Dresser Industries, Inc. v. C.I.R.

• Decision Date: 19 September 1990
• Docket Number: No. 89-4809,89-4809
• Citation: 911 F.2d 1128
• Parties: -5637, 90-2 USTC P 50,505 DRESSER INDUSTRIES, INC. and Consolidated Subsidiaries, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Fifth Circuit

Page 1128

911 F.2d 1128

66 A.F.T.R.2d 90-5637, 90-2 USTC P 50,505

DRESSER INDUSTRIES, INC. and Consolidated Subsidiaries Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 89-4809.

United States Court of Appeals Fifth Circuit.

Sept. 19, 1990.

John C. Klotsche, Gregory P. Gunderson, Jerrold E. Miertschin, Robert H. Albaral, Baker & McKenzie, Dallas, Tex., for petitioners-appellants.

William F. Nelson, Chief Counsel, I.R.S., Bruce R. Ellisen, Gary R. Allen, Chief, Charles Bricken, John A. Dudeck, Jr., David English Carmack, Appellate Section, William S. Rose, Asst. Atty. Gen., Dept. of Justice, Tax Div., Washington, D.C., for respondent-appellee.

Appeal from the Decision of the United States Tax Court.

Before GOLDBERG, GEE, and WILLIAMS, Circuit Judges.

GOLDBERG, Circuit Judge:

Dresser Industries ("Dresser") petitioned the Tax Court for a redetermination of deficiencies for the 1976 and 1977 tax years which the Commissioner of Internal Revenue ("Commissioner") alleged resulted from an improper calculation of the combined taxable income attributable to Dresser and its wholly-owned export subsidiary. The Commissioner claimed that Dresser improperly calculated the amount of interest expense allocable to export income pursuant to code sections 994 and 861, and that Dresser failed to directly deduct the discount loss on certain export receivables from gross export receipts in accordance with Treas.Reg. 1.994-1(c)(6)(v). ¹ The Tax Court held for the Commissioner on both issues and Dresser appeals. AFFIRMED IN PART, REVERSED IN PART, AND REMANDED.

THE FACTS

The facts in this case have been fully stipulated by the parties and only a brief summary is necessary at this point. Additional facts relevant to the two issues presented on appeal are included in the discussion of those issues.

Dresser is a worldwide supplier of technology, products, and services to industries involved in the development of energy and natural resources. In January 1972, Dresser established Dresser International Sales Corp. ("International"), a wholly-owned subsidiary, which qualified as a Domestic International Sales Corporation (DISC) under code section 992. The tax code provides substantial tax benefits for companies that establish DISCs by deferring taxes on a portion of DISC income. Dresser and International entered into an agreement under which Dresser appointed International as its exclusive agent for the sale of export property as defined in code section 993(c). As part of the agreement, Dresser paid International a commission equal to the maximum commission allowable under code section 994. For the 1976 and 1977 tax years, Dresser calculated the maximum commission in accordance with the "50-50 combined taxable income" and "4 percent gross receipts" methods described in code section 994(a).

In 1976 and 1977, Dresser earned interest income, worldwide, of $36 million from the investment of surplus cash. During this same period, Dresser incurred $58.8 million of interest expense, none of which is directly traceable to export sales made through International. In calculating combined taxable income ("CTI") for the tax years at issue in this case, Dresser allocated net interest expense of $22.8 million ($58.8 million interest expense minus $36 million interest income) among its divisions on the basis of the assets of each division, and between the domestic and export sales of each division on the basis of the dollar volume of sales in each category. Using this method, Dresser allocated $2,202,097 and $1,175,226 of its net interest expense to gross income from export sales in computing CTI for the respective tax years.

In an unrelated practice, International purchased, with recourse, undivided fractional interests in Dresser's accounts receivable which arose from the sale of export property during the tax years in question. International purchased the export receivables at a ten percent discount from their face value. The parties have stipulated that this constituted an arm's length purchase price for the receivables. In 1976 and 1977, International realized discount income of $3,774,098 and $5,709,609 from the collection of the export receivables it had purchased at a discount from Dresser. The parties have stipulated that International's discount income constitutes "qualified export receipts" under code section 993(a) and that Dresser's discount losses are deductible under code section 165.

In its calculation of combined taxable income for 1976 and 1977, Dresser allocated its discount losses among all of its divisions based upon the export sales of each division, and then apportioned the entire discount loss of each division to gross income from the export sales of that division. Using this method, Dresser allocated the entire loss attributable to export receivables to gross income from export sales in its computation of combined taxable income.

Dresser subsequently asserted to the Tax Court that its discount losses should have been allocated among all of its divisions in keeping with the same allocation method it had used for its net interest expense. This allocation method would have the effect of "untying" the discount loss attributable to export receivables from gross export income. Thus, Dresser contended that only $1,072,203 and $819,971, respectively, of discount expense should have been allocated to gross receipts from exports for the 1976 and 1977 tax years, instead of the total discount losses mentioned above.

The Commissioner claimed that Dresser's approach to allocating interest income and discount losses to DISC income were improper. The Commissioner argued that under the applicable code sections, gross interest expense, not net interest expense,

must be allocated to gross export receipts for purposes of determining combined taxable income. Furthermore, the Commissioner stated that under the applicable Treasury Regulations, discount loss from export receivables must be deducted directly from export income, not allocated proportionately to income derived from export and non-export operations. According to the Commissioner, Dresser's interest netting practice, and its suggested approach to the allocation of discount losses, would result in an overstatement of combined taxable income eligible for favorable tax treatment under the DISC legislation. The Tax Court agreed with the Commissioner on both of these issues.

DISCUSSION

I. Background

The Domestic International Sales Corporation (DISC) is a creation of U.S. tax law, conceived in the early 1970s ² as part of an overall strategy to boost U.S. exports by providing tax incentives to companies involved in export trade. ³ Typically, a DISC is a paper company without facilities, employees, or inventory of its own. See Caterpillar Tractor Co. v. United States, 589 F.2d 1040, 1044, 218 Ct.Cl. 1978 (1978) (DISC is no more than "shell corporation with no employees"). "In essence, a DISC acts as a paper broker of its parent corporation's export products. A DISC skims the export profits of the parent corporation by taking 'commissions' on the parent's export sales." ⁴ Substantial tax benefits are available to exporters who set up DISCs because the tax on a portion of DISC income is deferred, perhaps indefinitely. ⁵

These benefits, however, are not unlimited. Although the DISC itself is not taxed on income from export sales, its shareholders are taxed on a specified percentage of DISC taxable income as if a dividend distribution had been made at the end of the tax year. In turn, DISC taxable income, from which this "deemed" distribution is calculated, is based on a complex statutory framework that establishes a "deemed" transfer price for export goods provided to the DISC by its parent or related supplier. As part of the original DISC legislation, Congress set out three alternative formulas for determining this "deemed transfer price": (1) 4 percent of "qualified export receipts"; (2) 50 percent of the "combined taxable income" of the DISC and its "related supplier" (typically the parent); or (3) the arm's length pricing convention provided in code section 482. See 26 U.S.C. Sec. 994(a). Dresser chose alternative (2), in which the transfer price, and ultimately DISC taxable income, is based on combined total income ("CTI") of the DISC and its parent. Under this alternative, there is a direct relationship between CTI and the amount of export income that qualifies for deferred treatment--the larger CTI, the larger the tax benefit. It is Dresser's approach to calculating CTI that gives rise to the issues in this case.

II. Interest Netting

Combined taxable income is not defined by the code. In the legislative history accompanying [T]he 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. ⁶

the DISC laws, however, Congress specified...