EI Du Pont de Nemours & Co. v. United States

• Citation: 608 F.2d 445
• Decision Date: 17 October 1979
• Docket Number: 371-66.,No. 256-66,256-66
• Parties: E. I. DU PONT DE NEMOURS AND COMPANY v. The UNITED STATES.
• Court: U.S. Claims Court

608 F.2d 445

E. I. DU PONT DE NEMOURS AND COMPANY v. The UNITED STATES.

Nos. 256-66, 371-66.

United States Court of Claims.

October 17, 1979.

Daniel M. Gribbon, Washington, D. C., for plaintiff. Harris Weinstein, Coleman S. Hicks, Michael R. Levy, Washington, D. C., Roy A. Wentz, William F. Loftus, Wilmington, Del., Thomas M. Russon, Legal Dept., E. I. du Pont de Nemours & Co., Wilmington, Del., and Covington & Burling, Washington, D. C., of counsel.

Gilbert W. Rubloff, Washington, D. C., with whom was Asst. Atty. Gen. M. Carr Ferguson, Washington, D. C., for defendant. Theodore D. Peyser, Jr., and Donald H. Olson, Washington, D. C., of counsel.

Before FRIEDMAN, Chief Judge, and DAVIS, NICHOLS, KASHIWA, KUNZIG, BENNETT and SMITH, Judges, en banc.

OPINION

DAVIS, Judge:

Taxpayer Du Pont de Nemours, the American chemical concern, created early in 1959 a wholly-owned Swiss marketing and sales subsidiary for foreign sales — Du Pont International S.A. (known to the record and the parties as DISA). Most of the Du Pont chemical products marketed abroad were first sold by taxpayer to DISA, which then arranged for resale to the ultimate consumer through independent distributors. The profits on these Du Pont sales were divided for income tax purposes between plaintiff and DISA via the mechanism of the prices plaintiff charged DISA. For 1959 and 1960 the Commissioner of Internal Revenue, acting under section 482 of the Internal Revenue Code which gives him authority to reallocate profits among commonly controlled enterprises, found these divisions of profits economically unrealistic as giving DISA too great a share. Accordingly, he reallocated a substantial part of DISA's income to taxpayer, thus increasing the latter's taxes for 1959 and 1960 by considerable sums. The additional taxes were paid and this refund suit was brought in due course. Du Pont assails the Service's reallocation, urging that the prices plaintiff charged DISA were valid under the Treasury regulations implementing section 482. We hold that taxpayer has failed to demonstrate that, under the regulation it invokes and must invoke, it is entitled to any refund of taxes.

I. Design, Objectives and Functioning of DISA¹

A. Du Pont first considered formation of an international sales subsidiary in 1957.

A decreasing volume of domestic sales, increasing profits on exports, and the recent formation of the Common Market in Europe convinced taxpayer's president of the need for such a subsidiary. He envisioned an international sales branch capable of marketing Du Pont's most profitable type of products — Du Pont proprietary products, particularly textile fibers and elastomers² specially designed for use as raw materials by other manufacturers. Du Pont had utilized two major marketing techniques to sell such customized products.³ One mechanism consisted of technical sales services: an elaborate set of laboratory services making technical improvements, developing new applications, and solving customer problems for Du Pont products. The other was "indirect selling," a method of promoting demand for Du Pont products at every point in the distribution chain. These two techniques were to be developed by DISA, Du Pont's international branch in Europe. DISA was not to displace plaintiff's set of independent European distributors, but rather to augment the distributors' efforts by the two marketing methods and to police the independents adequately.

B. Neither in the planning stage nor in actual operation was DISA a sham entity; nor can it be denied that it was intended to, and did, perform substantial commercial functions which taxpayer legitimately saw as needed in its foreign (primarily European) market. Nevertheless, we think it also undeniable that the tax advantages of such a foreign entity were also an important, though not the primary, consideration in DISA's creation and operation. During the planning stages, plaintiff's internal memoranda were replete with references to tax advantages, particularly in planning prices on Du Pont goods to be sold to the new entity. The tax strategy was simple. If Du Pont sold its goods to the new international subsidiary at prices below fair market value, that company, upon resale of the goods, would recognize the greater part of the total profit (i. e., manufacturing and selling profits). Since this foreign subsidiary could be located in a country where its profits would be taxed at a much lower level than the parent Du Pont would be taxed here, the enterprise as a whole would minimize its taxes. Cf. Baldwin-Lima-Hamilton Corp. v. United States, 435 F.2d 182, 184 (7th Cir. 1970). The new company's accumulated profits would be used to finance further foreign investments. The details of this planning are set forth in the findings, and they leave us without doubt that a significant objective of plaintiff was to create a foreign subsidiary which would be able to accumulate large profits with which to finance Du Pont capital improvements in Europe.⁴

C. Consistently with that aim, plaintiff's prices on its intercorporate sales to DISA were deliberately calculated to give the subsidiary the lion's share of the profits. Instead of allowing each individual producing department to value its goods economically and to set a realistic price,⁵ Du Pont left pricing on the sales to DISA with the Treasury and Legal Departments. Neither department was competent to set an economic value on goods sold to DISA, and no economic correlation of costs to prices was attempted.⁶ Rather, an official of the Treasury Department established a pricing system designed to leave DISA with 75 percent of the total profits. If the goods' cost was greater than DISA's selling price, the department would price the item at its cost less DISA's selling expense. This latter provision was designed to insulate DISA from any loss. On the whole, the pricing system was based solely on Treasury and Legal Department estimates of the greatest amount of profits that would be shifted to DISA without evoking IRS intervention.⁷

As it turned out, for the taxable years involved here, 1959 and 1960, the actual division of total profits between plaintiff and DISA was closer to a 50-50 split. In 1959 DISA realized 48.3 percent of the total profits, while in 1960 its share climbed to 57.1 percent. This departure from the original plan was the result of the omission of certain intercorporate transfers — a result not contemplated in the initial pricing scheme.

D. In operation, DISA enjoyed certain market advantages which helped it to accumulate large, tax-free profits. For its technical service function, the subsidiary did not develop its own extensive laboratories (with resulting costs and risks), but could rely on its parent's laboratory network in the United States and England. DISA was not required to hunt intensively (or pay as highly) for qualified personnel, since in both 1959 and 1960 it drew extensively on its parent's reservoir of talent. The international company's credit risks were very low, in part because of a favorable trade credit timetable by Du Pont. DISA also selected its customers to avoid credit losses, having a bad debt provision of less than one-tenth of one percent of sales. Unlike other distributor or advertising service agencies, DISA, because of its special relationship to the Du Pont manufacturing departments, had relatively little risk of termination.⁸ And as explained supra, Du Pont's pricing formula was intended to insulate DISA from losses on sales.⁹

In operating DISA, Du Pont also maximized its subsidiary's income by funneling a large volume of sales through DISA which did not call for large expenditures by the latter. Many of the products Du Pont sold through DISA required no special services, or already had ample technical services provided. Du Pont routed sales to Australia and South Africa through DISA although the latter provided no additional services to sales in these non-European countries. DISA made sales of commodity-type products and opportunistic spot sales to competitors temporarily short in a raw material, although neither type of sale required DISA's specialized marketing expertise. Du Pont also routed all European sales of Elastomers through DISA, even though the parent had a well-established English subsidiary which had all the necessary technical services and marketing ability.

E. We have itemized the special status of DISA — as a subsidiary intended and operated to accumulate profits without much regard to the functions it performed or their real worth — not as direct proof, in itself, supporting the Commissioner's reallocation of profits under Section 482, but instead as suggesting the basic reason why plaintiff's sales to DISA were unique and without any direct comparable in the real world. As we shall see in Part II, infra, taxpayer has staked its entire case on proving that the profits made by DISA in 1959 and 1960 were comparable to those made on similar resales by uncontrolled merchandizing agencies. DISA's special status and mode of functioning help to explain why that effort has failed. It is not that there was anything "illegal" or immoral in Du Pont's plan; it is simply that that plan made it very difficult, perhaps impossible, to satisfy the controlling Treasury regulations under Section 482.¹⁰

II. Section 482 and the "Resale Price Method" of Allocating Profits.

A. Section 482¹¹ gives the Secretary of the Treasury (or his delegate) discretion to allocate income between related corporations when necessary to "prevent evasion of taxes or clearly to reflect the income" of any of such corporations. The legislative history parallels the general purpose of the statutory text to prevent evasion by "improper manipulation of financial accounts", "arbitrary shifting of profits," and to accurately reflect "true tax liability." See H.R.Rep.No.350, 67th Cong., 1st Sess. 14 (1921) (section 240(d) of 1921 Act); ...