Cf Industries, Inc. v. Commissioner
| Decision Date | 25 November 1991 |
| Docket Number | Docket No. 9420-88. |
| Citation | 62 T.C.M. 1249 |
| Parties | CF Industries, Inc. and Subsidiaries v. Commissioner. |
| Court | U.S. Tax Court |
Raymond P. Wexler, Todd F. Maynes, and William R. Welke, 200 E. Randolph Dr., Chicago, Ill., for the petitioner. James S. Stanis, Judith M. Picken, and William G. Merkle, for the respondent.
Memorandum Findings of Fact and Opinion
The Commissioner determined deficiencies in petitioner's Federal income tax as follows:
Taxable
Year Deficiency
1980 ......................... $4,732,815
1981 ......................... $4,520,696
Due to concessions by both parties, the only remaining issue in this case is whether interest income earned by petitioner should be deemed patronage-sourced income within the meaning of subchapter T of the Internal Revenue Code.1
Some of the facts have been stipulated and are so found. The stipulations, supplemental stipulations, and attached exhibits are incorporated herein by this reference.
Petitioner corporation, CF Industries, Inc. and subsidiaries (hereinafter petitioner or CF), had its principal place of business in Long Grove, Illinois, at the time it filed its petition. CF is the parent corporation of three operating subsidiaries, CF Chemicals, Inc. (manufacturer of finished phosphate fertilizers), CF Mining Corp. (phosphate rock mining and processing), and Central Phosphates, Inc. (manufacturer of finished phosphate fertilizers). The parent and the subsidiaries operate on a nonexempt cooperative basis within the meaning of section 1381(a)(2) of subchapter T.
Ownership of CF is made up of 18 shareholder patrons, all of whom are regional farmers cooperatives. Of these shareholder patrons, 16 are located in the United States and also operate under subchapter T while the remaining two shareholder patrons are located in Canada and operate as cooperatives under Canadian law. Each shareholder patron owns one share of CF's common stock and the board of directors is composed of one representative from each of the shareholder patrons.
Petitioner's primary business is the manufacture and distribution of chemical fertilizers, specifically nitrogen, phosphate, and potash. During the years in issue, CF held approximately 20 percent of the domestic nitrogen and phosphate fertilizer markets and approximately 16 percent of the domestic potash market. CF also engages in mining and sales activities which pertain to its fertilizer business.
CF also received income during 1980 and 1981 from an oil and gas venture, management fees for managing fertilizer plants, and proceeds from sales of fertilizer byproducts. During the years in issue, CF operated an extensive distribution system involving regional liquid terminals and dry product warehouses, an ocean-going tug/barge unit, and an extensive rail car fleet. In addition, CF was a shareholder patron in a cooperative barge company named Agritrans which supplies distribution services.
CF sells fertilizer to its shareholder patrons on a patronage basis; that is, the net earnings received by CF from business done with its shareholder patrons are repaid to them once each year in the form of patronage dividends. The amount of the patronage dividend received by each shareholder patron each year is not dependent upon a percentage ownership of CF's stock. Rather, patronage dividends are allocated and paid according to the amount of business done by each shareholder patron with CF during the year and on the profitability of the products purchased by that shareholder patron. Each shareholder patron, in turn, resells and distributes the fertilizer products to local cooperatives or directly to farmers.
After CF has met the needs of its shareholder patrons for its products, it sells to nonshareholders. CF does not, however, sell its products to nonshareholders on a patronage basis (nonshareholder patrons do not receive patronage dividends). CF's shareholder patrons have first priority for its products.
Nitrogen fertilizers, consisting primarily of anhydrous ammonia, urea, and UAN solutions, represent approximately 40 to 45 percent of CF's sales. Phosphate fertilizers, primarily diammonium phosphate, represent 35 to 45 percent of CF's sales. Potash fertilizers represent approximately 10 to 20 percent of CF sales. In 1980, 87.8 percent of CF's product sales were made to shareholder patrons and 12.2 percent were made to nonshareholders. In 1981, 95.8 percent of CF's sales were to its shareholder patrons while 4.2 percent of its sales were made to nonshareholders.
CF's practice in 1980 and 1981 was to pay its patronage dividends, if any, to its shareholder patrons in the form of one-half in cash and one-half in "qualified written notices of allocation." These qualified written notices of allocation take the form of preferred stock.
CF paid $157,757,957 in patronage dividends in 1980 and, in 1981, it paid $39,488,271. CF deducted these amounts as patronage dividends on its consolidated income tax returns for 1980 and 1981.
The fertilizer industry is highly volatile due to many changes in supply, demand, and price that are affected by seasonal factors, cyclical factors, political factors, and the weather. Demand for fertilizer products is derived from demand for agricultural products. Weather conditions (excessive moisture, frozen ground, etc.) can shorten the time period that a farmer has to conduct pre-plant field work, thereby reducing demand for fertilizer. Federal programs in which farmers are subsidized in exchange for agreements to idle certain portions of acreage also affect fertilizer demand. In addition, fertilizer products are fungible commodities that are produced, consumed, and traded on a worldwide basis. The market is highly sensitive to changes in both the U.S. and world economies.
The fertilizer industry is also seasonal. The primary planting seasons are in the spring and fall; fertilizer sales peak during those seasons. CF, therefore, builds up its inventories in the summer and winter months in anticipation of the spring and fall planting seasons.
CF's cost of purchasing raw materials does not necessarily move in tandem with fertilizer prices. Raw material costs often rise or fall with fertilizer prices moving in the opposite direction. This is illustrated by the difference between CF's accounts receivable and the accounts payable on a monthly basis for the taxable years in issue:
(000's Omitted)
1980 1981
Accounts Accounts Accounts Accounts
Receivable Payable Receivable Payable
Jan .................................. $ 95,786 $ 85,746 $ 98,166 $ 86,428
Feb .................................. 84,064 86,869 69,101 95,735
Mar .................................. 56,429 84,754 99,897 105,658
Apr .................................. 158,707 101,412 128,526 108,763
May .................................. 73,943 73,300 92,293 98,774
Jun .................................. 105,627 123,122 105,015 110,427
Jul .................................. 98,968 134,881 120,603 132,767
Aug .................................. 96,054 139,845 107,537 121,522
Sep .................................. 81,005 93,650 48,786 85,803
Oct .................................. 108,440 85,974 70,770 86,381
Nov .................................. 127,315 107,643 68,590 93,583
Dec .................................. 125,615 118,300 75,827 99,590
CF dedicates a substantial amount of time, effort, and money to preparing an annual budget, which consists of twelve monthly budgets. Due to the volatility of the fertilizer market, however, such budgets are not completely reliable.
For example, in 1979, CF budgeted a loss of more than $13 million, but then earned more than $136 million. For 1980, CF budgeted $201 million as expected net earnings, but actually earned $215 million. In 1981, CF budgeted $170 million as expected earnings but the actual earnings were only $65 million.
CF grew rapidly in sales volume, total assets, and equity from 1970 to 1980. In 1979 and 1980, CF's management decided that, as a result of CF's expansion in the 1970's, CF was too highly leveraged, that is, its ratio of long-term debt to total capital employed was too high. The debt ratio on December 31, 1978, was 68 percent. CF's management goal was to strengthen its balance sheet in order to withstand volatile business cycles and satisfy outstanding loan agreements. In order to do this, CF would have to reduce the ratio of long-term debt to equity.
Accordingly, in June 1980, CF devised its Capital Structure Policy Plan that, among other things, resolved to reduce the debt ratio so that long-term debt would be no more than 50 percent of total capital. The method of achieving a reduced debt ratio included restricting the payment of cash for patronage dividends owed to shareholder patrons, replacing asset-based financing with unsecured financing, and increasing flexibility on the terms of its long-term capital funds.
In 1980 and 1981, CF entered into agreements with its shareholder patrons called Member Product Purchase Agreements which set forth a volume range of fertilizer that CF was to sell to them. These agreements provided a measure of stability to CF's sales volume on a tonnage basis, because it created, in essence, "preferred customers" to which CF could reasonably assume that large amounts of fertilizer would be sold. Because these membership agreements were in place, CF decided that it could bear a higher debt ratio than other fertilizer companies similarly situated.
The...
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