General Dynamics Corporation and Subsidiaries v. Commissioner

108 T.C. No. 9UNITED STATES TAX COURT
GENERAL DYNAMICS CORPORATION AND SUBSIDIARIES, Petitioner
v. COMMISSIONER OF INTERNAL REVENUE, Respondent
GENERAL DYNAMICS FOREIGN SALES CORP., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 19202-94, 19203-94. Filed March 26, 1997.
P formed wholly owned corporations (one a DISC,
the other an FSC). P computed and reported its Federal
income using the completed contract method. P elected,
under sec. 1.451-3(d)(5)(iii), Income Tax Regs., to
annually deduct certain period costs. In computing the
base (combined taxable income) for the statutorily
conferred tax benefit to promote exports, P did not
account for period costs, which it had elected to
deduct annually in prior years. R determined that sec.
994 and/or 925, I.R.C., and the regulations thereunder,
required P to include prior years' period costs that
are attributable to the gross receipts from foreign
exports in computing the base for P's deferral or
exemption from income.
P manufactured specialized ocean-going vessels for
the transport of liquefied natural gas. Sec. 1.993-
3(d)(2)(i)(b), Income Tax Regs., requires that to
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generate qualified export receipts the export property
must be used in foreign commerce prior to 1 year after
its sale. For reasons beyond P's control the vessels
were not so used. P contends that the regulation is
not a proper interpretation of the statutory provision.
Held: Sec. 1.994-1(c)(6), Income Tax Regs.,
interpreted to require P to reduce gross export
receipts by related period costs even though P is
permitted to elect to deduct those costs in years prior
to the combined taxable income computation.
Held, further, P's vessels are not qualified
export property because they fail to meet the
requirements of sec. 1.993-3(d)(2)(i)(b), Income Tax
Regs. Sim-Air, USA, Ltd. v. Commissioner, 98 T.C. 187,
190-197 (1992), followed in upholding the validity of
the regulation.
David C. Bohan, Richard T. Franch, James M. Lynch, Philip A.
Stoffregen, David D. Baier, Scott Schaner, Gregory S.
Gallopoulos, and Debbie L. Berman, for petitioner in docket No.
19202-94.
David C. Bohan, James M. Lynch, Philip A. Stoffregen, and
David D. Baier, for petitioner in docket No. 19203-94.
William H. Quealy, Jr., Alice M. Harbutte, Jeffrey A.
Hatfield, Thomas C. Pliske, and William T. Derick, for
respondent.
GERBER, Judge: General Dynamics Corp. and its consolidated
subsidiaries (GENDYN) (docket No. 19202-94) and its foreign sales
corporation, General Dynamics Foreign Sales Corp. (GENDYN/FSC)
(docket No. 19203-94), are petitioners in these consolidated
cases. Respondent determined corporate income tax deficiencies
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for GENDYN in the amounts of $26,118,976 and $291,218,973 for its
1985 and 1986 taxable years, respectively. With respect to
GENDYN/FSC, respondent determined a $586,533 corporate income tax
deficiency for its 1986 taxable year. Although these cases are
consolidated and related, for purposes of briefing and opinion
the issues have been divided into two generalized categories:
Domestic and foreign. This opinion addresses the foreign issues.
The parties have settled some of the foreign issues, and the
following controversies remain for our consideration and
decision: (1) Whether in computing combined taxable income
attributable to qualified export receipts under sections 9941 and
925 petitioners must, in addition to current year period costs,
deduct prior year period costs, as determined by respondent; and
(2) whether two liquefied natural gas tankers manufactured by
petitioner and sold to an unrelated third party for foreign use
constitute export property under section 993(c)(1) even though no
foreign use occurred during the first year and/or domestic use
occurred on one occasion prior to any foreign use.
FINDINGS OF FACT
The parties have stipulated most of the facts bearing on the
foreign issues, and those facts are found and incorporated by
this reference. GENDYN was incorporated on February 21, 1952,
1
Unless otherwise indicated, section references are to the
Internal Revenue Code as amended and in effect for the taxable
years in issue.
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and, at all relevant times, was the common parent of a group of
corporations that filed consolidated corporate Federal income tax
returns. At the time the petitions were filed in these cases,
GENDYN's and GENDYN/FSC’s principal places of business were in
Falls Church, Virginia. GENDYN engineered, developed, and
manufactured various products for the U.S. Government and, to a
lesser extent, foreign governments, including military aircraft,
missiles, gun systems, space systems, tanks, submarines,
electronics, and other miscellaneous goods and services. GENDYN
was also involved in business activities, including design,
engineering, and manufacture of general aircraft; mining coal,
lime, limestone, sand, and gravel; manufacture and sale of ready-
mix concrete, concrete pipe, and other building products;
production of commercial aircraft subassemblies; design,
engineering, and manufacture of commercial space launch vehicles
and services; and shipbuilding. GENDYN, for the taxable years
1977 through 1986, used the completed contract method to report
Federal income and the percentage of completion method for its
financial accounting purposes.
GENDYN, on February 25, 1972, incorporated an entity
(GENDYN/DISC)2 to serve as an export sales representative.
2
The issues in these consolidated cases span a time period
within which the statutory provisions relating to domestic
international sales corporations were replaced by those related
to foreign sales corporations. Due to these statutory changes,
GENDYN ended use of its specially formed domestic international
(continued...)
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GENDYN owned 100 percent of GENDYN/DISC's sole class of voting
stock. GENDYN/DISC had no employees or business operations and
existed for the sole purpose of receiving commissions from
GENDYN. On the date of the incorporation, GENDYN and GENDYN/DISC
entered into an Export Sales Commission Agreement. On May 24,
1972, GENDYN/DISC elected to be treated as a domestic
international sales corporation (DISC) under section 992(b), and
it filed Federal income tax returns (Forms 1120-DISC) on the
basis of a fiscal year ended March 31.
GENDYN/DISC, through the period ended December 31, 1984,
reported the commissions it earned on GENDYN's sales of export
property based on the completed contract method of accounting in
accordance with section 1.993-6(e)(1), Income Tax Regs.
At the end of each year, commissions on export property
sales involving long-term contracts were deducted by GENDYN and
included in income by GENDYN/DISC in its appropriate taxable
period. Commissions were normally computed under the 50-50
combined taxable income method (50-percent method) provided for
2
(...continued)
sales corporation and began use of a foreign sales corporation.
Although some differences exist between the two sets of statutory
provisions and the entities created to comply with the statutes,
for purposes of resolving the issues in this case we need not
make any distinctions. The foreign sales corporation became a
petitioner in these consolidated cases because it was the
surviving entity. Accordingly, the domestic international sales
corporation will be referred to as GENDYN/DISC and the foreign
sales corporation will be referred to as GENDYN/FSC. When
referred to generally, they will be referred to, along with the
other entities collectively, as petitioners.
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in section 994 because that method yielded the largest
commission. On certain rare occasions, the 4-percent gross
receipts method of section 994 was utilized.
Petitioners computed combined taxable income for each long-
term contract under the 50-percent method, as follows:
(a) Add: gross receipts from the contract as determined
under the completed contract method of accounting;
(b) Less: direct costs allocated to the contract under
section 1.451-3(d)(5)(i), Income Tax Regs.;
(c) Less: indirect costs allocated to the contract under
section 1.451-3(d)(5)(ii), Income Tax Regs.;
(d) Less: period costs incurred in the year of completion
allocated to the contract under section 1.451-3(d)(5)(iii),
Income Tax Regs.
In computing combined taxable income, petitioners did not
make a reduction for period costs, as defined in section 1.451-
3(d)(5)(iii), Income Tax Regs., incurred and allocated to the
contract prior to the year of contract completion. Respondent
determined that petitioners incorrectly computed combined taxable
income under the 50-percent method. In particular, respondent
determined that petitioners were required to aggregate and
deduct, in the year of completion of each long-term contract, all
period costs allocated to the contract, including those deducted
for prior years.
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GENDYN/DISC ceased performing as GENDYN’s commission agent
on December 31, 1984, and was dissolved on October 23, 1992.
On December 27, 1984, GENDYN incorporated petitioner General
Dynamics Foreign Sales Corp. (GENDYN/FSC) in the U.S. Virgin
Islands to serve as GENDYN’s export sales representative. GENDYN
owned the sole class of voting stock and entered into a Foreign
Sales Commission Agreement with GENDYN/FSC. On March 22, 1985,
GENDYN/FSC elected under section 927(f) to be treated as a
foreign sales corporation (FSC). During 1985 and 1986,
GENDYN/FSC functioned as GENDYN’s export sales representative and
was involved in no other trade or business. GENDYN/FSC filed
Federal Forms 1120-FSC and used the completed contract method of
accounting to report the commissions earned on GENDYN’s sales of
export property involving long-term contracts.
At the end of each year, commissions on export property
sales involving long-term contracts were deducted by GENDYN and
included in income by GENDYN/FSC in its appropriate taxable
period. With rare exceptions, the 23-percent combined taxable
income method (23-percent method) was used because it produced
the largest commission. In a few instances, the 1.83-percent
gross receipts method was used.
Petitioners computed combined taxable income for each long-
term contract under the 23-percent method as follows:
(a) Add: gross receipts from the contract as determined
under the completed contract method of accounting;
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(b) Less: direct costs allocated to the contract under
section 1.451-3(d)(5)(i), Income Tax Regs.;
(c) Less: indirect costs allocated to the contract under
section 1.451-3(d)(5)(ii), Income Tax Regs.;
(d) Less: period costs incurred in the year of completion
allocated to the contract under section 1.451-3(d)(5)(iii),
Income Tax Regs.
In computing combined taxable income, petitioners did not
make a reduction for period costs incurred prior to the year of
contract completion that had been allocated to the contract in
years prior to completion under section 1.451-3(d)(5)(iii),
Income Tax Regs. Respondent determined that petitioners
incorrectly computed combined taxable income under the 23-percent
method. In particular, respondent determined that petitioners,
in the year of completion of each long-term contract, were
required to aggregate all period costs allocated to the contract,
including those deducted for prior years, and reduce combined
taxable income by the aggregated amount.
Respondent also determined that GENDYN was not entitled to
deduct commissions on sales involving two ships because they did
not qualify as export property under section 993. In the
alternative, if the ships are found to qualify as export property
under section 993, respondent determined that petitioners
incorrectly computed the commissions attributable to the ships,
in the same manner as described above.
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Pantheon, Inc. (Pantheon), is a wholly owned domestic
subsidiary of GENDYN. Pelmar Co. (Pelmar) and Morgas, Inc.
(Morgas), are wholly owned domestic subsidiaries of corporations
unrelated to petitioners. On May 7, 1976, Pantheon, Pelmar, and
Morgas formed the Lachmar Partnership (Lachmar), a general
partnership. Pantheon and Pelmar each owned 40 percent, and
Morgas owned the remaining 20 percent of Lachmar. Lachmar was
organized for the purpose of purchasing, owning, and operating
two specialized vessels (LNG tankers) that were designed and
built for transoceanic transport of liquefied natural gas (LNG).
LNG is made by cooling natural gas to a temperature below
minus 256 degrees Fahrenheit. It is then transported at that
temperature in special-purpose tankers. After delivery from the
tankers, the LNG is returned to a state in which it can be
distributed through pipelines. The construction of LNG tankers
incorporates specialized and expensive technology which when
installed in a tanker renders it economically unusable for other
transportation purposes. Due to the cost to specially build them
and the lack of economically feasible convertibility, LNG tankers
are normally constructed for well-defined long-term projects, and
there is virtually no open market for LNG tankers.
There are four LNG terminals within the contiguous United
States and one in Alaska, all of which are capable of landing and
receiving the type of LNG tanker under consideration in this
case. Throughout the period under consideration, it was not
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economically suitable to ship LNG between Alaska and the other
four domestic locations. Throughout the period under
consideration, it was not economically suitable to domestically
ship LNG where it is accessible in gas form through a pipeline.
Trunkline LNG Co. (Trunkline), a wholly owned subsidiary of
Pelmar’s parent, was organized to purchase LNG from Algeria and
to arrange for its transportation to Lake Charles, Louisiana, for
U.S. distribution. On September 17, 1975, Pelmar’s parent
entered a contract (LNG contract) with an Algerian national gas
producer to purchase 7,700,000 cubic meters of LNG annually for
20 years. The purchaser was required to provide trans-Atlantic
transportation for 3,200,000 cubic meters of LNG each year. On
January 2, 1976, the contract rights and obligations were
assigned to Trunkline.
Trunkline contracted with Lachmar (transportation contract),
on May 7, 1976, to transport LNG from Algeria to Louisiana over a
20-year period beginning in the first quarter of 1980. On May 7,
1976, Lachmar entered into two contracts with GENDYN for the
construction and purchase of two LNG tankers to transport the
LNG. Because of the combined 60-percent control by Morgas and
Pelmar, GENDYN did not control Lachmar, so the transactions
between GENDYN and Lachmar were on an arm’s-length basis. GENDYN
manufactured the LNG tankers in the ordinary course of its
business for sale to Lachmar. The LNG tankers were to be
delivered on December 4, 1979, and March 18, 1980. On May 7,
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1976, Lachmar entered into a contract with an affiliate of Morgas
to oversee the construction and then to maintain and operate the
LNG tankers.
Bonds, guaranteed by the U.S. Government, were issued by
Lachmar to finance the construction of the tankers, and the
Federal Government also subsidized the construction of the
tankers. A portion of the subsidy was eventually repaid to the
Federal Government because one of the tankers was used for
domestic transportation. The tankers were delivered and
transferred to Lachmar on May 15 and September 25, 1980. Morgas’
affiliate was prepared to begin transportation of LNG at the time
of the tankers’ delivery.
To satisfy its obligations under the LNG contract, the
Algerian national LNG company was to construct a terminal
facility for the tankers. For technical, financial, and
political reasons, the facility was not completed until the fall
of 1982, and the Algerian company could not deliver sufficient
quantities of LNG to fulfill its obligations to Trunkline.
Accordingly, the initial uses of the LNG tankers outside the
United States were on September 3 and November 16, 1982,
respectively. Prior to that time, Lachmar bore the expense of
storing the tankers at various locations.
During 1980 through 1982, there was overcapacity in the
world market for LNG tankers, and Lachmar was able to find only
limited use for the tankers prior to their use under the
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transportation contract. That use occurred between June and July
of 1981, when one of the tankers transported LNG from
Everett/Boston, Massachusetts, to Elba Island, Georgia. The LNG
being transported was originally from Algeria. For that
transportation, Lachmar received gross compensation of
$2,038,468, which resulted in a gross profit of $588,228. The
$2,038,468 was paid $1,349,581 in 1981 and $688,887 in 1982. Due
to the domestic use of one of the tankers, Lachmar obtained an
exception from the Federal Government; otherwise it would have
risked losing all of its Government subsidies. The two tankers
made voyages between Algeria and Louisiana a total of four times
during 1982 and seven times during 1983 under the transportation
contract. Thereafter, the LNG and transportation contracts were
breached, and the tankers were stored in Virginia until 1988 and
1989, at which time they no longer belonged to Lachmar and began
service transporting LNG in foreign commerce.
On Lachmar’s Federal partnership returns, for purposes of
claiming credits and depreciation allowances, Lachmar reported
that one of the tankers was placed in service in 1980 and the
other in 1981. Respondent questioned the placed-in-service dates
reported by Lachmar, and after the tax audit, the parties agreed
that one tanker was placed in service on January 1, 1981, and the
other on July 1, 1981.
OPINION
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The issues under consideration arise in connection with
GENDYN and its foreign sales corporations. One issue concerns
the manner in which petitioners compute the amount of commission
income that may be deferred or excluded under the foreign sales
corporation statutes and regulations. That issue is one of first
impression, involving the interpretation of certain statutes and
regulations. The other issue concerns whether either of two
ships is export property under section 993(c)(1) so as to enable
petitioners to include it in the computation of commission income
under the foreign sales corporation statutes and regulations. We
first consider the former issue.
I. Petitioners’ Treatment of Period Costs in Computing Combined
Taxable Income
Petitioners were on the completed contract method of
accounting for long-term contracts for Federal income tax
purposes. In the process of computing corporate Federal income
tax under the completed contract method, GENDYN, under section
1.451-3(d)(5)(iii), Income Tax Regs., elected to expense rather
than capitalize certain period expenses. Normally, under the
completed contract method, the income and expenses connected with
long-term contracts are not reported or claimed until the
completion of the contract.
In computing the allowable amount of deferral or exclusion
of DISC or FSC commission income, petitioners did not include the
period costs that were deducted in prior years' domestic Federal
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income tax computations (prior year period costs). Instead, in
computing the amount of foreign sales corporation commission
income to be deferred or excluded, petitioners used only the
period costs incurred in the year of completion (current period
costs) and allocated to the particular contract under section
1.451-3(d)(5)(iii), Income Tax Regs.
Respondent determined that petitioners’ approach resulted in
a permanent exclusion and/or distortion in the form of
exaggerated amounts of deferral or exclusion of DISC or FSC
income because of an understatement of the amount of cost. The
additional deferral or exclusion claimed by petitioners, in
respondent's view, does not harmonize with Congress' intent. The
parties, to a great degree, rely on the same statutes and
regulations but arrive at opposite conclusions. First, we
analyze the pertinent statutory and regulatory material.
A. Statutory Background and Framework for DISC’s and FSC’s
In 1971, Congress enacted3 the DISC provisions4 as a tax
incentive to encourage and increase exports. The legislation
allowed domestic corporations to defer taxes on a significant
portion of profits from export sales similar to the tax benefits
available to corporations manufacturing abroad through foreign
3
Revenue Act of 1971, Pub. L. 92-178, sec. 501, 85 Stat.
497, 535.
4
Secs. 991-997.
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subsidiaries. H. Rept. 92-533, at 58 (1971), 1972-1 C.B. 498,
529; S. Rept. 92-437, at 90 (1971), 1972-1 C.B. 559, 609. A
domestic corporation that conducts its foreign operations through
a foreign subsidiary generally does not pay domestic Federal tax
on the income from those operations until the subsidiary's income
is repatriated to the domestic parent.
In 1984, Congress enacted the FSC provisions5 to replace and
cure some shortcomings in the DISC provisions. Deficit Reduction
Act of 1984, Pub. L. 98-369, sec. 801(a), 98 Stat. 494, 990; S.
Rept. 98-169, at 636 (1984). Under the FSC provisions, a
taxpayer may permanently avoid Federal income tax on a portion of
its profits on qualifying export sales.
The DISC and FSC provisions reallocate income generated by
export sales from the parent corporation to its DISC or FSC.
DISC’s are generally not subject to tax. Sec. 991. However, the
parent corporation is taxed on a specified portion of the DISC
profits as a deemed distribution. Sec. 995; L & F Intl. Sales
Corp. v. United States, 912 F.2d 377, 378 (9th Cir. 1990). The
remaining profits are tax-deferred until distributed
(repatriated) to the parent or until the corporation ceases to
qualify as a DISC. Secs. 995(a) and (b) and 996(a)(1). The FSC
provisions permanently exempt a portion of FSC profits from tax.
Sec. 923(a). The amount of the deferral or exemption is in
5
Secs. 921-927.
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controversy here. For purposes of this case, the DISC and FSC
provisions are generally similar, and the parties do not argue
that the outcome should vary depending on which of the provisions
apply.
The focus here is whether petitioners must consider period
costs attributable to the gross receipts from export sales of the
foreign sales corporation, even though the period costs were
deducted in prior years. There is a direct relationship between
the quantity of DISC income and the tax benefit available to a
domestic corporation under the DISC provisions. The greater the
costs allocated to export sales, the lower the combined taxable
income attributable to the DISC or FSC, and thus the smaller the
tax deferral or exclusion.
Ordinarily, taxpayers seek ways to reduce the amount of
their reportable income, such as by means of deductions. In
computing combined taxable income (CTI) of a foreign sales
corporation, however, taxpayers benefit where the amount of
export sales is larger or maximized to take advantage of the
congressionally intended deferral or exclusion of income. We are
therefore presented with the somewhat unusual circumstance where
petitioners argue that the amount of income should be larger, and
respondent argues it should be smaller. Petitioners assert that
they should not be required to reduce CTI by the portion of their
costs that was deducted in prior years.
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B. Allocation of Income From Export Sales to DISC’s
1. Statutory Requirement
Under the DISC provisions, Congress created intercompany
pricing rules for the purpose of limiting the amount of income
that the parent can allocate to the DISC and thereby limiting the
amount of tax incentive by means of income deferral. The pricing
rules provide for the price at which the parent corporation is
deemed to have sold its products to the DISC, regardless of the
price actually paid. Bently Labs., Inc. v. Commissioner, 77 T.C.
152, 163 (1981). Section 994(a) provides three alternative
pricing methods for DISC’s: (1) 4 percent of qualified export
receipts on the sale of export property; (2) 50 percent of the
combined taxable income of the DISC and its related supplier (the
parent corporation); or (3) the arm's-length price, computed in
accordance with section 482.6 Taxpayers may use the method that
produces the largest amount of income allocation to the DISC’s.
Similarly, section 925 provides three pricing methods for FSC’s:
(1) 1.83 percent of foreign trading gross receipts; (2) 23
percent of combined taxable income; and (3) the arm's-length
price, computed in accordance with section 482. Sec. 925(a).
The CTI methods are at issue in this case.
6
Under the first two methods, the DISC is entitled to
include 10 percent of its export promotion expenses as additional
taxable income. Sec. 994(a)(1) and (2); sec. 1.994-1(a)(1),
Income Tax Regs.
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The parent corporation either sells its product to the DISC
for resale in foreign markets, a buy-sell DISC, or pays a
commission to the DISC for selling goods in foreign markets, a
commission DISC. Brown-Forman Corp. v. Commissioner, 94 T.C.
919, 926 (1990), affd. 955 F.2d 1037 (6th Cir. 1992). The DISC
in this case is a commission DISC. Although the section 994(a)
pricing rules literally apply only to a buy-sell DISC, they have
been adopted for commission DISC’s pursuant to statutory
authority granted to the Secretary. Sec. 994(b)(1); sec. 1.994-
1(d)(2)(i), Income Tax Regs.; see sec. 925(b)(1); sec. 1.925(a)-
1T(d)(2), Temporary Income Tax Regs., 52 Fed. Reg. 6447 (Mar. 3,
1987). In the case of a commission DISC, CTI is computed using
the gross receipts on the sale, lease, or rental of the property
on which the commissions arose. Sec. 993(f).
2. Regulatory Requirement
CTI equals the excess of the DISC's gross receipts from
export sales over the total costs of the DISC and the parent that
relate to the DISC's gross receipts. Sec. 1.994-1(c)(6), Income
Tax Regs.; see sec. 1.925(a)-1T(c)(6)(i), Temporary Income Tax
Regs., 52 Fed. Reg. 6446 (Mar. 3, 1987). Section 1.994-1(c)(6),
Income Tax Regs., provides rules for determining which costs
relate to export sales:
In determining the gross receipts of the DISC and the
total costs of the DISC and related supplier which
relate to such gross receipts, the following rules
shall be applied:
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(i) Subject to subdivisions (ii) through (v) of
this subparagraph, the taxpayer's method of accounting
used in computing taxable income will be accepted for
purposes of determining amounts and the taxable year
for which items of income and expense (including
depreciation) are taken into account. * * *
(ii) Costs of goods sold shall be determined in
accordance with the provisions of section 1.61-3
[Income Tax Regs.]. See sections 471 and 472 and the
regulations thereunder with respect to inventories.
* * *
(iii) Costs (other than cost of goods sold) which
shall be treated as relating to gross receipts from
sales of export property are (a) the expenses, losses,
and other deductions definitely related, and therefore
allocated and apportioned, thereto, and (b) a ratable
part of any other expenses, losses, or other deductions
which are not definitely related to a class of gross
income, determined in a manner consistent with the
rules set forth in section 1.861-8 [Income Tax Regs.].
See sec. 1.925(a)-1T(c)(6)(iii), Temporary Income Tax Regs., 52
Fed. Reg. 6446 (Mar. 3, 1987).
3. Application of Regulations by the Parties
Petitioners contend that subdivision (i) of the regulation
requires the computation of CTI in accordance with the method
they use to account for domestic taxable income. Section 1.451-
3(d)(5)(iii), Income Tax Regs., permits a variation from the
completed contract method for electing taxpayers to currently
deduct period costs even though the related income is not
reportable until a later taxable year when the contract is
completed. Due to their election to currently deduct period
costs, petitioners argue that, in the year of contract
completion, they should not be required to reduce foreign gross
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receipts by period costs that were deducted in computing prior
years' income taxes. Because they cannot deduct prior year
period costs in the years in issue, petitioners contend that
those period costs need not be utilized in computing CTI.
Conversely, respondent argues that, in accord with the
congressional intent as reflected in the legislative history, the
regulations require a taxpayer to account for all costs that
relate to export sales, including period costs deducted in prior
years. Respondent further argues that petitioners' accounting
method and any permissible variations therefrom do not control in
determining the statutory limitations for computing CTI. We
agree with respondent.
C. Whether Section 1.994-1(c)(6), Income Tax Regs., Is a
Reasonable Interpretation of the Statute
The regulation in controversy was intended to define the
statutory phrase "combined taxable income". That phrase is not
defined in the Internal Revenue Code. The regulation promulgated
by the Secretary is couched in broad terms, leaving room for the
parties to advance differing interpretations. In this regard,
petitioners have not questioned the validity of the regulation
under consideration. The regulatory formula for CTI is the
"excess of the gross receipts * * * over the total costs * * *
which relate to such gross receipts." Sec. 1.994-1(c)(6), Income
Tax Regs. The regulation also provides that the taxpayer may in
certain circumstances use the same method of accounting in
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computing CTI as used during the taxable year for which CTI is
being computed. Sec. 1.994-1(c)(6)(i), Income Tax Regs.
The term "total costs" is ambiguous and does not delineate
whether the "total" is for the year, as petitioners contend, or
all costs relating to the gross receipts, including those
incurred and deducted in a prior year. Accordingly, petitioners
and respondent are both placed in the position of advancing, for
purposes of this litigation, their respective interpretations of
the language of the regulation.
Normally, we defer to regulations which “implement the
congressional mandate in some reasonable manner.” United States
v. Vogel Fertilizer Co., 455 U.S. 16, 24 (1982) (quoting United
States v. Correll, 389 U.S. 299, 307 (1967)); Rowan Cos., Inc. v.
United States, 452 U.S. 247, 252 (1981); National Muffler Dealers
Association, Inc. v. United States, 440 U.S. 472, 476 (1979).7
7
The deference given to a regulation depends on the source
of authority under which the Secretary promulgated it. Less
deference is given to a regulation promulgated under the general
authority of sec. 7805(a), an interpretative regulation, and
greater deference to a regulation promulgated under a specific
statutory grant of authority, a legislative regulation. United
States v. Vogel Fertilizer Co., 455 U.S. 16, 24 (1982).
Pursuant to sec. 994(b)(1), the Secretary issued sec. 1.994-
1(d), Income Tax Regs., which subjects commission DISC’s to the
pricing rules set forth in sec. 994(a). See sec. 1.925(a)-1T(d),
Temporary Income Tax Regs., 52 Fed. Reg. 6447 (Mar. 3, 1987).
Sec. 1.994-1(d)(2), Income Tax Regs., refers to par. (c) of that
regulation for the proper method to apply the pricing rules.
However, that reference may not automatically make par. (c) a
legislative regulation when applied to commission DISC’s.
Congress did not specifically grant the Secretary authority to
promulgate regulations with regard to buy-sell DISC’s.
(continued...)
- 22 -
Respondent's litigating position is not afforded any more
deference than that of petitioners. By way of example, proposed
regulations and revenue rulings are generally not afforded any
more weight than that of a position advanced by the Commissioner
on brief. Laglia v. Commissioner, 88 T.C. 894, 897 (1987);
Estate of Lang v. Commissioner, 64 T.C. 404, 407 (1975), affd. in
part and revd. in part 613 F.2d 770 (9th Cir. 1980). That is
especially so here, where respondent did not publish her position
prior to this controversy. Accordingly, we proceed to decide
which party's approach harmonizes with the statutory intent.
Section 994(a)(2) presents the somewhat ambiguous and
completely undefined term "combined taxable income." The
regulation in question does not conflict with the language of the
statute it interprets. In addition, the regulatory definition of
costs related to export sales is consistent with legislative
history, which states:
the combined taxable income * * * would be determined
by deducting from the DISC's gross receipts the related
person's cost of goods sold with respect to the
property, the selling, overhead and administrative
expenses of both the DISC and the related person which
7
(...continued)
Subdivision (iii) of sec. 1.994-1(c)(6), Income Tax Regs.,
applies equally to buy-sell DISC’s and commission DISC’s.
Accordingly, portions of the regulation in question may be
legislative or interpretative or a mix of legislative and
interpretative elements. The parties’ disagreement, however,
does not focus on the source of the Government's authority for
issuance of the regulation in question, and it is unnecessary to
decide whether the regulation in question is interpretative,
legislative, or a mixture of both.
- 23 -
are directly related to the production or sale of the
export property and a portion of the related person's
and the DISC's expenses not allocable to any specific
item of income, such portion to be determined on the
basis of the ratio of the combined gross income from
the export property to the total gross income of the
related person and the DISC. [Fn. ref. omitted;
emphasis added.]
H. Rept. 92-533, at 74 (1971), 1972-1 C.B. 498, 538; S. Rept. 92-
437, at 107 (1971), 1972-1 C.B. 559, 619. The regulation in
issue defines an ambiguous term and reflects congressional intent
as to the types of costs taxpayers must allocate to export sales
in calculating CTI. Thus, the regulatory definition of CTI in
section 1.994-1(c)(6), Income Tax Regs., is a reasonable
interpretation of section 994.
D. Interpretation of the Regulatory Definition of "Combined
Taxable Income"
Regulations that are valid exercises of the powers of the
Secretary have the force and effect of law. Sim-Air, USA, Ltd.
v. Commissioner, 98 T.C. 187, 198 (1992). The rules for
interpreting a valid regulation are similar to those governing
the interpretation of statutes. KCMC, Inc. v. FCC, 600 F.2d 546,
549 (5th Cir. 1979); Intel Corp. & Consol. Subs. v. Commissioner,
100 T.C. 616, 631 (1993), affd. 67 F.3d 1445 (9th Cir. 1995).
When construing a statute, or in this case a regulation, we are
to give effect to its plain and ordinary meaning unless to do so
would produce absurd results. Green v. Bock Laundry Mach. Co.,
490 U.S. 504, 509 (1989); Exxon Corp. v. Commissioner, 102 T.C.
- 24 -
721 (1994). The most basic tenet of statutory construction is to
begin with the language of the statute itself. United States v.
Ron Pair Enters., Inc., 489 U.S. 235, 241 (1989). When the plain
language of the statute is clear and unambiguous, that is where
the inquiry should end. Id. Where a statute is silent or
ambiguous, we look to legislative history to ascertain
congressional intent. Peterson Marital Trust v. Commissioner,
102 T.C. 790, 799 (1994), affd. 78 F.3d 795 (2d Cir. 1996). We
apply these rules to interpret the regulations promulgated under
section 994.
An integral part of calculating CTI is determining the costs
of the export sales. Sec. 1.994-1(c)(6), Income Tax Regs. The
regulations under section 994 require taxpayers to account for
the "total costs" related to export sales. Sec. 1.994-1(c)(6),
Income Tax Regs.; see sec. 1.925(a)-1T(c)(6)(ii), Temporary
Income Tax Regs., 52 Fed. Reg. 6446 (Mar. 3, 1987). Total costs
include costs that definitely relate to the export sales and a
ratable share of costs that do not definitely relate to any class
of gross income. Sec. 1.994-1(c)(6)(iii), Income Tax Regs.; see
sec. 1.925(a)-1T(c)(6)(iii)(D), Temporary Income Tax Regs.,
supra. Thus, taxpayers must allocate their costs between export
sales and domestic sales to compute CTI. Sec. 1.994-
1(c)(6)(iii), Income Tax Regs.; see sec. 1.925(a)-
1T(c)(6)(iii)(D), Temporary Income Tax Regs., supra.
- 25 -
Rather than creating a new method of cost allocation within
the DISC provisions, Congress intended that taxpayers use the
method for allocating costs under section 1.861-8, Income Tax
Regs. The intended method for allocating expenses in the CTI
computations appears consistent throughout the legislative
history of the DISC provisions, which states:
the combined taxable income from the sale of the export
property is to be determined generally in accordance
with the principles applicable under section 861 for
determining the source (within or without the United
States) of the income of a single entity with
operations in more than one country. These rules
generally allocate to each item of gross income all
expenses directly related thereto, and then apportion
other expenses among all items of gross income on a
ratable basis. * * * [Emphasis added.]
H. Rept. 92-533, supra at 74, 1972-1 C.B. at 538; accord S. Rept.
92-437, supra at 107, 1972-1 C.B. at 619. Consistent with
legislative history, the regulations provide that taxpayers must
allocate and apportion their costs (other than costs of goods
sold) "in a manner consistent with the rules set forth in §
1.861-8." Sec. 1.994-1(c)(6)(iii), Income Tax Regs.; see sec.
1.925(a)-1T(c)(6)(iii)(D), Temporary Income Tax Regs., supra.
In general, section 1.861-8, Income Tax Regs., provides
geographic sourcing rules to allocate and apportion expenses
between the United States and foreign countries. It also
provides rules for determining taxable income from specific
activities and for allocating income and deductions to those
activities under other sections of the Code referred to as
- 26 -
"operative sections". Sec. 1.861-8(a)(1),(f)(1)(i)-(vi), Income
Tax Regs. Operative sections define the categories of income
between which taxpayers must allocate their deductions and gross
income.
Section 994 is an operative section wherein income is
grouped into two categories; i.e., income from export sales,
referred to as the statutory grouping, and all remaining gross
income, referred to as the residual grouping. St. Jude Medical,
Inc. v. Commissioner, 97 T.C. 457, 465 (1991), affd. in part and
revd. in part and remanded 34 F.3d 1394 (8th Cir. 1994); sec.
1.861-8(f)(1)(iii), Income Tax Regs. Under section 1.861-8,
Income Tax Regs., taxpayers must allocate their deductions to a
class of gross income and, then, if necessary to make the
determination required by the operative section, apportion the
deductions within the class of gross income between the statutory
and residual groupings. Sec. 1.861-8(a)(2), Income Tax Regs.
The apportionment must be accomplished in a manner that reflects
to a "reasonably close extent" the factual relationship between
the deduction and the income grouping. Sec. 1.861-8(c)(1),
Income Tax Regs.
Similar to the related costs definition in section 1.994-
1(c)(6)(iii), Income Tax Regs., section 1.861-8, Income Tax
Regs., requires allocation of deductions to definitely related
classes of gross income. Any deductions that do not definitely
relate to a class of gross income are ratably apportioned to all
- 27 -
gross income based on the ratio of gross income from each class
to the taxpayer's total gross income. Sec. 1.861-8(a)(2),
(b)(1), and (c)(3), Income Tax Regs. A cost is "definitely
related" to a class of gross income if it is incurred as a result
of, or incident to, an activity or in connection with property
from which that class of gross income is derived. Sec. 1.861-
8(b)(2), Income Tax Regs. In general, period costs benefit and
relate to the taxpayer's business as a whole and are not incident
to or necessary for the performance of a particular contract.
McMaster v. Commissioner, 69 T.C. 952, 955 (1978). Thus, period
costs are costs that do not definitely relate to any class of
gross income, as defined by sections 1.994-1(c)(6)(iii) and
1.861-8, Income Tax Regs., and must be ratably apportioned to all
gross income.
Additionally, section 1.861-8, Income Tax Regs., does not
distinguish period costs from other costs that relate to export
sales. Furthermore, section 1.861-8, Income Tax Regs., does not
excuse taxpayers from allocating costs to a class of gross income
unless the costs are definitely related to another class of gross
income. Section 1.861-8(a)(2), Income Tax Regs., provides:
“Except for deductions, if any, which are not definitely related
to gross income * * * and which, therefore, are ratably
apportioned to all gross income, all deductions of the taxpayer
* * * must be so allocated and apportioned.” Thus, consistent
with the section 994 regulations, section 1.861-8, Income Tax
- 28 -
Regs., requires taxpayers to prove that the prior year period
costs definitely relate to gross income from a source other than
export sales, which petitioners have failed to do, to avoid
having to account for those costs in determining CTI.
The regulations under section 994, which incorporate section
1.861-8, Income Tax Regs., are consistent with the statutory
intent and legislative history. By requiring taxpayers to
account for all costs incurred to produce export property in
calculating CTI, the regulations limit the deferral or exclusion
of income to the actual income from foreign sales after
considering "total costs". In addition, the regulations do not
permit the exclusion of any particular costs, such as prior year
period costs, from the computation of CTI, unless the costs
definitely relate to a class of gross income other than export
sales. Sec. 1.994-1(c)(6), Income Tax Regs.; sec. 1.925(a)-
1T(c)(6)(iii), Temporary Income Tax Regs., supra.
Implicit in petitioners' position that they are following
the completed contract method is that the total costs are only
those claimed in the computation year. Petitioners do not
provide us with a logical or reasonable definition of "total
costs" and/or "related costs" that would harmonize with the
statutory limitation intended by Congress. Nor have petitioners
shown that the prior year period costs definitely relate to a
class of gross income other than export sales. It has not been
argued that the prior year period costs are unrelated to
- 29 -
petitioners' export sales. In addition, petitioners previously
allocated the prior year period costs to particular export sales
contracts as they accrued. Thus, we find that the regulatory
definition of related costs includes prior year period costs that
have previously been deducted. Petitioners must account for both
current and prior year period costs in determining their CTI.
E. The Effect of the Taxpayer's Method of Accounting on the
Computation of Combined Taxable Income
Petitioners also argue that they are properly applying their
method of accounting by not reducing CTI by prior year period
costs. Rather than suggesting an alternative definition of total
costs that excludes prior year period costs, petitioners rely on
subdivision (i) of section 1.994-1(c)(6), Income Tax Regs. That
subdivision permits taxpayers to use their normal method of
accounting in computing CTI. Petitioners interpret that
regulation to require taxpayers to compute CTI in accordance with
their method of accounting. Accordingly, petitioners contend
that whether costs related to export sales, as defined in section
1.994-1(c)(6)(iii), Income Tax Regs., are allocable to those
export sales for purposes of determining CTI depends on their
accounting method.
Section 1.994-1(c)(6)(i), Income Tax Regs., provides:
(i) Subject to subdivisions (ii) through (v) of
this subparagraph, the taxpayer's method of accounting
used in computing taxable income will be accepted for
purposes of determining amounts and the taxable year
- 30 -
for which items of income and expense (including
depreciation) are taken into account. * * *
See sec. 1.925(a)-1T(c)(6)(iii)(A), Temporary Income Tax Regs.,
supra. Use of the taxpayer's accounting method is expressly
subject to subdivision (iii)'s definition of related costs that
taxpayers must take into account in calculating CTI. Sec. 1.994-
1(c)(6)(i), Income Tax Regs.; see sec. 1.925(a)-1T(c)(6)(iii)(D),
Temporary Income Tax Regs., supra. Thus, section 1.994-
1(c)(6)(iii), Income Tax Regs., defines the costs related and
allocable to petitioners' export sales; such costs are not
defined by petitioners' method of accounting.
In addition to their misplaced reliance on subdivision (i)
of section 1.994-1(c)(6), Income Tax Regs., petitioners also
assert that section 1.861-8, Income Tax Regs., supports their
position that they are not required to account for prior year
period costs. As stated above, Congress intended taxpayers
exporting through DISC’s to allocate their income and costs to
export sales pursuant to the requirements of section 1.861-8,
Income Tax Regs. Rather than address the substantive allocation
requirements of section 1.861-8, Income Tax Regs., as described
above, petitioners again concentrate their argument on their
accounting method. Petitioners argue that section 1.861-8,
Income Tax Regs., requires that the principles of annual
accounting apply to income and cost allocations. Petitioners
deducted the period costs in prior years in accordance with the
- 31 -
completed contract method. Therefore, petitioners contend that
requiring them to account for the prior year period costs in the
year of contract completion to compute CTI is inconsistent with
the principles of annual accounting.
Under the principles of annual accounting, a transaction
must be accounted for under the taxpayer's method of accounting
on the basis of the facts in the year the transaction occurs.
Security Flour Mills Co. v. Commissioner, 321 U.S. 281 (1944);
Burnet v. Sanford & Brooks Co., 282 U.S. 359 (1931); Landreth v.
Commissioner, 859 F.2d 643 (9th Cir. 1988), affg. in part, revg.
in part, and remanding T.C. Memo. 1985-413. Section 461(a)
requires that a deduction be taken in the taxable year that is
proper under the taxpayer's method of accounting.
The completed contract method requires income and deductions
from long-term contracts to be reported in the year in which the
contracts are completed. Sec. 1.451-3(d)(1), Income Tax Regs.
However, section 1.451-3(d)(5)(iii), Income Tax Regs., provides a
variation or exception to the requirement that deductions be
deferred. A current deduction is allowed, at the taxpayer's
election, for period costs. Texas Instruments Inc. v.
Commissioner, T.C. Memo. 1992-306; sec. 1.451-3(d)(5)(iii),
Income Tax Regs. Period costs include marketing and selling
expenses, distribution expenses, general and administrative
expenses attributable to the performance of services that benefit
the taxpayer's activities as a whole, casualty losses, certain
- 32 -
pension and profit-sharing contributions, and costs attributable
to strikes, rework labor, scrap, and spoilage. Sec. 1.451-
3(d)(5)(iii), Income Tax Regs.
Petitioners' use of the completed contract method of
accounting to report income and deductions for their long-term
contracts has not been questioned. This method of accounting
provides an alternative to the annual accrual method of
accounting for long-term contracts for which the ultimate profit
or loss is not ascertainable until the contract is completed.
See RECO Indus., Inc. v. Commissioner, 83 T.C. 912, 921 (1984).
The method allows a taxpayer to account for the entire result of
a long-term contract at one time. Id. The purpose of the
completed contract method is to match the costs of generating
income with the income produced. In this case, however,
petitioners try to use the completed contract method to avoid the
matching of costs with income from export sales for purposes of
computing CTI as required by the regulations under sections 994
and 925. As a result, petitioners did not subtract all the costs
related to their export sales as defined in section 1.994-
1(c)(6)(iii), Income Tax Regs., from the export income that the
expenditures generated.
The completed contract method of accounting does not
necessarily conflict with requiring taxpayers to account for all
related period costs in determining CTI. The completed contract
method is an accounting method that allocates to a particular
- 33 -
taxable year the items of income and expenses that must be
reported within that year. It is relevant only to the timing of
deductions and income recognition. RECO Indus., Inc. v.
Commissioner, supra at 922. Like other accounting methods, the
completed contract method relies on other sections of the Code,
such as the DISC provisions, to determine the amount of income to
be recognized and the amount of allowable deductions. The
purpose of the pricing rules in the DISC provisions is to
determine the amount of income that taxpayers engaged in export
activities must recognize and the amount of income that is tax
deferred. The completed contract method has a different purpose.
It determines the taxable year in which a related supplier
recognizes the income attributable to export sales, the amount of
income to be recognized having been determined by the DISC
provisions. Thus, the variations or exceptions to the completed
contract method here do not govern which costs are allocable to
long-term export contracts for purposes of determining CTI.
In addition, requiring taxpayers to account for prior year
period costs in calculating CTI does not interfere with the
current deduction allowed for period costs under the completed
contract method. Petitioners' interpretation of the completed
contract method gives taxpayers benefits in addition to their
ability to currently deduct period costs. There is no indication
that Congress intended the limitation on deferral or exclusion to
promote foreign exports to include a double or extra benefit only
- 34 -
for those taxpayers on the completed contract method who elected
to deduct period costs on an annual basis.
Accepting petitioners' argument would mean that taxpayers
using the completed contract method of accounting would calculate
their CTI in accordance with section 1.451-3, Income Tax Regs.,
as opposed to the regulations under sections 994 and 925. Under
section 1.861-8, Income Tax Regs., the costs to be allocated are
defined by the operative section which references that
regulation. Thus, we look to sections 994 and 925 and the
related regulations to determine which costs are allocable to
export sales for purposes of determining CTI, not the regulations
under section 451 as petitioners contend. Although period costs
are not required to be allocated to long-term contracts for cost-
deferral purposes under section 1.451-3(d)(5)(iii), Income Tax
Regs., sections 994(a) and 925(a) and the related regulations
require that all costs, including prior year period costs, be
accounted for in determining CTI.
Requiring petitioners to account for all period costs in
determining CTI is consistent with the completed contract method
of accounting. Allowing taxpayers to use their normal method of
accounting to compute CTI does not necessarily cede to the
accounting methodology the computation of the limitation of the
benefit to be generated by foreign exports. Petitioners must
account for all related costs, including period costs, of both
- 35 -
current and prior years in determining their CTI from export sales.
II. Regulatory Definition of "Export Property"
Petitioners manufactured two specialized vessels that were
designed and built for transoceanic transport of liquefied
natural gas. The tankers were manufactured under contract for
sale to a company for direct use outside the United States.
After the completion, but before the tankers could be used for
foreign purposes, unforeseen delays caused some domestic use of
one of the tankers. The delay also caused both tankers not to be
used in foreign commerce prior to 1 year after their sale.
In order for petitioners' DISC to retain its statutory
status, 95 percent of its gross receipts must consist of
qualified export receipts. Sec. 993(e). Qualified export
receipts include gross receipts from the sale, exchange, or other
disposition of export property. "Export property" is statutorily
defined, in pertinent part, as "property * * * manufactured * * *
in the United States by a person other than a DISC, * * * held
primarily for sale, * * * in the ordinary course of trade or
business * * * for direct use, consumption, or disposition
outside the United States”. Sec. 993(c)(1).
The regulations in connection with the definition of "export
property" provide for a "destination test". Property satisfies
the destination test "only if it is * * * directly used * * *
outside the United States * * * by the purchaser * * * within 1
- 36 -
year after such sale". Sec. 1.993-3(d)(2)(i)(b), Income Tax
Regs. Petitioners contend that the destination test of the
regulation is not a proper interpretation of the statutory
provision and hence is invalid.
We have already addressed the destination test and found
valid section 1.993-3(d)(2)(i)(b), Income Tax Regs., in Sim-Air,
USA, Ltd. v. Commissioner, 98 T.C. 187, 190-197 (1992). There is
nothing in petitioners' argument here that would warrant a change
in our reasoning or conclusion concerning the validity of that
aspect of the DISC regulations. Petitioners also raise factual
distinctions between this case and Sim-Air. Factual differences
between cases, however, do not address the question of whether a
particular regulation is a proper interpretation of a statutory
provision.
Petitioners also argue that they should be relieved of the
1-year destination requirement because of the unforeseen factual
circumstances that caused them not to meet the regulation's
requirement. The taxpayer in Sim-Air made a similar argument
that was rejected. Id. at 197-198. Once a regulation is found
valid, it has the force and effect of law. That law (both the
statute and the regulation in question here) does not provide any
exception for reasonable delay or unforeseen events. Nor is
there room to interpret the statute or regulation to permit
petitioners' factual circumstances different treatment by means
- 37 -
of a waiver or exemption from the requirement under
consideration.
Petitioners also question the validity of other subparts of
the export property regulation, but we find it unnecessary to
consider that and other positions of the parties because
petitioners' failure to satisfy the 1-year test is dispositive of
this issue.
To reflect the foregoing,
An appropriate order will be
issued reflecting the resolution of
the foreign issues in controversy.