Addison Int'l, Inc. v. Comm'r of Internal Revenue, Docket No. 6058-82.

• Citation: 90 T.C. No. 78,90 T.C. 1207
• Decision Date: 21 June 1988
• Docket Number: Docket No. 6058-82.
• Parties: ADDISON INTERNATIONAL, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: United States Tax Court

90 T.C. 1207

90 T.C. No. 78

ADDISON INTERNATIONAL, INC., Petitioner

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 6058-82.

United States Tax Court

Filed June 21, 1988.

P, a DISC, was organized and operated in reliance upon the Handbook, a guidebook for DISCs issued by the Department of the Treasury. P held no property, had neither employees nor place of business, and conducted no activity beyond those steps necessary to ensure qualification as a DISC. R sent a statutory notice of deficiency to P in which R determined that P failed to qualify as a DISC for taxable years 1976 and 1977 on the grounds that a commission payment was not made within the 60-day period allowed by regulation. HELD: Because P was entitled to rely on the Handbook the regulation cannot be applied retroactively to P with respect to taxable year 1976. Therefore, P was disqualified as a DISC for taxable year 1977 only. HELD FURTHER: P was the proper taxpayer with respect to its current income for taxable year 1977. Ernest Getz, Michael D. Horlick, Timothy G. Reaume and Joseph M. Persinger, for the petitioner.

Beth L. Williams, for the respondent.

WRIGHT, JUDGE:

By notice of deficiency dated December 15, 1981, respondent determined deficiencies in petitioner's Federal income taxes for the taxable years 1976 and 1977 in the amounts of $1,100,583 and $1,170,603, respectively.

After concessions by the parties, the issues for our decision are (1) whether petitioner Addison International, Inc., failed to qualify as a Domestic International Sales Corporation (DISC) under sections 991 through 997 during its taxable years 1976 and 1977 and, if so, (2) whether petitioner Addison International, Inc., is properly taxable under section 11 on its taxable income.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulated facts and attached exhibits are incorporated herein by this reference.

Petitioner, Addison International, Inc. (AI), was incorporated on September 21, 1973, under the laws of the State of Michigan as a Domestic International Sales Corporation (DISC) pursuant to sections 991 through 997 of the Internal Revenue Code. ¹ Since its inception, AI has been the wholly owned subsidiary of Addison Products Company (APC), a corporation organized and operated under the laws of the State of Michigan. AI's outstanding stock consists of 2,500 shares of common stock with a par value of $1 per share. Both AI and APC use the accrual method of accounting and report taxable income on a calendar year. APC and AI have never filed consolidated returns.

APC manufactures heating and air conditioning equipment for commercial and residential use. At the time of trial APC had its primary manufacturing plant in Addison, Michigan, and additional facilities in Michigan and in Texas. Initially, APC sold heating and air conditioning equipment exclusively in domestic markets. Using the Original Equipment Manufacturing (OEM) method, APC would sell its product to a retailing company which was usually a major manufacturing company with brand-name recognition. In addition to selling its own manufactured products, the retailer would affix its own brand-name to the APC product for sale. Neither the names ‘Addison‘ nor ‘APC‘ achieved name-brand recognition because the products manufactured by APC did not carry either name. Furthermore, under the OEM method of selling, APC saved costs by not having to maintain a retail or distribution network.

In the mid-1960's, APC began exporting its products overseas. When it commenced its export operations, APC did not use the OEM method of selling; instead its products were exported under its own name through the sales management firm of J.D. Marshall International (Marshall). Marshall purchased the products from APC and exported them independently. Although Marshall was not APC's agent, Marshall was granted an exclusive right to sell APC products bearing the Addison name on the retail level in the overseas market. The products proved very marketable and successful, particularly with respect to the sales of air conditioners in the Middle East.

In 1964 or 1965, APC expanded its export activities and began exporting products under the OEM method. APC sold its products to name-brand retailers who in turn sold the APC products overseas under their own names and labels. Often these export retailers were the same companies or individuals who purchased APC products for domestic resale. Although APC was selling its products to both Marshall and to Marshall's competitors, the name-brand retailers, during this period, there was no conflict because the products prepared for OEM resale were cosmetically and superficially altered to satisfy the retailer's specifications. Under both arrangements, the export of APC products proved highly successful.

In September 1973, as a result of information learned at a seminar, APC organized and incorporated AI as a DISC. On the Certificate of Incorporation AI's sole purpose was listed as ‘any activity permitted to be carried on by a Domestic International Sales Corporation.‘ Donald L. Ball (Ball) who was vice president and treasurer for APC during the years in issue, stated that APC's sole reason for incorporating AI was to receive the tax deferral benefits available to a DISC. According to Ball, there were no additional economic considerations for such action.

On October 1, 1973, APC and AI executed an Agreement pursuant to which AI promised that it would conduct its business at all times in such a fashion as to ensure its status as a DISC. In return, APC granted a franchise to AI with respect to all qualified export property sold for use outside of the United States and Puerto Rico. APC agreed to be responsible for the solicitation and satisfaction of orders. APC agreed to pay AI the maximum amount allowable as a commission, occasionally in advance. Such commissions were to be determined and paid within eight months of the end of each accounting period. ²

In considering the arguments with respect to the retroactive application of sections 1.993-2(d)(3) and 1.994-1(e)(3), Income Tax Regs., we initially note that our decision should have limited impact. The tax years in question must, by definition, precede 1978, because the regulations became final on October 14, 1977. Commencing with the tax year 1978, all taxpayers were responsible for complying with the enacted regulations.

The Seventh Circuit and the Second Circuit both base their decisions to deny retroactive application on the narrow grounds of the singular and unusual nature of the DISC. Because the entire purpose of the DISC legislation was to entice taxpayers into following a path of behavior which satisfied the Congressional objective of increasing United States exports, taxpayer compliance with the Handbook implicitly served Congressional objectives. The Handbook promised the taxpayers that any modifications would be prospective and many taxpayers relied on that. As the Seventh Circuit noted, regulations are subject to change, even substantial change, prior to final promulgation. Strict compliance with proposed regulations could cause extra time and labor if the proposed regulations undergo substantial modification upon final promulgation. In the uncharted sea of structuring and operating a DISC, taxpayers who followed the guidelines in the Handbook were adhering to the most reliable information available. Because the DISC is a creature of statutory artifice, a taxpayer would have no independent reasons for any actions taken with respect to the organization and operation of a DISC. Thus, we conclude that the positions taken by the Second and the Seventh Circuits are well founded. When sections of the Internal Revenue Code are designed to invoke taxpayers to follow a course of behavior for which they have no other motives, respondent cannot, in fairness, complain when the desired compliance is forthcoming and the taxpayers take the Commissioner at his word.

Petitioner did not maintain that the commission payment made by APC to AI on October 19, 1977, was motivated by the discovery that the regulations had been promulgated in final form. Although payment was made within five days of the promulgation, the timing was purely coincidental. Nonetheless, even if petitioner had been aware of the final promulgation of the regulations, it would not have expected that they affected it, because it believed it was protected according to the promises contained in the Handbook. While we cannot condone willful ignorance, we conclude that petitioner's failure to comply with the 60-day payment rule stemmed from its reliance on the Handbook. Accordingly, sections 1.993-2(d)(3) and 1.994-1(e)(3), Income Tax Regs., may not be retroactively applied to petitioner for taxable year 1976.

Petitioner's next argument is that the payments, although late, were sufficiently timely to constitute substantial compliance with the regulations in issue. This argument has been considered and rejected on several occasions. Gehl Co. v. Commissioner, supra at 1331; Thomas International Ltd. v. United States, supra at 305. ¹¹ Because the regulations in this case are substantive rather than procedural, compliance must be strict and total. Tipps v. Commissioner, 74 T.C. 458, 468 (1980). Petitioner's position that substantial compliance with sections 1.993-2(d)(3) and 1.994-1(e)(3), Income Tax Regs., will suffice, is without merit.

Normally, the choice of doing business in corporate form will be respected.

Whether the purpose be to gain an advantage under the law of the state of incorporation or to avoid or to comply with the demands of creditors or to serve the creator's personal or undisclosed convenience, SO LONG AS THAT PURPOSE IS THE EQUIVALENT OF BUSINESS ACTIVITY OR IS FOLLOWED BY THE CARRYING ON OF BUSINESS BY THE CORPORATION, the corporation remains a separate taxable entity. * * * »Moline Properties, Inc. v. Commissioner, 319...