Procter & Gamble Co. v. C.I.R., s. 91-1515

• Decision Date: 09 July 1992
• Docket Number: 91-1557,Nos. 91-1515,s. 91-1515
• Parties: -1063, 92-1 USTC P 50,209 The PROCTER & GAMBLE COMPANY, Petitioner-Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant.
• Court: U.S. Court of Appeals — Sixth Circuit

Page 1255

961 F.2d 1255

69 A.F.T.R.2d 92-1063, 92-1 USTC P 50,209

The PROCTER & GAMBLE COMPANY, Petitioner-Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant.

Nos. 91-1515, 91-1557.

United States Court of Appeals, Sixth Circuit.

Argued March 17, 1992.

Decided April 20, 1992.

Rehearing En Banc Denied July 9, 1992.

Padric K. O'Brien, William Sanford Corey (Briefed), Sutherland, Asbill & Brennan, Washington, D.C., Burgess L. Doan (Briefed), Cohen, Todd, Kite & Stanford, Newport, Ky., J.D. Fleming, Jr. (Argued), Sutherland, Asbill & Brennan, Atlanta, Ga., for petitioner-appellee.

Abraham N.M. Shashy, Jr., Chief Counsel, John T. Lyons, I.R.S., Office of Chief Counsel, Gary R. Allen, Acting Chief (Briefed), Jonathan S. Cohen, Teresa McLaughlin (Argued), U.S. Dept. of Justice, Appellate Section Tax Div., Howard A. Berger, I.R.S., Washington, D.C., for respondent-appellant.

Before: KENNEDY and BATCHELDER, Circuit Judges; and TAYLOR, District Judge. ^*

KENNEDY, Circuit Judge.

The Commissioner of Internal Revenue appeals the decision of the Tax Court holding that allocation of income to Procter & Gamble (P & G) from a wholly-owned subsidiary under Internal Revenue Code § 482 was unwarranted. For the reasons to follow, we AFFIRM the Tax Court.

I.

P & G is an Ohio corporation engaged in the business of manufacturing and marketing consumer and industrial products. P & G operates through domestic and foreign subsidiaries and affiliates.

P & G owned all the stock of Procter & Gamble A.G. (AG), a Swiss corporation. AG was engaged in marketing P & G's products, generally in countries in which P & G did not have a marketing subsidiary or affiliate.

P & G and AG were parties to a License and Service Agreement, known as a package fee agreement, under which AG paid royalties to P & G for the nonexclusive use by AG and its subsidiaries of P & G's patents, trademarks, tradenames, knowledge, research and assistance in manufacturing, general administration, finance, buying, marketing and distribution. The royalties payable to P & G were based primarily on the net sales of P & G's products by AG and its subsidiaries. AG entered into agreements similar to package fee agreements with its subsidiaries.

In 1967, P & G made preparations to organize a wholly-owned subsidiary in Spain to manufacture and sell its products in that country. Spanish laws in effect at that time closely regulated foreign investment in Spanish companies. The Spanish Law of Monetary Crimes of November 24, 1938, in effect through 1979, regulated payments from Spanish entities to residents of foreign countries. This law required governmental authorization prior to payment of pesetas to residents of foreign countries. Making such payments without governmental authorization constituted a crime. Decree 16/1959 provided that if investment of foreign capital in a Spanish company was deemed economically preferential to Spain, a Spanish company could transfer in pesetas "the benefits obtained by the foreign capital."

P & G requested authorization to organize P & G Espana S.A. (Espana) and to own, either directly or through a wholly-owned subsidiary, 100 percent of the capital stock of Espana. P & G stated that its 100 percent ownership of Espana would allow Espana immediate access to additional foreign investment, and that P & G was in the best position to bear the risk associated with the mass production of consumer products. P & G also indicated that 100 percent ownership would allow P & G to preserve the confidentiality of its technology. As part of its application, P & G estimated annual requirements for pesetas for the first five years of Espana's existence. Among the items listed was an annual amount of 7,425,000 pesetas for royalty and technical assistance payments. Under Spanish regulations, prior authorization of the Spanish Council of Ministers was required in order for foreign ownership of the capital of a Spanish corporation to exceed fifty percent.

The Spanish government approved P & G's application for 100 percent ownership in Espana by a letter dated January 27, 1968. The letter expressly stated that Espana could not, however, pay any amounts for royalties or technical assistance. For reasons that are unclear in the record, it was determined that AG, rather than P & G, would hold 100 percent interest in Espana.

From 1969 through 1979, Espana filed several applications with the Spanish government seeking to increase its capital from the amount originally approved. The first such application was approved in 1970. The letter granting the increase in capital again stated that Espana "will not pay any amount whatsoever in the concept of fees, patents, royalties and/or technical assistance to the investing firm or to any of its affiliates, unless with the approval of the Administration." All future applications for capital increases that were approved contained the same prohibition.

In 1973, the Spanish government issued Decree 2343/1973, which governed technology agreements between Spanish entities and foreign entities. In order to obtain permission to transfer currency abroad under a technology agreement, the agreement had to be recorded with the Spanish Ministry of Industry. Under the rules for recording technology agreements, when a foreign entity assigning the technology held more than 50 percent of the Spanish entity's capital, a request for registration of a technology agreement was to be looked upon unfavorably. In cases where foreign investment in the Spanish entity was less than 50 percent, authorization for payment of royalties could be obtained.

In 1976, the Spanish government issued Decree 3099/1976, which was designed to promote foreign investment. Foreign investment greater than 50 percent of capital in Spanish entities was generally permitted, but was conditioned upon the Spanish company making no payments to the foreign investor, its subsidiaries or its affiliates for the transfer of technology.

Espana did not pay a package fee for royalties or technology to AG during the years at issue. Espana received permission on three occasions to pay P & G for specific engineering services contracts. The Spanish Foreign Investments Office clarified that payment for these contracts was not within the general prohibition against royalties and technical assistance payments. Espana never sought formal relief from the Spanish government from the prohibition against package fees.

In 1985, consistent with its membership in the European Economic Community, in Decree 1042/1985 Spain liberalized its system of authorization of foreign investment. In light of these changes, Espana filed an application for removal of the prohibition against royalty payments. This application was approved, as was Espana's application to pay package fees retroactive to July 1, 1987. Espana first paid a dividend to AG during the fiscal year ended June 30, 1987.

The Commissioner determined that a royalty of two percent of Espana's net sales should be allocated to AG as royalty payments under section 482 for 1978 and 1979 in order to reflect AG's income. The Commissioner increased AG's income by $1,232,653 in 1978 and by $1,795,005 in 1979 and issued P & G a notice of deficiency. ¹ P & G filed a petition in the Tax Court seeking review of the deficiencies.

The Tax Court held that the Commissioner's allocation of income was unwarranted and that there was no deficiency. The court concluded that allocation of income under section 482 was not proper in this case because Spanish law, and not any control exercised by P & G, prohibited Espana from making royalty payments.

II.

This Court applies a de novo standard of review to legal conclusions made by the Tax Court. Smith v. Commissioner, 937 F.2d 1089, 1096 (6th Cir.1991).

III.

P & G argues that the Tax Court correctly determined that the Commissioner was not authorized to allocate royalty income to it under section 482. At all times relevant to this action, section 482 provided:

In any case of two or more organizations, trades, or businesses ... owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any such organizations, trades, or businesses.

The purpose of section 482 is "to place a controlled taxpayer on a tax parity with an uncontrolled taxpayer." Treas.Reg. § 1.482-1(b)(1).

It is P & G's position that section 482 requires that any distortion of income of a controlled party result from the existence and exercise of control. P & G argues that where governing law, and not the controlling party or interests, causes a distortion of income, section 482 is unavailable to allocate income. P & G argues that the regulations promulgated under section 482 and the Supreme Court's decision in Commissioner v. First Security Bank, 405 U.S. 394, 92 S.Ct. 1085, 31 L.Ed.2d 318 (1972), support this position.

The term "controlled" is defined in Treas.Reg. § 1.482-1(a)(3) to include:

any kind of control, direct or indirect.... It is the reality of the control which is decisive, not its form or the mode of its exercise.

Treas.Reg. § 1.482-1(b)(1) states the level of control that is presumed to justify making a section 482 allocation:

The interests controlling a group of controlled taxpayers are assumed to have...