DocketNumber: Docket Nos. 7755-76, 1232-78
Citation Numbers: 77 T.C. 152, 1981 U.S. Tax Ct. LEXIS 90
Judges: Raum
Filed Date: 7/30/1981
Status: Precedential
Modified Date: 1/13/2023
*90
T Corp., an accrual basis corporation with a fiscal year ending Nov. 30, sells its products to a wholly owned domestic international sales corporation (DISC), with a fiscal year ending Jan. 31. The transfer price for T's sales to the DISC is determined at the end of the DISC's fiscal year under the intercompany pricing rules of
*153 OPINION
The Commissioner determined deficiencies of $ 453,968 and $ 438,995 in petitioners' 1972 and 1973 income taxes, respectively. Petitioner Bentley Laboratories, Inc. (Bentley Labs or Labs), owns all of the stock of Bentley International Ltd., a domestic international sales corporation (DISC or International). Bentley Labs is an accrual basis taxpayer with a fiscal year ending November 30, and the DISC is an accrual basis taxpayer with a fiscal year ending January 31. The principal issue is whether profit from sales of products by Bentley Labs to the DISC should be included in the parent corporation's income for the taxable year in which such sales are completed, or should be deferred until the succeeding taxable year when the precise transfer price 1 for such sales is finally ascertained at the DISC's yearend in accordance with the intercompany pricing rules set forth in
*94 Petitioner Bentley Laboratories, Inc., is a Delaware corporation organized on December 4, 1969. At the time of the filing of its petitions herein, its principal place of business was in Irvine, Calif. Sensorex is a California corporation organized on January 16, 1973, with a principal place of business in Irvine, Calif. Bentley Labs owns 95 percent of the issued and outstanding stock of Sensorex. Sensorex is a party to this action only because it joined Bentley Labs in filing a consolidated tax return for the year ended November 30, 1973, and Bentley Labs will accordingly sometimes hereinafter be referred to as the petitioner.
Since 1969, petitioner has been engaged in the business of manufacturing and selling paramedical equipment. It maintains its books and records and prepares its income tax returns on the accrual method of accounting and on the basis of a fiscal year ending November 30.
*154 Bentley International Ltd., a wholly owned subsidiary of petitioner, is a California corporation organized on January 18, 1972. It commenced doing business on February 1, 1972, and elected to be treated as a domestic international sales corporation for income tax purposes, in accordance*95 with the provisions of
Since commencing business, the DISC has purchased paramedical equipment from petitioner, and, in turn, has disposed of such equipment outside of the United States in accordance with an agreement between petitioner and the DISC dated February 1, 1972. In that agreement, International agreed to "accept billing for products from Labs in an amount which will yield to Labs the optimum tax benefit allowable" pursuant to
The transfer prices on sales by petitioner to the DISC during petitioner's taxable year ended November 30, 1972, were determined at the end of the DISC's fiscal year ended January 31, 1973, utilizing the 50-50 combined taxable income method provided by
On its books and records for the fiscal year ended November 30, 1972, petitioner recorded a total of $ 1,221,587.17 in sales to the DISC. It also recorded in its books and records for that year manufacturing costs in the amount of $ 687,119.06 with respect to the products sold to the DISC in that year. However, the sales to the DISC and the related*98 cost of manufacturing the goods sold to the DISC were "journalled out" of petitioner's accounts at the end of the taxable year, thereby causing a $ 534,468.11 decrease in petitioner's taxable income for the taxable year ended November 30, 1972.
Petitioner followed similar accounting procedures for the succeeding taxable year. It determined the transfer price on its sales to the DISC during the period February 1, 1973, through November 30, 1973, at the end of the DISC's fiscal year ended January 31, 1974, utilizing the 50-50 combined taxable income method authorized by
During the period February 1, 1973, through November 30, 1973, petitioner's cost to manufacture products sold to the DISC was $ 1,059,786, and, during this same period, petitioner recorded in its books and records the amount of $ 1,059,786 as sales to the DISC.
For financial reporting purposes, petitioner and the DISC are parent and subsidiary. Because of this, and for reasons which are unrelated to the Federal income tax laws, the petitioner and DISC are required to prepare consolidated financial statements in which all sales, costs to manufacture, and related profits on transactions between petitioner and the DISC are eliminated. As a result of this elimination of intercompany transactions, petitioner's financial statements for each of its years ended November 30 reflect sales between the DISC and third party customers.
In the notices of deficiency issued to petitioner, the Commissioner determined that the gross receipts and related manufacturing*100 costs with respect to petitioner's sales to the DISC should be reported on petitioner's return for the taxable year in which such sales take place, rather than in the taxable year following the end of the DISC's taxable year. As an alternative position, the Commissioner determined that if sales to the DISC were not to be recorded as of the end of petitioner's taxable year in which such sales take place, then the cost of goods sold, general and administrative expenses, and direct selling expenses related to such sales should not be recorded until the year in which the related sales to the DISC are recorded.
Although the deficiency notices contain alternative methods of computing the amounts by which petitioner purportedly understated its gross sales for each of the taxable years in issue, the Government now argues only that the amount of petitioner's sales to the DISC should be determined by computing a combined taxable income, realized by petitioner and the DISC from sales to third parties, and then working *157 from this amount to derive a transfer price for sales by petitioner to the DISC under one of the intercompany pricing methods specified in
*102 The figures which the Government uses in the alternative computation upon which it now relies in determining the transfer price of petitioner's sales to the DISC have all been stipulated 4 or derived from the stipulated figures and are the same as those in the deficiency notices, except that the stipulated amounts have not been rounded to the nearest dollar. That computation (in three parts) for petitioner's taxable year ended November 30, 1972, is as follows: 5*158
I. COMPUTATION OF COMBINED TAXABLE INCOME | ||
OF PETITIONER & DISC WITH RESPECT TO | ||
DISC SALES FROM 2/1/72-11/30/72 | ||
DISC gross sales to third parties | $ 1,632,885.00 | |
Less: | ||
Petitioner's cost to manufacture | ||
products sold to DISC | $ 687,119.06 | |
Petitioner's direct selling | ||
expenses on sales to DISC | 33,940.00 | |
Petitioner's general and | ||
administrative expenses | ||
apportioned to DISC sales 6*104 | 480,413.00 | |
DISC export promotion expenses | 94,578.00 | 1,296,050.06 |
Combined taxable income from DISC sales | 336,834.94 | |
II. COMPUTATION OF DISC INCOME UNDER THE "50-50" | ||
COMBINED TAXABLE INCOME METHOD PROVIDED | ||
BY SEC. 1.994-1(c)(3), INCOME TAX REGS. 7 | ||
50% of combined taxable income | $ 168,417.47 | |
10% DISC export promotion expenses | 9,457.80 | |
DISC income | 177,875.27 | |
III. COMPUTATION OF TRANSFER PRICE ON PETITIONER'S | ||
SALES TO DISC 2/1/72-11/30/72 | ||
DISC gross sales to third parties | $ 1,632,885.00 | |
Less: | ||
DISC expenses | $ 94,578.00 | |
DISC income | 177,875.27 | 272,453.27 |
Transfer price for petitioner's sales to DISC | 1,360,431.73 |
*159 The Government contends that this estimated transfer price for sales to the DISC should be included in petitioner's gross receipts for petitioner's taxable year ended November 30, 1972. If such sales are recorded, then petitioner's $ 687,119.06 cost to manufacture the products sold to the DISC would likewise be recorded in the same year. The net result of these adjustments would be a $ 673,312.67 increase in petitioner's taxable income for the year ended November 30, 1972.
With respect to petitioner's taxable*105 year ended November 30, 1973, the Government asserts that a similar procedure should be applied, with certain modifications. The Government first computes a separate "transfer price" for sales to the DISC from December 1, 1972, through January 31, 1973. From the transfer price reported by the DISC on its return for its purchases from petitioner during the DISC's taxable year ended January 31, 1973, $ 1,602,640, the estimated transfer price determined for petitioner's taxable year ended November 30, 1972, is subtracted. The difference between these sums, $ 242,208.27, would be the "transfer price" for petitioner's sales to the DISC for the 2-month period ended January 31, 1973. The Government would then compute the transfer price for the remainder of petitioner's taxable year ended November 30, 1973, in accordance with the method used for the preceding year.
Utilizing the stipulated amounts of sales, cost of products sold, and expenses for petitioner and the DISC, the Government's computations produce the following results:
I. COMPUTATION OF COMBINED TAXABLE INCOME | ||
OF PETITIONER & DISC WITH RESPECT TO | ||
DISC SALES FROM 2/1/73-11/30/73 | ||
DISC gross sales to third parties | $ 2,667,723.00 | |
Less: | ||
Petitioner's cost to manufacture | ||
products sold to DISC | $ 1,059,786.00 | |
Petitioner's direct selling | ||
expenses on sales to DISC | 22,839.00 | |
Petitioner's general and administrative | ||
expenses apportioned to DISC sales 8 | 750,048.00 | |
DISC export promotion expenses | 121,064.00 | $ 1,953,737.00 |
Combined taxable income from DISC sales | 713,986.00 | |
II. COMPUTATION OF DISC INCOME UNDER THE "50-50" | ||
COMBINED TAXABLE INCOME METHOD PROVIDED BY | ||
SEC. 1.994-1(c)(3), INCOME TAX REGS. 9 | ||
50 percent of combined taxable income | $ 356,993.00 | |
10 percent DISC export promotion expenses | 12,106.40 | |
DISC income | 369,099.40 | |
III. COMPUTATION OF TRANSFER PRICE ON PETITIONER'S | ||
SALES TO DISC 2/1/73-11/30/73 | ||
DISC gross sales to third parties | $ 2,667,723.00 | |
Less: | ||
DISC expenses | $ 121,064.00 | |
DISC income | 369,099.40 | 490,163.40 |
Transfer price for petitioner's sales to DISC | 2,177,559.60 |
*160 The Commissioner determined that the above transfer price, plus the reconciled "transfer price" for sales to the DISC from December 1, 1972, through January 31, 1973 ($ 2,177,559.60 + $ 242,208.27 = $ 2,419,767.87), should be the amount of petitioner's reported sales to the DISC for petitioner's taxable*107 year ended November 30, 1973. As set forth in the notice of *161 deficiency, petitioner's gross receipts from sales to the DISC were previously reported as $ 1,618,644. Thus, the net effect of the Government's position is an increase of $ 801,123.87 ($ 2,419,767.87 minus $ 1,618,644) in petitioner's gross receipts. Similarly, petitioner's $ 1,059,786 cost of manufacturing products sold to the DISC from February 1, 1973, through November 30, 1973, which petitioner deducted in the following year would be added to its manufacturing costs for its year ended November 30, 1973, and the $ 687,119.06 manufacturing costs allocable to the period February 1, 1972, through November 30, 1972, would have to be eliminated from manufacturing costs for the year ended November 30, 1973. As a result, there would be a net increase of $ 372,666.94 in deductions ($ 1,059,786 minus $ 687,119.06). The end result would be a net increase in petitioner's taxable income in the amount of $ 428,456.93 ($ 801,123.87 net increase in gross receipts minus $ 372,666.94 net increase in manufacturing costs). 10
*108 Petitioner argues that because it was entitled to determine the transfer price for its sales to the DISC on the basis of grouping transactions in accordance with
*162 We hold that in the circumstances, neither
As part of the Revenue Act of 1971, 11Congress enacted
In order to qualify as a DISC, 95 percent of a corporation's sales must be export sales of products produced domestically by the DISC's parent corporation, or "related supplier," and at least 95 percent of the corporation's assets must consist of property for export or assets related to or derived from the export sales of such property. See
Petitioner maintains its books and records and prepares its income tax returns on the accrual method of accounting.
*118 Petitioner argues that under the regulations, 17 the transfer price on its sales to the DISC may be computed either on a transaction-by-transaction basis, or on the basis of grouping of transactions by product or product lines. The election to utilize grouping is made annually, and the DISC so elected during each of the years in issue. Because the final transfer price for sales by petitioner to the DISC cannot be computed until this election is made at the DISC's yearend, and because the DISC's *167 yearend is the event which triggers the flow of DISC income to the shareholders under
*119 Although petitioner is correct in arguing that the ultimate computation of the transfer price must await the end of the DISC's taxable year, this does not bar interim transfer pricing computations necessary to determine the gross income realized by the DISC's related supplier on sales to the DISC. First of all, petitioner is incorrect in stating that the Code and regulations "do not provide for computations relating to * * * the portion of the [DISC's] taxable year which ends with the taxable year of the shareholder" when grouping is elected.
(5)
(a) The transfer price of such property sold by the DISC during such year shall be computed separately from the transfer price of the property*120 not sold by the DISC during such year.
(b) With respect to such property not sold by the DISC during such year, the transfer price paid by the DISC for such year shall be the related supplier's cost of goods sold (see subparagraph (6)(ii) of this paragraph) with respect to the property, except that, with respect to such taxable years ending on or before August 15, 1975, the transfer price paid by the DISC shall be at least (but need not exceed) the related supplier's cost of goods sold with respect to the property.
(c) For the subsequent taxable year during which such property is resold by the DISC, an additional amount shall be paid by the DISC (to be treated as income for such year by the related supplier) equal to the excess of the amount which would have been the transfer price under this section had the transfer to the DISC by the related supplier and the resale by the DISC taken place during the taxable year of the DISC during which it resold the property over the amount already paid * * *
[Emphasis added.]
Under this provision in the regulations, the transfer price for a related supplier's sale of products to a DISC must be computed separately from other transfer prices computed*121 at the end of *168 the related supplier's taxable year if the products sold to the DISC have not been resold within the related supplier's taxable year. Although the evidence suggests that none of the transactions between petitioner and the DISC fit precisely within the scope of the regulation, 18 we find the regulation instructive in its sanction of computations of the related supplier's income from sales to the DISC at the end of the related supplier's taxable year without waiting for the resale of the property at the close of the DISC's taxable year.
Moreover, even though petitioner rightly argues that the
Petitioner also asserts that under section 451 and the *169 related regulations, it was not required to accrue income from sales to the DISC until the DISC yearend because the income derived from such sales could not be determined with reasonable accuracy until that time. However, as already noted (p. 166
At the end of petitioner's taxable year, all of the information necessary for the computation of a combined taxable income on export sales of petitioner's products by the DISC, and a transfer price on petitioner's completed sales of such products to the DISC, *124 could have been obtained from petitioner's books or the DISC's books, which were maintained and overseen by personnel of the petitioner. 19 See
It is true that as of the end of petitioner's taxable year, the transfer price on petitioner's sales to the DISC could not be determined to a certainty. Although a transfer price could be precisely determined if petitioner elected*126 to compute the transfer price on sales to the DISC on a transaction-by-transaction basis, petitioner also retained the option to compute the transfer price on the basis of grouping transactions by product or product lines, and did in fact utilize grouping for computing the transfer price at the end of the DISC's taxable year. See
*128 *171 The regulations dealing with the inclusion of income under the accrual method of accounting require that the amount of income be ascertainable "with reasonable accuracy," not that the amount be established to a certainty.
*131 Petitioner did not present any computations of the amount to be included in its income with respect to sales to the DISC if it did not prevail in its position that such amounts were not includable in its income until after the close of the DISC's taxable year. In the absence of evidence as to other reasonable methods of determining the transfer price and petitioner's income from sales to the DISC as of the end of petitioner's taxable years ended November 30, 1972 and 1973, we accept the Government's computations, in respect of transfer prices and resulting taxable income (as modified for the second year, see p. 161
To reflect the foregoing and concessions by the parties,
1. As will appear more fully hereinafter, the term "transfer price" is an artificial concept based on the statutory provisions relating to domestic international sales corporations; it is not necessarily equal to the actual price the parent corporation charges its subsidiary.↩
2. The price at which the export property is deemed to be sold to the DISC is characterized in
3. In addition to setting forth adjustments in petitioner's income computed under the method described above, the deficiency notices also made an alternate determination that under the accrual method of accounting or sec. 482 "in order to clearly reflect income and to prevent distortion of income," petitioner's gross sales should be increased in each of its taxable years by an amount corresponding to the stipulated sales of the DISC to third parties during such taxable years. However, in its reply brief, the Government concedes that
4. Petitioner has objected to such stipulated figures on the ground of relevance. We overrule those objections.↩
5. See
6.
Petitioner's general and administrative expenses for Feb. 1, 1972, through Nov. 30, 1972, were $ 1,847,744. The difference between sales by the DISC of petitioner's products and petitioner's cost to manufacture such products was $ 945,766. The combined gross profit of petitioner and the DISC for the period ended Nov. 30, 1972, without regard to the parties' dispute regarding the application of
$ 945,766/$ 3,636,694 x $ 1,847,744 = $ 480,413↩
7.
8. See note 6
For the period Feb. 1, 1973, through Nov. 30, 1973, petitioner's general and administrative expenses were $ 2,492,411. The difference between sales by the DISC to third parties and petitioner's cost to manufacture the products sold to the DISC was $ 1,607,937. The combined gross profit of petitioner and the DISC for the period ended Nov. 30, 1973, without regard to the parties' dispute with respect to the application of
$ 1,607,937/$ 5,343,178 x $ 2,492,411 = $ 750,048↩
9. See note 7
10. The Government's brief (in one of its requested ultimate findings) and the Commissioner's determination in the notice of deficiency are not consistent with one another -- and are confusing -- in determining the ultimate consequence of the adjustments for this fiscal year. However, if we conclude as we in fact do hereinafter that the Government is correct in its basic position that petitioner's income from sales completed as of Nov. 30 of each fiscal year must be accrued as of the end of such year, the amount of deficiency should be computed in accordance with the foregoing computation.↩
11. Pub. L. 92-178, 85 Stat. 497.↩
12.
(a) In General. -- In the case of a sale of export property to a DISC by a person described in section 482, the taxable income of such DISC and such person shall be based upon a transfer price which would allow such DISC to derive taxable income attributable to such sale (regardless of the sales price actually charged) in an amount which does not exceed the greatest of -- (1) 4 percent of the qualified export receipts on the sale of such property by the DISC plus 10 percent of the export promotion expenses of such DISC attributable to such receipts, (2) 50 percent of the combined taxable income of such DISC and such person which is attributable to the qualified export receipts on such property derived as the result of a sale by the DISC plus 10 percent of the export promotion expenses of such DISC attributable to such receipts, or (3) taxable income based upon the sale price actually charged (but subject to the rules provided in section 482).
(b) Rules for Commissions, Rentals, and Marginal Costing. -- The Secretary shall prescribe regulations setting forth -- (1) rules which are consistent with the rules set forth in subsection (a) for the application of this section in the case of commissions, rentals, and other income, and (2) rules for the allocation of expenditures in computing combined taxable income under subsection (a)(2) in those cases where a DISC is seeking to establish or maintain a market for export property.
(c) Export Promotion Expenses. -- For purposes of this section, the term "export promotion expenses" means those expenses incurred to advance the distribution or sale of export property for use, consumption, or distribution outside of the United States, but does not include income taxes. Such expenses shall also include freight expenses to the extent of 50 percent of the cost of shipping export property aboard airplanes owned and operated by United States persons or ships documented under the laws of the United States in those cases where law or regulations does not require that such property be shipped aboard such airplanes or ships.↩
13. See R. Feinschreiber, Domestic International Sales Corporations 208 (1978).↩
14.
15. The exact point of sale would depend on the method used by petitioner in keeping its books.
16. To the extent that petitioner actually received payment from the DISC with respect to products transferred to the DISC, petitioner would not in any event be entitled to defer the inclusion of such payments in income.
17.
(7)
* * * *
(iii) A choice by the taxpayer to group transactions for a taxable year on a product or product line basis shall apply to all transactions with respect to that product or product line consummated during the taxable year. However, the choice of a product or product line grouping applies only to transactions covered by the grouping and, as to transactions not encompassed by the grouping, the determinations are made on a transaction-by-transaction basis. For example, the taxpayer may choose a product grouping with respect to one product and use the transaction-by-transaction method for another product within the same taxable year.
(6)
* * * *
(iv) The taxpayer's choice in accordance with subparagraph (7) of this paragraph as to the grouping of transactions shall be controlling, and costs deductible in a taxable year shall be allocated and apportioned to the items or classes of gross income of such taxable year resulting from such grouping.↩
18. The DISC's returns for the years ended Jan. 31, 1973 and 1974, show no inventory, thus suggesting that the DISC immediately resold the products purchased from the petitioner.↩
19. It is stipulated that for financial reporting purposes, petitioner and the DISC were required to prepare consolidated financial statements reflecting sales by the DISC to third party customers and eliminating intercompany profits on sales between petitioner and the DISC. Such statements were prepared on the basis of petitioner's fiscal year, and it would therefore not appear to have been unduly burdensome for petitioner to obtain the information necessary to compute a transfer price on its sales to the DISC at that time. Certainly, petitioner has presented no evidence that such information could not have been obtained from its accounting records and the records of the DISC.↩
20. On brief, petitioner has pointed to a number of hypothetical events, such as those mentioned above, as well as plant closings, bans on sales of petitioner's products, or other drastic changes, which might require consideration in the computation of the transfer price for petitioner's sales to the DISC. However, petitioner has not called our attention to evidence in the record indicating that any such hypothetical events actually occurred, or even if they did occur that the effects thereof could not have been reasonably anticipated. Moreover, although petitioner has argued that its recorded estimate of the transfer price for sales to the DISC as of Nov. 30, 1972, "turned out to be substantially in error," petitioner has not shown the basis for the estimate recorded on its books. Although petitioner's estimate proved to be incorrect, this does not provide a basis for finding that a reasonable estimate could not have been made by a proper consideration of the facts known to, or ascertainable by, petitioner at the end of its taxable year, since the record does not contain sufficient information to determine whether petitioner's estimate was computed by the most reasonable means. Cf.
21. It is undisputed that the Commissioner's method (as shown by his computation relating to the second of the 2 years involved herein) actually does make the necessary subsequent adjustment.↩
22. Petitioner argues that
23. See
24. See p. 170.↩
25. For example, it might be contended that a different allocation method should be used to allocate petitioner's general and administrative expenses to sales to the DISC. See
Automobile Club of New York, Inc. v. Commissioner of ... , 304 F.2d 781 ( 1962 )
denise-coal-company-v-commissioner-of-internal-revenue-estate-of-charles , 271 F.2d 930 ( 1959 )
Charles F. Dally and Sarafrancis Dally v. Commissioner of ... , 227 F.2d 724 ( 1955 )
The Cappel House Furnishing Company v. United States , 244 F.2d 525 ( 1957 )
Harrold v. Commissioner of Internal Revenue. Cromling v. ... , 192 F.2d 1002 ( 1951 )
Hagen Advertising Displays, Inc., an Ohio Corporation v. ... , 407 F.2d 1105 ( 1969 )
Spring City Foundry Co. v. Commissioner , 54 S. Ct. 644 ( 1934 )
Stephens Marine, Inc., Successor in Interest to Stephens ... , 430 F.2d 679 ( 1970 )
Continental Tie & Lumber Co. v. United States , 52 S. Ct. 529 ( 1932 )