R.E. Dietz Corp. v. U.S.

• Decision Date: 22 July 1991
• Docket Number: No. 1438,D,1438
• Citation: 939 F.2d 1
• Parties: -5238, 91-2 USTC P 50,375 R.E. DIETZ CORPORATION, Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant. ocket 90-6274.
• Court: U.S. Court of Appeals — Second Circuit

Page 1

939 F.2d 1

68 A.F.T.R.2d 91-5238, 91-2 USTC P 50,375

R.E. DIETZ CORPORATION, Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant.

No. 1438, Docket 90-6274.

United States Court of Appeals, Second Circuit.

Argued May 9, 1991.

Decided July 22, 1991.

Ernest J. Brown, Washington, D.C. (Frederick J. Scullin, Jr., U.S. Atty., N.D.N.Y., Albany, N.Y., Gary R. Allen, Jonathan S. Cohen, Tax Div., Department of Justice, Washington, D.C., Shirley D. Peterson, Asst. Atty. Gen., Washington, D.C., of counsel), for defendant-appellant.

Thomas C. Buckel Jr., Syracuse, N.Y., (Gerald F. Stack, Martha L. Berry, Hancock & Estabrook, Syracuse, N.Y., of counsel), for plaintiff-appellee.

Before PRATT, MINER and ALTIMARI, Circuit Judges.

MINER, Circuit Judge:

The United States appeals from a judgment entered in the United States District Court for the Northern District of New York (McAvoy, J.), finding that R.E. Dietz Corporation ("Taxpayer") was entitled to a refund of taxes and interest overpaid for the years 1981, 1982 and 1983. Pursuant to section 7422 of the Internal Revenue Code and 28 U.S.C. Sec. 1346(a)(1), Taxpayer commenced this action seeking a refund in the amount of $454,650.30 paid after the Internal Revenue Service ("IRS") determined that certain interest income earned by Taxpayer's controlled foreign corporation, R.E. Dietz Company, Ltd. ("Dietz"), in "offshore" bank accounts should be included in the gross income of Taxpayer under 26 U.S.C. Sec. 951. ¹ Dietz is a controlled foreign corporation as defined by I.R.C. Sec. 957, because more than fifty percent of its stock is owned by Taxpayer. In the notice of deficiency, the IRS informed Taxpayer that interest income earned by Dietz in 1981, 1982 and 1983 was not income that Taxpayer was entitled to exclude from its tax return under former I.R.C. Sec. 954(b)(4), which allowed for the exclusion of income earned by a controlled foreign corporation under certain circumstances.

After a two-day bench trial, the district court held that Taxpayer was entitled to the benefit of the exclusion under I.R.C. Sec. 954(b)(4). The government's principal contentions on appeal are that the district court was required to defer to the IRS deficiency determination, setting it aside only if the IRS acted arbitrarily, and that the district court erred in finding that none of the significant purposes of establishing the "offshore" accounts included a substantial reduction in income taxes. We hold that the determination of the Commissioner that the Taxpayer was not entitled to avail itself of the exclusion under I.R.C. Sec. 954(b)(4) may not be disturbed unless arbitrary or unreasonable. We also hold that, although the district court applied an erroneous standard of review, the record supports its conclusion that the Commissioner's determination was unreasonable.

BACKGROUND

For about 140 years, Taxpayer has been engaged in the manufacture of lighting products with its operations centered in Syracuse, New York. At its inception, it manufactured lanterns and burners, expanding in 1896 to manufacture kerosene lanterns. At the end of the Second World War, Taxpayer began to manufacture automotive lighting products, although it continued producing lanterns for sales throughout the world, especially in developing and third world nations. Because of the political and economic climate following World War II in some of those developing nations and as a result of competition from To offset declining profits in the mid-1950s, Taxpayer began to explore the possibility of setting up lantern-making operations in a foreign country. It selected Hong Kong to set up a foreign subsidiary for several reasons, including its abundance of unskilled labor, its status as the shipping and freight center of the Far East and the existence in Hong Kong of a free currency exchange, which greatly facilitated international trade. Dietz was formed and incorporated under the laws of Hong Kong on July 2, 1957 for the purpose of manufacturing and selling lanterns.

other manufacturers, Taxpayer's business began to decline.

At the time of its formation, Dietz's largest market for the sale of lanterns was in the area formerly known as British East Africa. All lantern prices were quoted in and paid for in the British pound sterling. However, all local expenses, such as labor and materials, were payable in Hong Kong dollars ("HK dollars"). This made it necessary to convert to HK dollars all monies Dietz received from sales. After the collapse of the international monetary system of fixed currency exchange rates in the early 1970s, the British pound sterling declined in value and virtually disappeared as a major trading currency. Because more nations had United States dollars ("U.S. dollars") available, Dietz began to quote prices in U.S. dollars in the early 1970s.

By 1975, Dietz was receiving U.S. dollars for the sale of its products and immediately converting them into HK dollars to pay its current obligations. The conversion to HK dollars was uneconomical because HK dollars on deposit in Hong Kong banks were receiving little or no interest and, because the U.S. dollar was the stronger currency, Dietz was losing money in the exchange. Although most of Dietz's expenses were payable in HK dollars, an increasing portion, such as freight and sales commissions, was becoming payable in U.S. dollars. Thus, Dietz resolved to establish reserves of U.S. dollars to hedge against currency exchange losses and to enable it to pay shipping and freight commissions and other expenses in U.S. dollars.

Dietz opened a U.S. dollar account, paying 4 1/2% interest, at the Hong Kong branch of the First National City Bank of New York ("First National"). In that account, not only were U.S. dollars on deposit earning a higher rate of return, but Dietz was entitled to overdraft privileges, enabling it to borrow money by overdrafting its bank accounts without providing any collateral. Dietz would pay its Hong Kong obligations in borrowed Hong Kong dollars, and, even though it had to pay interest on the overdraft loans, the expense was offset by the higher rate of interest earned on the U.S. dollar accounts. By the end of 1975, Dietz had a balance of $650,000 in the U.S. dollar account maintained at First National.

In 1976, Dietz resolved to increase its U.S. dollar reserves. At that time, Dietz established a U.S. dollar account at the Hong Kong branch of the Chase Manhattan Bank, N.A. ("Chase Manhattan"). The funds deposited in that account were used to purchase "Asian Currency Units" ("ACU") in Singapore for deposit in a Chase Manhattan branch there. U.S. dollars would be deposited in Hong Kong, and a book entry of the U.S. dollar amount would be made to Chase Manhattan's branch in Singapore, which paid higher interest. These accounts were called "offshore" accounts because the interest income was earned in a jurisdiction outside of Hong Kong. Hong Kong did not tax the income earned on ACU accounts, a fact that Dietz learned after establishing the accounts. In 1978, Dietz opened another offshore account with the Singapore branch of Chase Manhattan. Because of increased sales in deutsche marks, Dietz also opened an offshore account in that currency in 1981. Taxpayer had knowledge of the offshore accounts maintained by Dietz.

Beginning in the late 1970s through 1983, Dietz felt the effects of a world-wide recession. During this period, Dietz considered opening a new base of operations, setting aside $600 thousand (U.S. dollars) for this purpose. Dietz eventually opened a plant in the People's Republic of China ("China") in 1986. In any event, during Throughout the same 1981-1983 period, Taxpayer suffered a serious decline in the sales of its automotive products. For that reason, it reported on its tax returns for 1981-1983 net operating losses of its own, which were carried back to the years 1979-1981. As mentioned previously, the IRS disallowed the claimed losses on the ground that interest income earned by Dietz during the years 1981-1983 was "foreign base company income," see I.R.C. Sec. 954(a)(1), (c), and therefore was taxable as income of Taxpayer. In response to a notice of deficiency, Taxpayer paid the taxes, and subsequently on April 13, 1987 filed a claim for refund with the IRS. After six months elapsed without action by the IRS, Taxpayer commenced a lawsuit in the district court for a refund of taxes (and interest and penalties) allegedly overpaid for the years 1981-1983. After a two-day bench trial, Judge McAvoy held that Taxpayer was entitled to a refund.

this recessionary period, Dietz continued to increase its U.S. dollar deposits in offshore accounts. Although it suffered a significant decline in sales during the 1981-1983 period, the offshore accounts enabled it to remain liquid and allowed it to hedge against further devaluations of H.K. dollars. In fact, Dietz learned from its accountants that it earned a profit for that period only as a result of the interest income earned in offshore accounts.

DISCUSSION

I. The Standard of Review Identified

The government contends that the district court judge erred as a matter of law in "placing himself in the position of the Commissioner, as if he (the judge) were evaluating [T]axpayer's reasons for the ACU transactions." As the district court understood its role, it did "not sit in review of the determination by the IRS; rather as ... the trier of fact ..., [it had to] listen[ ] to and evaluate[ ] evidence so as to ultimately determine whether the taxpayer has proved by a preponderance of the evidence that the assessment is wrong." Thus, the district court made a de novo determination of tax liability based on the evidence presented to it. The government maintains that, in this case, the district court should not have substituted its own determination for that of the Commissioner, but, rather, should have set aside the Commissioner's determination only if...