petitioner's tax counsel that she relied on section 6038A as her
authority to request the documents.
Ms. Hamilton requested a worldwide organization chart; Hong
Kong income tax returns filed by ASAT, Ltd.; an audited financial
statement of ASAT, Ltd., covering the period under examination;
internal financial statements of ASAT, Ltd., broken down by
product line and subsidiary location; and business plans, market
studies, feasibility studies, corporate minutes, etc., conducted
or developed by ASAT, Ltd., in relation to the organization and
expectations for petitioner. This documentation was requested
again in a section 6038A summons issued on October 5, 1993.
During a meeting on September 24, 1992, Mr. Schainbaum advised
Ms. Hamilton that petitioner would not produce the information
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requested on the grounds that the "taxpayer is not ASAT, Ltd."
During the meeting on September 24, 1992, Ms. Hamilton advised
Ms. Maliwat of section 6038A, that respondent had the authority
to request documents concerning ASAT, Ltd., and that she needed
the documents to conduct the examination. The worldwide
organization chart, the Hong Kong income tax returns, audited
financial statements, and certain internal financial statements
of ASAT, Ltd., were provided to respondent on October 17, 1995,
after the statutory notice of deficiency was issued. No business
plans, market studies, feasibility studies, or corporate minutes
were provided to respondent. We cannot tell from the record
whether these items existed or were in the possession of
petitioner.
Ms. Hamilton notified petitioner's representatives,
including Mr. Borawski, during a meeting on June 14, 1993, that
she was considering an upward adjustment in petitioner's gross
profit spread to 14 percent by lowering its cost of goods sold.
Petitioner's Business as Described by Petitioner's
Representatives to Ms. Hamilton
During the examination, Ms. Hamilton was told by Mr.
Borawski and Ms. Maliwat that petitioner provided advertising for
the assembly services of ASAT, Ltd. During the initial interview
of the examination, Mr. Borawski advised Ms. Hamilton that
petitioner's business was contract representative services for
ASAT, Ltd.
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During the initial interview, Ms. Hamilton recorded in her
notes that she was told by Mr. Borawski and Ms. Maliwat that
petitioner was at risk of loss if collection of accounts
receivable was not made, that petitioner provided warranties for
the assembly services of ASAT, Ltd., and that petitioner provided
a 30-day warranty on workmanship and labor.
Ms. Maliwat explained to Ms. Hamilton that petitioner
purchased, on behalf of ASAT, Ltd., some materials and equipment.
However, the purchasing effort did not require substantial time
or effort as there were probably only five purchases a week.
IRS's Application of Section 6038A
A. Notice of Noncompliance
On November 25, 1992, respondent sent a certified letter to
petitioner and petitioner's counsel requesting that petitioner be
authorized as agent of ASAT, Ltd. pursuant to the provisions of
section 6038A(e)(1) and section 1.6038A-5 Income Tax Regs. When
respondent issued the request for authorization of agent to
petitioner, Worltek owned 95 percent of petitioner's stock.
Petitioner advised respondent by letter dated January 26, 1993,
that "agency status has not been granted to ASAT, Inc. from ASAT,
Ltd." Petitioner did, however, obtain an authorization of agent
from ASAT, Ltd., on July 26, 1995, after the notice of deficiency
was issued.
On June 14, 1993, respondent sent petitioner a certified
letter notifying petitioner that respondent was considering
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application of section 6038A(e)(3) (hereinafter sometimes
referred to as the noncompliance penalty) for failure to provide
an authorization of agent. On January 3, 1994, respondent sent
petitioner a certified letter notifying petitioner that she had
applied the noncompliance penalty because petitioner had not
provided respondent with its appointment as agent for ASAT, Ltd.,
and that the noncompliance penalty would be reflected in a notice
of deficiency. Respondent also informed petitioner that she
would be applying the noncompliance penalty for failure to comply
with a summons that she issued to petitioner.
B. Information in Commissioner's Possession
At the initial interview of the examination on August 26,
1992, petitioner's representatives provided Ms. Hamilton with the
following documents:
a. Advertising brochures and folders;
b. Table of Contents;
c. Organization;
d. ASAT, Inc. Chart of Accounts;
e. Trial Balance 1991;
f. ASAT, Inc. General Ledger FY 1991;
g. Cash Receipts FY 1991;
h. ASAT, Inc. Cash Disbursements FY 1991;
i. ASAT, Inc. Sales Journal FY 1991;
j. ASAT, Inc. Freight Invoice Journal FY 1991;
k. Adjusting entries;
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l. ASAT, Inc. Intercompany Transactions FY 1991;
m. Interco 1989 & 1990;
n. Form 1120 (1989); and
o. Form 1120 (1990).
All of these documents were in respondent's possession at the
time the notice of deficiency was issued.
Respondent also had the following documents in her
possession when the notice of deficiency was issued:
a. Correspondence between petitioner,
petitioner's counsel, and respondent;
b. notes taken by Ms. Hamilton;
c. initial interview questions and notes of the
initial interview;
d. the Manufacturers' Agents National Association
(MANA) materials;
e. Duns Market Identifier for petitioner dated August
25, 1992; and
f. a copy of petitioner's tax return for the fiscal
year ended April 30, 1992.
C. Information Not Available or Not in Existence
Petitioner did not provide to respondent any budget plans,
work plans, business plans, or other documents showing the
expected income and expenses of petitioner for the years ending
April 30, 1989, through April 30, 1992. Nor did petitioner
provide to respondent any price lists or price guidelines showing
the prices charged by petitioner and/or ASAT, Ltd., to third
parties.
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Petitioner did not make available to respondent any
advertising copy, press releases, brochures, videos, or other
documents distributed to third parties concerning the services
offered by either petitioner or ASAT, Ltd., during the years
ending April 30, 1989, through April 30, 1992.
During the examination, Ms. Hamilton requested information
regarding how petitioner's gross profit spread was set on sales
of ASAT, Ltd.'s, assembly services. Neither petitioner nor ASAT,
Ltd., provided any documentation to Ms. Hamilton regarding how
petitioner's gross profit spread was set on sales of ASAT,
Ltd.'s, assembly services. Petitioner did not provide Ms.
Hamilton with any information as to which company, petitioner or
ASAT, Ltd., set the gross profit spread.
During the examination, petitioner did not provide
respondent with any documentation on petitioner's anticipated
costs, profits, or break-even points from its transactions with
ASAT, Ltd. We cannot tell whether this information was not
available or was not in existence. Petitioner did not provide
Ms. Hamilton with an analysis or projection of income or expenses
for petitioner. Petitioner did not know what commission rate it
would need to charge ASAT, Ltd., in order to be profitable.
D. Application of Section 6038A
The Internal Revenue Manual provides procedures for the use
and application of section 6038A. Ms. Hamilton followed the
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Internal Revenue Manual procedures during the examination in this
case.
During the examination, Ms. Hamilton was also auditing
another taxpayer that provided services similar to those provided
by petitioner, that is, selling the integrated circuit assembly
services of its foreign parent. The other taxpayer received a
commission rate ranging from 11 to 15 percent. The other
taxpayer had three separate divisions. Two of these divisions
were distributors of goods. The third division was similar to
petitioner in that it found customers for the integrated circuit
assembly services of the foreign parent. There was separate
accounting for each activity. The division which found customers
for the services of the foreign parent had no warehousing
expenses and no inventory.
To assist in her determination as to the appropriate amount
of petitioner's gross profit spread, Ms. Hamilton consulted with
an economist employed by respondent, Ron McGinley. During the
examination, Ms. Hamilton related to Mr. McGinley what
petitioner's representatives told her about petitioner's business
and what petitioner's functions were with respect to its sales.
Mr. McGinley provided Ms. Hamilton with information from the
examination of another taxpayer presenting an issue concerning
services rendered similar to that in petitioner's case. Mr.
McGinley advised Ms. Hamilton that, based upon the functions
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performed and risks borne by petitioner, a gross profit spread of
10 to 15 percent was appropriate.
During the examination, Mr. McGinley provided copies of the
following documents to Ms. Hamilton:
a. The 1992 MANA Research Bulletin Survey of Sales
Commissions;
b. the 1990 MANA Research Bulletin Survey of Sales
Commissions;
c. an article entitled "Compensating Manufacturers'
Agents: Guidelines for Determining Agency
Commissions, Fees and Incentive Programs";
d. an article entitled "Guidelines for Determining
Agency Commissions, Fees Incentive Programs"; and
e. the 1992 MANA Survey of Manufacturers' Sales
Agency Annual Revenues and Expenses.
The MANA Research Bulletins provide data concerning the
sales commissions charged by agents to their principals. The
MANA Research Bulletin states:
Typically, an agent and a manufacturer will offer what
they feel is a fair rate for the work to be done when
they negotiate their contract. * * * But, in general,
fair is a figure whereby both parties can make money
and where both are pleased with the arrangement. * * *
* * * * * * *
The important point to remember is that a commission
rate should be determined empirically to insure that
you and your agencies can make money--read profits.
* * * * * * *
Decide specifically what the agent is expected to
do in order to receive his basic commission
compensation.
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Determine what services, in addition to those
needed to determine the basic commission rate, will be
needed.
Determine whether the additional services will be
paid for as increased commissions or as special fees.
* * * * * * *
[T]he one factor that ultimately rules the marketplace
is whether or not the agent feels he or she can make a
decent living with a given commission. * * *
* * * * * * *
[W]hile [many] agents receive most of their income as
sales commissions, many are also paid fees for special
services. The typical manufacturers' agency today is
as likely to perform some special marketing tasks for
its principals as it is to do its main job of selling
the products.
Ms. Hamilton interpreted the MANA Research Bulletins as "[making]
it clear that if entities perform additional functions they
should be compensated--additionally compensated for those
functions."
The MANA Research Bulletin reports sales commission rates in
the categories high, low, and average. In the product category
of Electronic/Technical Products, the MANA Research Bulletins
show commission ranges of 6.97 percent to 12.19 percent in 1990
and 7.32 percent to 12.30 percent in 1992. The average rates in
those years were 9.58 percent and 9.81 percent, respectively.
Petitioner performed functions and other activities in addition
to selling the services of ASAT, Ltd. Ms. Hamilton read the MANA
materials prior to determining her adjustment to petitioner's
gross profit spread.
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Ms. Hamilton prepared a "what if" scenario showing the
resulting profit attributable to petitioner for gross profit
spreads of 10 percent through 15 percent. In her report on Form
4665, Report Transmittal, Ms. Hamilton states, "Providing a
commission [gross profit spread] in the upper range insures that
the TP will report profits from its activities. In no case
should the commission be reduced below 10 percent. Ten percent
(10%) is the lowest commission which would result in profit (See
What-if Scenario workpaper)." If the gross profit spread was
below 10 percent there would be no tax liability. Ms. Hamilton
testified that there would be no need to process the case if no
additional tax liability would result.
Ms. Hamilton was guided by temporary regulations under
section 482 which indicated that ranges should be used, even
though she believed the regulations did not apply retroactively.
As a result of the examination and based upon the
information she had, Ms. Hamilton determined that based on the
additional functions petitioner performed, it should receive a
gross profit spread above the average commission rate shown in
the MANA Research Bulletin for sales services alone. For the
additional services and functions, Ms. Hamilton determined that
petitioner should be compensated an additional 5 percent above
the average rate of approximately 10 percent as shown in the MANA
materials.
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Ms. Hamilton was told by Mr. Borawski that, in his opinion,
the industry average for this type of commission [gross profit
spread] was 5 percent. Ms. Hamilton knew of Mr. Borawski's 20
years of experience in the industry. Ms. Hamilton considered Mr.
Borawski's opinion, but did not adopt it in forming her
conclusion.
E. Deficiency Notice
The notice of deficiency was mailed to petitioner on
December 21, 1994. The notice of deficiency states:
As required by Section 6038A(e)(1) of the Internal
Revenue Code and Section 1.6038A-5 of the Income Tax
Regulations, the foreign related party, ASAT, Ltd.,
with which you have engaged in transactions, has failed
to provide the Internal Revenue Service an
authorization of agent within 30 days of the request by
letter from the Internal Revenue Service dated November
25, 1992. See Section 1.6038A-5(b) of the Income Tax
Regulations. * * *
Therefore, the noncompliance penalty adjustment under
Section 6038A(e)(3) has been imposed; accordingly, your
cost of goods sold [consulting fees expense, net
operating loss deduction] has been determined based on
information available to the Internal Revenue Service.
* * *
Consulting Fees
In 1990, Mr. Li contacted a friend, Mr. Chapple, president
and 50-percent shareholder of Worltek, and thereafter hired
Worltek to perform an evaluation or review of petitioner. During
1990 and 1991, two employees of Worltek, Mr. Combs and Mr. Smith,
performed services that were billed to petitioner. Mr. Combs
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worked half-time for Worltek and half-time for petitioner.9
There were no written contracts relating to the hiring or
retention of Worltek employees by petitioner during 1990 and
1991. Worltek sent petitioner the following invoices:10
Date Description Amount
11/9/90 Consultant fees for W.D. Smith
for the calendar month of November $31,000
2/15/91 Consulting fees for W.D. Smith and
Edward Combs for the month of February
1991 51,000
3/12/91 Consultant fees for W.D. Smith and
Edward Combs for the calendar month
of March 31,000
4/10/91 Consultant fees for W.D. Smith and
Edward Combs for the calendar month
of April 55,300
5/10/91 To bill for consulting fees for the
month of April 1991
William D. Smith 24,916
Edward G. Combs 38,716 69,63211
These invoices were marked either "Payable upon receipt" or
"Payable on sight". Handwritten notations on the invoices
indicate that petitioner paid them promptly.
9
The record does not show what percentage of time Mr.
Smith worked for petitioner.
10
These invoices were provided to respondent in response
to an IDR; the record does not show if these were the only
invoices sent by Worltek to petitioner.
11
Worltek's total was incorrect.
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OPINION
The interpretation and application of section 6038A involve
issues of first impression; there are but two published cases12
that discuss section 6038A.
In her notice of deficiency, respondent cited the section
6038A(e)(3) noncompliance penalty as statutory support for her
determination. Section 6038A(e)(3) is available to respondent if
a taxpayer fails to maintain specified records and to honor a
summons as required by section 6038A(e)(2) or if a taxpayer fails
to obtain authorization to be a related foreign corporation's
agent as required by section 6038A(e)(1). As respondent's notice
of deficiency relies on section 6038A(e)(1), we focus on that
section and its relationship to section 6038A(e)(3).13
A. Whether Section 6038A Applies to Petitioner
Section 6038A provides in pertinent part:
12
Asat, Inc. v. United States, 76 AFTR 2d 95-7821, 95-2
USTC par. 50,498 (N.D. Cal. 1995); Nissei Sangyo Am., Ltd. v.
United States, 76 AFTR 2d 95-5736, 95-2 USTC par. 50,327 (N.D.
Ill. 1995).
13
The notice of deficiency is predicated on the failure by
petitioner to obtain ASAT, Ltd.'s authorization of agent.
Petitioner's failure, however, to comply with the summons issued
by respondent as required by sec. 6038A(e)(2), and to seek timely
judicial review of the notice of noncompliance as required by
sec. 6038A(e)(4), appears to provide respondent with an
additional ground for applying the noncompliance penalty
adjustment of sec. 6038A(e)(3). See Asat, Inc. v. United States,
supra.
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SEC. 6038A. INFORMATION WITH RESPECT TO CERTAIN
FOREIGN-OWNED CORPORATIONS.
(a) Requirement.--If, at any time during a taxable
year, a corporation (hereinafter in this section
referred to as the "reporting corporation")--
(1) is a domestic corporation, and
(2) is 25-percent foreign-owned,
such corporation shall furnish, at such time and in
such manner as the Secretary shall by regulations
prescribe, the information described in subsection (b)
and such corporation shall maintain * * * such records
as may be appropriate to determine the correct
treatment of transactions with related parties as the
Secretary shall by regulations prescribe * * *.
* * * * * * *
(c) Definitions.--For purposes of this section--
(1) 25-percent foreign-owned.--A
corporation is 25-percent foreign-owned if at
least 25 percent of--
(A) the total voting power of all
classes of stock of such corporation entitled
to vote, or
(B) the total value of all classes of
stock of such corporation,
is owned at any time during the taxable year by 1
foreign person (hereinafter in this section referred to
as a "25-percent foreign shareholder").
Hence, recordkeeping, reporting, and authorization of agent
requirements under section 6038A apply to "reporting
corporations" who have "transactions" with "related parties".
1. Reporting Corporation
Section 6038A(c)(1) defines a reporting corporation as a
domestic corporation that is 25-percent foreign-owned, meaning
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ownership by one foreign person of either 25 percent of the
voting stock or 25 percent of the value of all classes of the
domestic corporation's stock. A "foreign person" is any person
who is not a "United States person" under section 7701(a)(30),
including a corporation. Sec. 6038A(c)(3); sec. 1.6038A-1(f)(3),
Income Tax Regs. Petitioner stipulated that it always has been a
corporation and from December 22, 1988, to June 30, 1992, that it
was wholly owned by a foreign corporation, ASAT, Ltd.
Consequently, petitioner is a "reporting corporation" for its
year ending April 30, 1991, the taxable year covered by the
notice of deficiency.
2. Related Party
Section 6038A(c)(2)(A) defines a "related party" to include
any 25-percent foreign shareholder of the reporting corporation.
ASAT, Ltd., owned 100 percent of petitioner at all times during
the year in issue. Thus, ASAT, Ltd., is a "related party" to
petitioner for its taxable year ending April 30, 1991.
3. Transaction
Section 1.6038A-2(a)(2), Income Tax Regs., provides a
definition of "transaction" in the context of triggering Form
5472 filing requirements: "A reportable transaction is any
transaction of the types listed in paragraphs (b)(3) and (4) of
this section."
Section 1.6038A-2(b)(3), Income Tax Regs., provides in part:
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(3) Foreign related party transactions for which
only monetary consideration is paid or received by the
reporting corporation. If the related party is a
foreign person, the reporting corporation must set
forth on Form 5472 the dollar amounts of all reportable
transactions for which monetary consideration * * * was
the sole consideration paid or received during the
taxable year of the reporting corporation. * * * The
types of transactions described in this paragraph are:
* * * * * * *
(v) Consideration paid and received for
technical, managerial, engineering,
construction, scientific, or other services;
* * * * * * *
(x) Other amounts paid or received not
specifically identified in this paragraph
(b)(3) to the extent that such amounts are
taken into account for the determination and
computation of the taxable income of the
reporting corporation.
The above provisions defining a transaction are very broad.
Indeed, petitioner does not dispute, and we hold, that it engaged
in transactions with a related party for its taxable year ending
April 30, 1991, when it contracted with and paid for assembly
services by ASAT, Ltd. Petitioner nevertheless maintains that
section 6038A is inapplicable for the reasons set forth below.
Before those reasons are examined, however, a review of the
statute's background is in order to provide context to an
analysis of the statute and the parties' arguments.
4. Background of Section 6038A
Section 6038A, as originally enacted in 1982, imposed
reporting requirements on foreign controlled U.S. corporations
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and branches of foreign corporations. The Omnibus Budget
Reconciliation Act of 1989, Pub. L. 101-239, sec. 7403, 103 Stat.
2358, added record maintenance requirements that were broadened
by the Omnibus Budget Reconciliation Act of 1990, Pub. L. 101-
508, sec. 11315(a), 104 Stat. 1388, to affect all open years.
The IRS issued final implementing regulations on June 19, 1991.
Sec. 1.6038A-1, Income Tax Regs., 56 Fed. Reg. 28056 (June 19,
1991). Section 6038A was drafted to aid the IRS in enforcement
of section 482; its sponsors in the House of Representatives
described it as an effort to "Improve [the] enforceability of
section 482". H. Rept. 101-247, at 1295 (1989). The IRS had
experienced difficulties obtaining information from foreign
parents of U.S. corporations. See United States v. Toyota Motor
Corp., 561 F. Supp. 354 (C.D. Cal. 1983). The noncompliance
penalty of section 6038A(e)(3) is among the principal enforcement
mechanisms of the statute.
Section 6038A(e)(3) provides:
(3) APPLICABLE RULES IN CASES OF NONCOMPLIANCE.--
If the rules of this paragraph apply to any
transaction--
(A) the amount of the deduction allowed under
subtitle A for any amount paid or incurred by the
reporting corporation to the related party in
connection with such transaction, and
(B) the cost to the reporting corporation of
any property acquired in such transaction from the
related party (or transferred by such corporation
in such transaction to the related party),
- 24 -
shall be the amount determined by the Secretary in the
Secretary's sole discretion from the Secretary's own
knowledge or from such information as the Secretary may
obtain through testimony or otherwise.
5. Contentions of the Parties
Petitioner contends that section 6038A does not apply
because it was not 25 percent owned by a foreign corporation when
respondent requested the authorization of agent on November 25,
1992. Petitioner further contends that Worltek, a domestic
corporation, became a "successor in interest" to ASAT, Ltd., when
Worltek, on July 15, 1992, purchased newly issued stock from
petitioner and became its 95-percent shareholder. Under section
1.6038A-5(e), Income Tax Regs., a "successor in interest to a
related party must execute the authorization of agent as
described in paragraph (b) of this section." Petitioner finally
contends that "Section 6038A is not operative because it was a
legal impossibility for Petitioner to obtain the authorization of
agent." Petitioner argues that since it "exercised considerable
effort to obtain the authorization of agent from ASAT, Ltd., with
no success" and since it did not have the power to compel ASAT,
Ltd., to grant the authorization of agent, then it should not be
penalized under section 6038A(e)(3).
Respondent argues that section 6038A is applicable to
petitioner, as it is undisputed that petitioner was a reporting
corporation during the year ending April 30, 1991. According to
respondent, "the status of a corporation as a 'reporting
- 25 -
corporation' for a particular year is unaffected by subsequent
events." Respondent correctly points out that "Neither section
6038A, the regulations thereunder, nor the legislative history
contains any provision permitting a reporting corporation to
avoid the requirements and penalties of that section for a
particular year because of a subsequent change in stock
ownership." It is equally true, however, that section 6038A, the
regulations thereunder, and the legislative history make no
mention of the issue whatsoever. The issue is not whether
petitioner was a reporting corporation for the year in issue--it
was--but whether section 6038A(e)(3) applies for the year in
issue, an issue of first impression.
6. Discussion
We begin our analysis with the well-established rule that
statutory construction begins with the language of the relevant
statute. Consumer Prod. Safety Commn. v. GTE Sylvania, Inc., 447
U.S. 102, 108 (1980). Statutes are to be read so as to give
effect to their plain and ordinary meaning unless to do so would
produce absurd or futile results. United States v. American
Trucking Associations, Inc., 310 U.S. 534, 543-544 (1940); see
Tamarisk Country Club v. Commissioner, 84 T.C. 756, 761 (1985).
Moreover, 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, 899 (1991);
- 26 -
Huntsberry v. Commissioner, 83 T.C. 742, 747-748 (1984). We may
use legislative history to clarify an ambiguous statute. City of
New York v. Commissioner, 103 T.C. 481, 489 (1994), affd. 70 F.3d
142 (D.C. Cir. 1995). Even where the statutory language appears
clear, we may seek out any reliable evidence as to legislative
purpose. Id.The statute applies to a reporting corporation "If, at any
time during a taxable year," it has "transactions" with "related
parties". Sec. 6038A(a). We have already established that
petitioner was a "reporting corporation" that had "transactions"
with a "related party" during the year in issue. The phrase "If,
at any time during a taxable year" relates to the taxable year
that the reporting corporation has a transaction with a related
party. Likewise, section 6038A(e)(1) provides in part:
The rules of paragraph (3) [the noncompliance penalty]
shall apply to any transaction between the reporting
corporation and any related party who is a foreign
person unless such related party agrees (in such manner
and at such time as the Secretary shall prescribe) to
authorize the reporting corporation to act as such
related party's limited agent * * * [Emphasis added.]
Again, the relevant time period is when the transaction took
place. This interpretation is consistent with the intent of
Congress, as shown by legislative history. Congress intended for
the IRS to have access to the information necessary to determine
if related party transactions complied with section 482. The
relevant time period for establishing a taxpayer's status as a
reporting corporation is when the transaction(s) took place; the
- 27 -
statute speaks in those terms. As stated by the Supreme Court in
Commissioner v. Engle, 464 U.S. 206, 217 (1984):
Our duty then is "to find that interpretation which can
most fairly be said to be imbedded in the statute, in
the sense of being most harmonious with its scheme and
with the general purposes that Congress manifested."
NLRB v. Lion Oil Co., 352 U.S. 282, 297 (1957)
(Frankfurter, J., concurring in part and dissenting in
part). * * *
Petitioner would have us read into section 6038A(e) the
additional requirement that petitioner be a reporting corporation
at the time the request for authorization of agent is made upon
it by the IRS. If the statute could be rendered inapplicable by
subsequent ownership changes in a reporting corporation, then it
might lose a substantial part of its efficacy for its stated
purpose. A subsequent change of ownership in the reporting
corporation, after the taxable year containing the transactions
in question, does not insulate petitioner from the application of
section 6038A(e).
Petitioner further contends that "Section 6038A is not
operative because it was a legal impossibility for Petitioner to
obtain the authorization of agent." More accurately stated,
petitioner contends that it was not able to compel its onetime
parent to provide the authorization of agent. A subsidiary is
generally not in the position to compel its parent to perform any
act; such is the nature of a parent/subsidiary relationship. The
legislative history to section 6038A discusses the situation
where a related party, which is not known to be such by the
- 28 -
reporting corporation at the time the two conduct a transaction,
refuses to authorize the reporting corporation to act as its
agent. In that situation, the reporting corporation "would
generally be subject to the disallowance rule [noncompliance
penalty] with respect to transactions" with the related party
taking place prior to the time the reporting corporation became
aware that section 6038A would apply. See H. Rept. 101-247, at
1299 (1989). Although this result could be called "harsh", the
House report anticipated that no exception would be made unless,
among other conditions, the reporting corporation did not know or
have reason to know that it was conducting transactions with a
related party. Id. There is no evidence, and petitioner does
not argue, that it did not know that it was engaged in
transactions with its sole shareholder during petitioner's 1991
tax year. We reject petitioner's argument that section 6038A
should not apply because petitioner allegedly was unable to
compel its onetime sole shareholder to authorize petitioner as
its agent for purposes of section 6038A.
We deal next with petitioner's "successor in interest"
argument. The term "successor in interest" is not defined in
section 6038A or its regulations. Petitioner argues that
Worltek, a domestic corporation, is a successor in interest to
- 29 -
ASAT, Ltd., since Worltek replaced ASAT, Ltd., as majority
shareholder in petitioner.14
ASAT, Ltd., did not sell its stock in petitioner to Worltek;
rather, after the year in issue petitioner issued stock to
Worltek, which diluted the interest of ASAT, Ltd., in petitioner
from 100 percent to 5 percent. Respondent correctly points out
that one of the purposes of section 6038A is to allow the IRS to
obtain the records of a foreign related party's transactions with
a domestic corporation through the issuance of a summons. See S.
Comm. Prt. 101-57, at 112 (1989). Therefore, "successor in
interest" must be interpreted in that light. For section 6038A
to accomplish its purpose, the IRS must be able to compel
production of records from the party that has possession of, or
controls the records of, the related party's transactions. In
this case, the records sought are ASAT, Ltd.'s, a foreign related
party, not Worltek's. Worltek succeeded to nothing of ASAT,
Ltd.'s. We conclude that Worltek is not a successor in interest
14
Sec. 1.6038A-5(e), Income Tax Regs., provides that "A
successor in interest" to a related party must authorize the
reporting corporation to act as agent. Petitioner argues that
since Worltek is a domestic corporation, it cannot be required to
comply with sec. 1.6038A-5(b), Income Tax Regs., which provides
that "Upon request by the Service, a foreign related party shall
authorize as its agent (solely for purposes of sections 7602,
7603, and 7604) the reporting corporation with which it engages
in transactions." (Emphasis added.) The latter provision
however, does not define "successor in interest". We shall,
nevertheless, address the issue of whether Worltek is a successor
in interest to ASAT, Ltd., and thus would be the proper party to
execute the authorization of agent.
- 30 -
to ASAT, Ltd., as that term is used in section 1.6038A-5(e),
Income Tax Regs. In sum, we hold that section 6038A does apply
to petitioner.
B. Failure To Designate Agent Issue
The section 6038A(e)(3) noncompliance penalty is operative
in this case if petitioner did not comply with section
6038A(e)(1), which provides:
(e) Enforcement of Requests for Certain Records.--
(1) Agreement to treat corporation as agent.--The
rules of paragraph (3) shall apply to any transaction
between the reporting corporation and any related party
who is a foreign person unless such related party
agrees (in such manner and at such time as the
Secretary shall prescribe) to authorize the reporting
corporation to act as such related party's limited
agent solely for purposes of applying sections 7602,
7603, and 7604 with respect to any request by the
Secretary to examine records or produce testimony
related to any such transaction or with respect to any
summons by the Secretary for such records or testimony.
The appearance of persons or production of records by
reason of the reporting corporation being such an agent
shall not subject such persons or records to legal
process for any purpose other than determining the
correct treatment under this title of any transaction
between the reporting corporation and such related
party.
Petitioner stipulated that it did not obtain the authorization of
ASAT, Ltd., to be its agent until after the notice of deficiency
was issued. Section 1.6038A-5(b), Income Tax Regs., requires
that the authorization be provided to the IRS within 30 days
after the IRS requests it; petitioner failed to meet the
deadline.
- 31 -
C. Abuse of Discretion Issue
1. Standard of Proof
The standard of review of respondent's determination under
section 6038A(e)(3) is liberal. Whereas the word "discretion"
does not appear in section 482, when the noncompliance penalty of
section 6038A(e)(3) applies, "the amount of the deduction * * *
and the cost * * * of any property * * * shall be the amount
determined by the Secretary in the Secretary's sole discretion
from the Secretary's own knowledge or from such information as
the Secretary may obtain through testimony or otherwise."
(Emphasis added.) The conference committee report offers
guidance to a court reviewing respondent's determination under
section 6038A(e)(3):
The conferees intend that a taxpayer seeking
judicial review of the exercise of the Secretary's sole
discretion under the noncompliance rules shall bear the
burden of proof by clear and convincing evidence that
the Secretary abused that discretion. The conferees do
not intend to foreclose a court from overturning a
determination by the Secretary that was proven (by
clear and convincing evidence) either to have been made
with improper motive, or to have been clearly erroneous
by reference to all reasonably credible interpretations
or assumptions of facts. On the other hand, the
conferees do not expect a court to overturn a
determination unless it could do so even after
accepting as true all allegations and inferences that
may support the Secretary's position. [H. Conf. Rept.
101-386, at 594 (1989).]
The conference committee report also states:
Under the conference agreement, in cases of
noncompliance, the amount of any deduction for any
amount paid or incurred to the related party by the
reporting corporation, or the cost of property
- 32 -
transferred between such persons, shall be determined
by the Secretary in the Secretary's sole discretion,
based on the Secretary's own knowledge or from such
information as the Secretary may choose to obtain.* * *
The conferees wish to clarify that the exercise of
the Secretary's sole discretion to establish allowable
amounts of deductions and the cost of goods sold in the
event of noncompliance shall be subject only to limited
judicial review. * * * In addition, the conferees do
not expect a court to overturn a determination on
grounds that the Secretary might have sought to obtain
additional information but failed to do so. [Id. at
593-594.]
The standard of proof is not identical to that in a section
482 case--proving that the Commissioner's allocations are
arbitrary, capricious, or unreasonable. Rather, the standard of
proof under section 6038A(e)(3) requires petitioner to show by
clear and convincing evidence and without reference to
information not in respondent's possession or knowledge when the
determination was made, that respondent's determination was made
with an improper motive or is clearly erroneous in light of all
reasonably credible interpretations or assumptions of facts.
Petitioner has not argued improper motive on the Secretary's
part. The parties do not disagree on what information was in
respondent's possession when she issued the notice of deficiency
and determined that petitioner's cost of goods sold and net
operating loss should be adjusted downward. Based on that
information, and that information alone, we must decide if
respondent abused her discretion, applying the standard set forth
above, in determining the deficiency under section 6038A.
- 33 -
2. Petitioner's Expert Report
Petitioner submitted an expert report15 (the report) by Dr.
Clark Chandler,16 which opined that it was an abuse of discretion
for respondent to have determined that petitioner should have
received a 15-percent commission [gross profit spread].17
Respondent objected to the admission of the report. We allowed
the report into evidence, subject to respondent's objection.
However, we advised the parties that they could address the issue
of the report's admissibility on brief.
We found the report to be of no help to petitioner's case.
Specifically, the report utilized information not in respondent's
possession and did not accept as true credible allegations and
inferences that may support the Secretary's position. Moreover,
the report equivocated while purporting to form a conclusion ("It
is impossible for me to verify the reasonableness of the IE's
[International Examiner] conclusions."). The role of an expert
is to assist the trier of fact to understand the evidence or to
15
Dr. Clark Chandler prepared a report entitled "ASAT,
Inc., an Economic Evaluation of the International Examiner's
Methodology and Resulting Adjustment."
16
Dr. Chandler is an economist with Economic Consulting
Services. The parties stipulated that Dr. Chandler is an expert
in the area of intercompany pricing under sec. 482. Dr. Chandler
received his Ph.D. degrees from the University of Michigan in
1977 and 1978. He has previously testified in numerous cases
before this Court as an expert witness in intercompany pricing.
17
Dr. Chandler also referred to the gross profit spread as
a "commission".
- 34 -
determine a fact in issue. Fed. R. Evid. 702. Under section
6038A(e)(3), we are reviewing whether respondent abused her
discretion in reducing petitioner's cost of goods sold. The
report itself cannot be considered as evidence of the proper
gross profit spread since it was not in respondent's possession
at the time the determination under section 6038A(e)(3) was made.
The only function the report can serve is to help us evaluate the
information that was in respondent's possession at the time the
determination was made. The report failed to perform that
function. The report is not appropriate expert testimony because
it purports to apply a legal standard. See Laureys v.
Commissioner, 92 T.C. 101, 127-129 (1989). As explained above,
the test is not identical to a section 482 test, which is Dr.
Chandler's area of expertise. We are not holding that an expert
report is never appropriate in a section 6038A case, only that to
be considered the report must be helpful in light of the standard
of review called for by the statute. Dr. Chandler's report did
not provide assistance in that respect.
3. Respondent's Section 6038A(e)(3) Determination
Petitioner had no documentation to show how its gross profit
spread was set. Respondent, based her determination of a 15-
percent gross profit spread on three main factors:
a. Experience With a Similar Taxpayer.
Ms. Hamilton was examining a taxpayer with a separate
division that conducted a business similar to petitioner's. That
- 35 -
taxpayer engaged in selling the services of its foreign parent to
assemble integrated circuits, did not maintain inventory, and had
no warehousing expenses. The taxpayer (a U.S. subsidiary)
received commissions ranging from 11 to 15 percent from its
foreign parent.
b. IRS Economist.
Ms. Hamilton received advice from an IRS economist, Ron
McGinley. Ms. Hamilton described to Mr. McGinley petitioner's
business and its relationship to its foreign parent. He told her
that he had experience in determining an appropriate commission
rate for services and that he was currently examining a company
that provided services similar to those provided by petitioner.
Mr. McGinley also told Ms. Hamilton that petitioner should be
compensated for each additional function performed on behalf of
its foreign parent. Based on his experience, Mr. McGinley told
Ms. Hamilton that a 10 to 15-percent commission range would be
appropriate.
c. MANA Survey.
Mr. McGinley also gave Ms. Hamilton research bulletin
surveys prepared by MANA (the MANA survey). The MANA surveys
provided data concerning the sales commissions charged by
manufacturing agents to their principals. In brief, the MANA
survey indicated that a commission rate should enable the agent
to make a profit and that additional services warrant additional
fees. In the product category of Electrical/Technical Products,
- 36 -
the MANA survey reported that commissions ranged from 12.3
percent to 7.32 percent in 1992 and 12.19 percent to 6.97 percent
in 1990.
Respondent asked for and did not receive information from
petitioner regarding its contractual relationship with ASAT,
Ltd., specific pricing policies, cost analysis, projections,
budgets, or their negotiations in deciding on the proper gross
profit spread.
Ms. Hamilton used the above factors to determine a basic
gross profit spread of 10 percent and then added 5 percent (15-
percent total) to compensate petitioner for the services that it
rendered to ASAT, Ltd., in addition to locating customers.
4. Petitioner's Argument
Petitioner argues that we may find respondent's
determination to be clearly erroneous by focusing on either her
results or her methodology. Petitioner argues that it should be
able to present evidence (expert testimony) "to show the correct
costs and expenses based on the information available [not to be
confused with information in respondent's possession] to the
Respondent."
Petitioner states that a commission rate [gross profit
spread] of 6 percent "was determined by market conditions and is
economically realistic and reasonable." To support its claim,
petitioner cites a statement by Mr. Borawski (an officer and
employee of petitioner) that the industry average for commissions
- 37 -
is 5 percent. Petitioner also refers the Court to Dr. Chandler's
report in support of petitioner's commission rate.
Petitioner argues that the IRS economist was "unauthorized
IRS personnel not assigned to the case" and that respondent
should have made him available for trial.18 Petitioner requests
that the Court draw an adverse inference from respondent's not
calling the economist as a witness.
Petitioner further argues that the international examiner
erroneously relied on noncomparable MANA surveys. Petitioner
cites section 482 cases for the proposition that the use of
industry averages is not appropriate unless the data is
representative of the taxpayer. Petitioner points out that it is
not in the manufacturing business and that the MANA survey deals
with manufacturers' agents.
Petitioner also argues that Ms. Hamilton "erroneously made
an increase to her commission rate adjustment beyond her base
adjustment." Petitioner argues that since the MANA survey cannot
be shown to have used comparable companies, it is impossible to
know what services are included in the base commission rate.
Finally, petitioner argues that Ms. Hamilton's use of the
"what if" scenario shows that she backed into the 15-percent
18
Despite knowing the economist's identity before
petitioner prepared its pretrial memorandum and that respondent
did not intend to call the economist as a witness, petitioner did
not attempt to subpoena the economist until the day of the trial.
- 38 -
gross profit spread. Therefore, petitioner argues that the
determination is an abuse of discretion.
5. Application of Law to Facts
Petitioner would like us to perform a section 482 analysis;
such an analysis would not be appropriate. Petitioner, after
failing to provide respondent with basic information about its
related party transactions, argues that respondent determined an
incorrect gross profit spread. Petitioner's attack on
respondent's results--that respondent's gross profit spread is
not as accurate as petitioner's--ignores the purpose of the
statute. Section 6038A was enacted to insure that the IRS either
would have timely access to the information necessary to make a
complete analysis of costs between related parties or the right
to make an adjustment based solely on the information that it did
have. Whether the taxpayer can later justify a cost is
irrelevant:
Accordingly, the amounts established by the Secretary
cannot be overturned by a court on the basis that they
diverge from actual costs or other amounts incurred, or
on the basis that they do not clearly reflect income.
The fact that amounts established by the Secretary can
be proven to be clearly erroneous, by reference to
information or materials that were not within the
Secretary's knowledge or possession, would not alone,
in the conferees' view, be sufficient cause for a court
to redetermine allowable amounts of deductions and the
costs of goods sold. * * * [H. Conf. Rept. 101-386, at
594 (1989).]
Petitioner argues that Ms. Hamilton should have accepted Mr.
Borawski's opinion that the 6-percent gross profit spread "was
- 39 -
determined by market conditions and is economically realistic and
reasonable" since Mr. Borawski had 20 years of experience in the
industry. Suffice it to say that the IRS is not required to
accept the assertions of interested parties on faith. In fact,
the legislative history also addressed this point:
Similarly, the exercise of the Secretary's sole
discretion in determining how much weight, if any, to
give to any individual document or other item of
information that has been submitted is subject to the
same scope of review, i.e., proof by clear and
convincing evidence that the Secretary abused that
discretion, while accepting as true all allegations and
inferences that may support the Secretary's position.
[Id.]
Petitioner's argument that Ms. Hamilton used an
"unauthorized" IRS economist is without merit. The case cited by
petitioner does not support its argument.19 Nor will we draw an
adverse inference from respondent's not calling the IRS economist
as a witness. It is not up to respondent to prove that her
determination is correct; it is petitioner who has the heavy
burden.
If a party fails to introduce evidence within that party's
possession, we may presume in some circumstances that, if
produced, the evidence would be unfavorable to that party.
Wichita Terminal Elevator Co. v. Commissioner, 6 T.C. 1158, 1165
(1946), affd. 162 F.2d 513 (10th Cir. 1947). This is true where
the party which does not produce the evidence has the burden of
19
Center on Corporate Responsibility, Inc. v. Shultz, 368
F. Supp. 863 (D.D.C. 1973).
- 40 -
proof or the other party has established a prima facie case. Id.Petitioner has the burden of proof and has not made a prima facie
showing of the facts which it wishes to establish by adverse
inference. Petitioner knew the identity of the IRS economist in
ample time to call him as a witness but failed to do so. Under
these circumstances we shall not draw an adverse inference
against respondent.
Petitioner argues that Ms. Hamilton erroneously relied on
MANA surveys, which in petitioner's view did not involve
comparable companies or transactions. Although petitioner is not
in the manufacturing business, it performs a service similar to a
manufacturer's commissioned agent. Taking into account the
materials within respondent's possession at the time of making
the section 6038A(e)(3) determination, we are not persuaded that
respondent's reliance on the MANA survey was misplaced.
Petitioner argues that the "what if" scenario shows that Ms.
Hamilton backed into the 15-percent gross profit spread and that
her suggestion that a 10-percent spread would ensure a profit
shows that the determination was arbitrary. Ms. Hamilton did
calculate the minimum spread necessary for petitioner to show a
profit. The MANA Research Bulletin states:
Typically, an agent and a manufacturer will offer what
they feel is a fair rate for the work to be done when
they negotiate their contract. * * * But, in general,
fair is a figure whereby both parties can make money
and where both are pleased with the arrangement. * * *
* * * * * * *
- 41 -
The important point to remember is that a commission
rate should be determined empirically to insure that
you and your agencies can make money--read profits.
It was not an abuse of the Commissioner's discretion under
section 6038A to assume that a fair gross profit spread is one
that would allow petitioner to make an overall profit.
Petitioner also argues that Ms. Hamilton erroneously
increased the gross profit spread beyond the base adjustment
(from 10 to 15 percent). However, petitioner admits that it
performed additional services for ASAT, Ltd. Given the latitude
mandated by section 6038A, we cannot say that the Commissioner
abused her discretion by increasing the base spread by 5-percent
for the additional services.
Even without the MANA survey, Ms. Hamilton's and the IRS
economist's experiences with similar taxpayers support a gross
profit spread in the 10 to 15-percent range, establishing that
the IRS's determination was not an abuse of discretion. We hold
that petitioner has failed to show a section 6038A abuse of
discretion in respondent's determination.
D. NOL
No NOL deduction is allowed since it was created using a 6-
percent gross profit spread.20 Petitioner admits that a 15-
percent gross profit spread in earlier years would eliminate its
NOL deduction.
20
Petitioner's gross profit spread for the 1990 tax year
appears to be zero.
- 42 -
E. Consulting Fees
The deductibility of the consulting fees is not a section
6038A issue since it does not involve a transaction with a
foreign related party; the consulting payments were made by
petitioner to Worltek, a domestic corporation that was not
related to petitioner at the time. The parties presented
evidence on the consulting fee issue and argued it on brief.
Therefore, we shall decide the issue. See Rule 41(b).
Deductions are a matter of legislative grace; petitioner has
the burden of showing that it is entitled to any deduction
claimed. Rule 142(a); New Colonial Ice Co. v. Helvering, 292
U.S. 435, 440 (1934). To be entitled to a business expense
deduction for consulting fees under section 162, petitioner must
prove that the expenses were: (1) Ordinary and necessary, (2)
paid or incurred in carrying on a trade or business, (3) incurred
during the taxable year in which the taxpayer seeks to deduct
them, and (4) paid by the person to whom the services were
rendered. Sec. 162(a).
Respondent argues that the consulting expenses were the
expenses of ASAT, Ltd. or QPL, and thus not deductible by
petitioner. We need not decide the issue on that ground as
petitioner has failed to show that the consulting fee expense was
ordinary and necessary. Whether an expenditure is ordinary and
necessary is generally a question to fact. Commissioner v.
Heininger, 320 U.S. 467, 475 (1943). To be "necessary" within
- 43 -
the meaning of section 162, an expense need be "appropriate and
helpful" to the taxpayer's business. Welch v. Helvering, 290
U.S. 111, 113 (1933). The requirement that an expense be
"ordinary" connotes that "the transaction which gives rise to it
must be of common or frequent occurrence in the type of business
involved." Deputy v. DuPont, 308 U.S. 488, 495 (1940) (citing
Welch v. Helvering, supra at 114).
We question whether the consulting fees were determined on
an arm's-length basis. Mr. Li and Mr. Chapple were friends.
Worltek, a corporation owned 50 percent by Mr. Chapple,
eventually acquired 95 percent of petitioner. QPL, a corporation
whose majority shareholder was Mr. Li, later acquired Worltek.
There is no evidence in the record of how the consulting fees
were determined. The monthly amounts, which were usually billed
on the 10th of each month, were for the half-time services of Mr.
Combs and the services of Mr. Smith. The monthly fees ranged
from $31,000 (for just Mr. Smith) to $124,932 (69,632 + 55,300).
These relatively large amounts--given the size of petitioner's
business--were promptly paid, even though there was no written
contract between petitioner and Worltek and the invoices
themselves provided almost no detail. There is no evidence in
the record of the skills Mr. Combs and Mr. Smith may have
possessed to warrant such consulting fees. We hold that
petitioner has failed to prove that the consulting fees were
ordinary and necessary business expenses.
- 44 -
F. Section 6662(a) Accuracy-Related Penalty
Section 6662(a) imposes a penalty in an amount equal to 20
percent of the portion of the underpayment of tax attributable to
one or more of the items set forth in section 6662(b), including
negligence or disregard of rules or regulations. Respondent
asserts that the entire underpayment of petitioner's tax was due
to negligence or intentional disregard of rules or regulations.
Sec. 6662(b)(1). As under the predecessor section covering the
addition to tax for negligence, section 6653(a), petitioner bears
the burden of proof on the penalty in issue. Rule 142(a); Neely
v. Commissioner, 85 T.C. 934, 947 (1985). "Negligence" includes
any failure to make a reasonable attempt to comply with the
provisions of the internal revenue laws. Sec. 6662(c); sec.
1.6662-3(b)(1), Income Tax Regs. Negligence is the failure to
exercise due care or the failure to do what a reasonable and
prudent person would do under the circumstances. Neely v.
Commissioner, supra. "Disregard" includes any careless,
reckless, or intentional disregard of rules or regulations. Sec.
6662(c); sec. 1.6662-3(b)(2), Income Tax Regs.
The accuracy-related penalties of section 6662 do not apply
with respect to any portion of an underpayment if it is shown
that there was a reasonable cause for such portion and that the
taxpayer acted in good faith with respect to such portion. Sec.
6664(c)(1). The determination of whether a taxpayer acted with
reasonable cause and in good faith depends upon the pertinent
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facts and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs.
The most important factor is the extent of the taxpayer's effort
to assess his or her proper tax liability. Id.
Reliance on a return preparer, however, may relieve a
taxpayer from the addition to tax for negligence where the
taxpayer's reliance is reasonable. Freytag v. Commissioner, 89
T.C. 849, 888 (1987), affd. 904 F.2d 1011 (5th Cir. 1990), affd.
501 U.S. 868 (1991). A taxpayer, however, is not relieved from
liability for the addition to tax for negligence merely by
shifting the responsibility to a tax professional. Enoch v.
Commissioner, 57 T.C. 781, 802 (1972). Reliance on an expert is
not an absolute defense but is a factor to be considered.
Freytag v. Commissioner, supra at 888. A taxpayer's reliance
must be in good faith and demonstrably reasonable. Ewing v.
Commissioner, 91 T.C. 396, 423 (1988), affd. without published
opinion 940 F.2d 1534 (9th Cir. 1991); Freytag v. Commissioner,
supra at 888-889. In such a case, a taxpayer will be entitled to
rely upon an expert's advice, even if the advice should prove to
be erroneous. Jackson v. Commissioner, 86 T.C. 492, 539 (1986),
affd. on other issues 864 F.2d 1521 (10th Cir. 1989); Brown v.
Commissioner, 47 T.C. 399, 410 (1967), affd. per curiam 398 F.2d
832 (6th Cir. 1968).
The ultimate responsibility for a correct return lies with
the taxpayer, who must furnish the necessary information to the
agent who prepared the return. Enoch v. Commissioner, supra at
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802. In other words, reliance upon expert advice will not
exculpate a taxpayer who supplies the return preparer with
incomplete or inaccurate information. Lester Lumber Co. v.
Commissioner, 14 T.C. 255, 263 (1950).
In this decision, except for the consulting fee issue, among
the rules or regulations to be considered for applying the
negligence penalty are section 6038A and the accompanying
regulations.
Respondent argues that petitioner did not keep the records
required by section 6038A and did not provide an authorization of
agent when repeatedly asked to do so by respondent. Respondent
argues that petitioner ignored the requirements of section 6038A
by not keeping records from which respondent could determine the
correct tax treatment of transactions between petitioner and
ASAT, Ltd., citing section 1.6038A-3(a)(1), Income Tax Regs.
Respondent points out that petitioner's 1990 tax return preparer,
a C.P.A. from Deloitte & Touche, informed petitioner in writing
that it "noted concern" in the level of documentation and in
intercompany pricing. Respondent further argues that petitioner
has not introduced any evidence that it has reasonable cause for
failure to comply with section 6038A.
Petitioner argues that:
The evidence adduced at bar demonstrates that
Petitioner was not negligent. * * *
Petitioner charged a 6% commission rate to ASAT,
Ltd. The average commission rate is 5%. Under all the
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circumstances of industry competition and individual
customer order specifications, there is substantial
economic justification for the rate used by Petitioner
and reported on its income tax return. * * *
Petitioner further argues that its C.P.A. used "boiler plate"
language regarding intercompany transaction recordkeeping
requirements. Finally, petitioner argues that it gave its tax
return preparer the information necessary to prepare its return.
Unfortunately for petitioner, the "evidenced adduced at bar"
does not demonstrate that the industry average commission rate
was 5 percent. Petitioner confuses the self-serving, unsupported
testimony of its officer with proof. Saying something is so does
not make it so. Petitioner had no records whatsoever to document
how it determined the value of ASAT, Ltd.'s services, a
requirement under section 6038A. Petitioner has not shown that
it attempted to comply with the recordkeeping requirements of the
statute. Petitioner cannot escape the penalty by blaming its tax
return preparer; petitioner's tax return preparer warned
petitioner that intercompany transactions require documentation.
That this warning was "boiler plate" does not make it any less
true. We hold that petitioner has failed to prove that it was
not negligent on the section 6038A issues.
Petitioner has offered no evidence that it was not negligent
in deducting the consulting fees and does not address the issue
on brief. Respondent's determination of the applicable penalty
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must be sustained as petitioner has not met its burden of proof
on this issue.
To reflect the foregoing,
Decision will be entered
for respondent.