Phillips Petroleum Co. & Affiliated Subsidiaries v. Comm'r of Internal Revenue, Docket No. 34019-87.

• Decision Date: 08 July 1991
• Docket Number: Docket No. 34019-87.
• Citation: 97 T.C. No. 3,97 T.C. 30
• Parties: PHILLIPS PETROLEUM CO. AND AFFILIATED SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

97 T.C. 30

97 T.C. No. 3

PHILLIPS PETROLEUM CO. AND AFFILIATED SUBSIDIARIES, Petitioner

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 34019-87.

United States Tax Court

Filed July 3, 1991.As Corrected July 8, 1991.

P is an affiliated group of corporations that filed consolidated returns for the years at issue. Ph is the common parent and a member of P.

Ph produced liquefied natural gas (LNG) in the United States and sold it in Japan. HELD, the income from the LNG sales was derived partly from sources within and partly from sources without the United States. Sec. 863(b)(2), I.R.C. 1954, applied; sec. 1.863-1(b), Income Tax Regs., invalidated. HELD FURTHER, respondent may require P to apportion the LNG income between United States and foreign sources according to Example 1 of sec. 1.863-3(b)(2), Income Tax Regs., if the factual prerequisites to the application of that example existed. HELD FURTHER, Ph's foreign source income was foreign oil related income under sec. 907(c)(2), I.R.C. 1954. Stephen D. Gardner, John Hartje, Ann-Elizabeth Purintun, and Carolyn J. Schwarz, for the petitioner.

Val J. Albright, Stephen C. Coen, and Martin Van Brauman, for the respondent.

KORNER, JUDGE:

This case is presently before the Court on the parties' cross-motions for partial summary judgment, submitted pursuant to Rule 121. ¹ At issue is the proper source and character of Phillips Petroleum Company's (hereinafter Phillips) income from certain sales of liquefied natural gas (LNG). Resolution of this issue initially requires that we determine whether section 1.863-1(b), Income Tax Regs., is a valid regulation. If we hold that the regulation is invalid, we must also decide whether respondent may require petitioner to apportion the LNG income according to the method set out in Example (1) of section 1.863-3(b)(2), Income Tax Regs., and whether Phillips' foreign source LNG income was “foreign oil related income,” within the meaning of section 907(c)(2).

The deficiencies determined in this case are for calendar years 1975, 1976, 1977, and 1978. The present motions involve positions taken on petitioner's 1976, 1977, and 1978 returns.

FINDINGS OF FACT

The parties filed a stipulation of facts solely for purposes of their cross-motions for partial summary judgment. The stipulation of facts is incorporated herein by this reference. The facts underlying the parties' motions are not in dispute.

Petitioner is an affiliated group of corporations that filed consolidated Federal income tax returns for the years at issue. Phillips was the common parent and a member of petitioner. Phillips' principal office was in Bartlesville, Oklahoma, when petitioner filed the petition herein.

During 1976, 1977, and 1978, Phillips sold quantities of LNG to Tokyo Gas Company Limited (Tokyo Gas) and The Tokyo Electric Power Company, Inc. (Tokyo Electric). The sales took place under a 1967, 15-year contract (subject to extension, and as amended and in effect at the times of sale) between Phillips and Tokyo Gas and Tokyo Electric. Pursuant to the contract, Phillips owned the LNG until it was delivered to Japan, where the sales occurred.

Phillips' LNG operations were located in the State of Alaska. In 1962 Phillips acquired mineral interests in certain oil and gas leases in the North Cook Inlet Field in the Upper Cook Inlet area of Alaska. Phillips extracted natural gas from this field, which was transported by pipeline to an onshore liquefaction facility near Kenai, Alaska. It was there processed into LNG, and shipped via tankers to Japan. As stated, the actual sales occurred upon delivery of the LNG to Tokyo Gas and Tokyo Electric.

On its 1976, 1977, and 1978 consolidated Federal income tax returns, petitioner took the following positions when reporting the net income from sales of LNG to Tokyo Gas and Tokyo Electric: (1) It treated the income as derived partly from sources within the United States and partly from sources without the United States (mixed source); (2) it apportioned the income between such sources according to the method set out in Example (2) of section 1.863-3(b)(2), Income Tax Regs.; and (3) it reported the income it treated as derived from a foreign source as foreign oil related income, under section 907(c)(2).

In his notice of deficiency respondent determined that none of the income at issue was foreign source, and that none of the income was foreign oil related income.

For purposes of their cross-motions, the parties have also stipulated that “No portion of the net income generated by the LNG sales was attributable to anything other than the extraction of the natural gas, the transportation of the natural gas, the liquefaction of the natural gas, the transportation of the LNG and the sale of the LNG,” and that “a portion of the net income generated by the LNG sales was attributable to the extraction of the natural gas.”

OPINION

ISSUE (1): THE VALIDITY OF SECTION 1.863-1(b), INCOME TAX REGS.

The first issue for decision is the proper source of Phillips' income from the sales of LNG to Tokyo Gas and Tokyo Electric. Respondent determined that the income was entirely U.S. source; petitioner claims it to be mixed source.

Respondent relies upon section 1.863-1(b), Income Tax Regs. That regulation provides, inter alia, that income derived from the ownership or operation of any oil or gas well located within the United States, and from the sale by the producer of the products thereof without the United States, shall ordinarily be considered U.S. source income. Exceptions to this general rule may be imposed or granted by respondent or his officials. ²

The Senate's version of H.R. 8245 eliminated the express sourcing rules for natural resources, i.e., the House's sections 217(a)(5), 217(c)(5). The Senate's version also eliminated the express sourcing rules for personal property both “produced” and “sold” within or without the United States, i.e., the House's sections 217(a)(7) and 217(c)(7). The Senate instead gave the Secretary wide latitude to promulgate sourcing rules (section 217(e), now section 863(a)), as to both natural resources and certain personal property. The Senate's version retained the House's language as to “personal property produced (in whole or in part) by the taxpayer within the United States and sold without the United States,” the section 863(b)(2) language which the majority now regards as limiting the Secretary's rule-making authority in regard to natural resources. The Senate version also maintained the House's definition of the word “produced.” The Senate's version was adopted in conference. H.R. 8245 (67th Cong., 1st Sess. (November 19, 1921)).

The Senate Finance Committee held hearings on H.R. 8245 between September 1, 1921 and October 1, 1921, and these hearings provide an explanation of the above amendments. The principal witness at the hearings was Dr. Thomas Sewall Adams, the Economic Advisor of the Treasury Department, who is considered to have been the “father” of the Senate bill. ³ During the course of the hearings, Dr. Adams testified, in part, as follows:

Petitioner does not disagree with the assertion that the LNG income falls within the general rule of section 1.863-1(b)(1), Income Tax Regs. Petitioner instead challenges the validity of that regulation. It is petitioner's position that section 1.863-1(b) of the regulations contradicts the clear and unambiguous language of section 863(b)(2) ³ of the Code and, accordingly, is invalid. For the reasons stated below, we agree with petitioner.

We initially note that section 1.863-1(b) is a “legislative regulation,” issued pursuant to a specific delegation of legislative authority. ⁴ In general, we must defer to Treasury Regulations as long as they “implement the congressional mandate [to prescribe all needful rules for the enforcement of the Internal Revenue Code] in some reasonable manner.” United States v. Correll, 389 U.S. 299, 307 (1967). Legislative regulations are entitled to an especially high degree of deference. See, e.g., Rowan Cos., Inc. v. United States, 452 U.S. 247, 253 (1981), and cases cited therein. Nonetheless, a regulation which exceeds its congressionally mandated scope of authority and is “plainly inconsistent with the revenue statutes,” cannot be sustained. See Commissioner v. Portland Cement Co. of Utah, 450 U.S. 156, 169 (1981), quoting Commissioner v. South Texas Lumber Co., 333 U.S. 496, 501 (1948).

Dr. Adams. Page 48, lines 5 to 8: This is the foreign traders. It is proposed to strike out paragraphs 5 and 7. Paragraph 5 relates to “gains, profits, and income from the ownership or operation of any farm, mine, oil or gas well, other natural deposits, or timber, located in the United States, and from any sale by the producer of the products thereof.”

This says that the gains or profits and all that kind of thing shall be taxed in the United States if the property is here. THAT IS A SOUND RULE AND WILL GO WITHOUT SAYING IN THE AVERAGE CASE. THERE ARE SOME CASES WHERE POSSIBLY IT OUGHT NOT TO APPLY. For instance, we have a number of important American business enterprises at the present time owning mines in Canada which have their factories over here and bring this stuff over. This would deprive us of any tax in that case.

Senator Reed. The present language?

Dr. Adams. The present language would. THE PRESENT LANGUAGE PUTS FAVOR ON THE SITUS OF THE MINE OR PROPERTY; THAT IS THE GENERAL RULE AND WILL BE FOLLOWED, but there is occasionally a case where the factory is located elsewhere or where the element of location is very important, and I think we should be silent on it.

THIS PRESENT THING IS WHAT MIGHT BE CALLED A NATURAL RULE APPLIED ABSOLUTELY IN EVERY CASE. THERE WILL BE NO TROUBLE ABOUT THE WAY THE AVERAGE CASE IS DECIDED; IT WILL TAKE CARE OF ITSELF. ⁴ BUT I THINK THERE IS A CASE WHERE YOU WANT TO TEMPER IT.

The Chairman. If there is no objection, the amendment will be adopted.

Dr. Adams. * * *

I suggest...