Bowater Inc. v. Comm'r of Internal Revenue

Decision Date14 September 1993
Docket NumberNo. 18436–91.,18436–91.
Citation101 T.C. 207,101 T.C. No. 14
PartiesBOWATER INCORPORATED, F.K.A. Bowater Holdings, Inc., and Subsidiaries, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
CourtU.S. Tax Court


Robert T. Carney, Alex Edward Medovich, John N. Tsigakos, Ecton R. Manning, and John B. Glendon, Darien, CT, for petitioner.

Stephen M. Miller, Washington, DC, and Meryl Silver, Hartford, CT, for respondent.

COLVIN, Judge:

Respondent determined deficiencies in petitioner's Federal income tax of $3,231,988 for 1976, $5,214,010 for 1979, and $27,096,396 for 1980.

The issue for decision is whether petitioner may net interest income against interest expense in determining the amount of the interest deduction to be allocated and apportioned in computing the combined taxable income (CTI) of petitioner and its domestic international sales corporations (DISC's). We hold that petitioner may.

As explained below, we distinguish Dresser Industries, Inc. v. Commissioner, 911 F.2d 1128 (5th Cir.1990), revg. on this issue 92 T.C. 1276 (1989), because a regulation (sec. 1.861–8(e)(2), Income Tax Regs.) applies here that did not apply in Dresser Industries.

The parties submitted this issue for decision on a fully stipulated basis. Other issues in this case will be tried or otherwise resolved in due course. Section references are to the Internal Revenue Code in effect for the years at issue. Rule references are to the Tax Court Rules of Practice and Procedure.

1. Petitioner

Bowater, Inc., F.K.A. Bowater Holdings, Inc., and Subsidiaries (petitioner), is a domestic corporation formed under the laws of Delaware. Petitioner's principal place of business was in Darien, Connecticut, when the petition was filed. During petitioner's taxable years 1979 and 1980, its stock was wholly owned, directly or indirectly, by Bowater Corp., Ltd., a British corporation.

Petitioner and its subsidiaries filed consolidated Federal income tax returns for 1979 and 1980. Included in these returns were Bowater Southern Paper Corp. (Southern), and Bowater Carolina Corp. (Carolina). Carolina and Southern were wholly owned U.S. subsidiaries of petitioner.

2. The Domestic International Sales Corporations

Southern Export Corp. (Southern Export) was a wholly owned U.S. subsidiary of Southern. Carolina Export Co. (Carolina Export) was a wholly owned U.S. subsidiary of Carolina. Southern Export and Carolina Export qualified as DISC's throughout 1979 and 1980. They were accrual basis taxpayers and adopted fiscal years ending January 31. They filed timely Federal income tax returns (Forms 1120–DISC) for their fiscal years ending in 1980 and 1981.

In 1979 and 1980, Southern Export and Carolina Export acted as commission agents for Southern and Carolina, respectively, in connection with the export sales of wood pulp and related products to customers outside of the United States and its possessions. Southern and Carolina computed the commissions paid to Southern Export and Carolina Export under the “50/50 combined taxable income” (CTI) method. Sec. 994(a)(2).

In computing interest expense to be apportioned under sections 1.994–1(c)(6)(iii) and 1.861–8, Income Tax Regs., in the computation of the CTI of Southern and Carolina and their DISC's, petitioner allocated net interest expense (i.e., gross interest expense less gross interest income), as follows:

                ¦Amounts of Gross and Net Interest Expense  ¦
                ¦1979                  ¦Carolina  ¦¦Southern¦
                ¦Gross interest expense¦$1,036,575¦¦$329,833¦
                ¦Gross interest income ¦932,151   ¦¦184,627 ¦
                ¦Net interest expense  ¦104,424   ¦¦145,206 ¦
                ¦1980                  ¦          ¦¦        ¦
                ¦Gross interest expense¦1,332,345 ¦¦544,906 ¦
                ¦Gross interest income ¦1,787,258 ¦¦406,455 ¦
                ¦Net interest expense  ¦(454,913) ¦¦138,451 ¦

The interest income of Southern and Carolina used to calculate net interest expense resulted primarily from the following procedure: sales proceeds from the sales of pulp and paper products sold by Carolina and Southern through their respective DISC's were collected by petitioner. Petitioner disbursed amounts to Carolina and Southern to cover their expenses. Petitioner retained the remainder for various periods and treated it on the books of the respective companies as loans from Carolina and Southern to petitioner.1

1. Background

Congress enacted the DISC provisions (secs. 991–997) in 1971 to stimulate exports and to remove a tax disadvantage faced by U.S. firms exporting through domestic corporations. Revenue Act of 1971, Pub.L. 92–178, 85 Stat. 497; H.Rept. 92–533 (1971), 1972–1 C.B. 498, 502, 529; S.Rept. 92–437 (1971), 1972–1 C.B. 559, 565, 609. A qualifying DISC may defer part of the Federal tax on income from exports. However, the shareholders of a DISC are taxable currently on part of the profits and may generally defer taxation on the remaining part until the profits are withdrawn from the DISC or until the corporation ceases to qualify as a DISC. Secs. 995(a) and (b), 996(a)(1).

For a corporation to qualify as a DISC, at least 95 percent of its gross receipts must be qualified export receipts, and 95 percent of its assets must be qualified export assets. Secs. 992(a)(1), 993(a), (b), (f).

Section 994 provides intercompany pricing rules which are used to determine the price at which the parent corporation is deemed to have sold its products to the DISC. A DISC must use one of three intercompany pricing methods: (1) Four percent of qualified export receipts on the sale of export property; (2) 50 percent of the CTI of the DISC and its supplier; or (3) the arm's-length price, computed in accordance with section 482. Sec. 994(a). The 50–percent method is at issue in this case. Sec. 994(a)(2). It allows a DISC to earn taxable income of 50 percent of the CTI of a DISC and its supplier which is attributable to qualified export receipts derived from the sale by the DISC of export property plus 10 percent of export promotion expenses of the DISC attributable to those receipts.

2. Treatment of Interest Expense for Computing CTI

We must decide whether petitioner may net interest income against interest expense in determining the amount of interest deductions to be allocated and apportioned in computing the CTI of Southern, Carolina, and their DISC's. Petitioners have a larger CTI and a larger DISC tax benefit if they are permitted to net interest income against interest expense.

CTI is determined generally in accordance with the principles applicable under section 861. H.Rept. 92–533, supra, 19722 C.B. at 538. The legislative history provides:

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. Thus, the combined taxable income of a DISC and a related person with respect to the sale by the DISC of export property 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 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.]

See also S.Rept. 92–437, supra, 19721 C.B. at 619. The Congressional reference to section 861 also appears in the DISC regulations:

(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 § 1.861–8. Sec. 1.994–1(c)(6)(iii), Income Tax Regs.

3. Fungibility of Money and Section 1.861–8(e)(2), Income Tax Regs.

For purposes of section 861, interest is assumed to be fungible. Sec. 1.861–8(e)(2), Income Tax Regs. These regulations are based on the theory that all of a taxpayer's activities and assets need funds and that a taxpayer has great flexibility as to the source and use of funds. See Isenbergh, International Taxation, par. 6.8.1, at 205 (1990); Kuntz & Peroni, U.S. International Taxation, par. A2.05(5)(a), at A2–202 and 203 (1992). Section 1.861–8(e)(2), Income Tax Regs., was adopted on January 3, 1977, effective for taxable years beginning after December 31, 1976. It states:

(e) Allocation and apportionment of certain deductions(1) In general. Subparagraphs (2) and (3) of this paragraph contain rules with respect to the allocation and apportionment of interest expense * * *

(2) Interest(i) In general. The method of allocation and apportionment for interest set forth in this paragraph (e)(2) is based on the approach that money is fungible and that interest expense is attributable to all activities and...

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