Procter & Gamble Co. v. Comm'r of Internal Revenue

• Decision Date: 18 September 1990
• Docket Number: Docket No. 16521-84.
• Citation: 95 T.C. 323,95 T.C. No. 23
• Parties: PROCTER AND GAMBLE COMPANY, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

95 T.C. 323

95 T.C. No. 23

PROCTER AND GAMBLE COMPANY, Petitioner

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 16521-84.

United States Tax Court

Filed September 18, 1990.

AG, a Swiss corporation and a wholly owned subsidiary of petitioner, owned 100 percent of E, a corporation organized in Spain. Spanish law effectively precluded E from making royalty payments to AG for the use of petitioner's intangible property. Respondent determined that an allocation of income from E to AG pursuant to section 482 was necessary to clearly reflect income. The allocation in turn increased petitioner's subpart F income under section 951. HELD, because Spanish law effectively precluded E from paying AG, effectively blocking AG's receipt of the income, there was no impermissible shifting of income and the section 482 allocation was unwarranted. Commissioner v. First Security Bank of Utah, 405 U.S. 394 (1972), and Salyersville National Bank v. United States, 613 F.2d 650 (6th Cir. 1980), are controlling. William S. Corey, J.D. Fleming Jr., Burgess L. Doan, Mac Asbill, Jr., T. Paul Freeland, and Harold W. Walker, for the petitioner. ¹

Robert J. Kastl and Ann J. Davidson, for the respondent.

HAMBLEN, JUDGE:

Respondent determined deficiencies in petitioner's Federal income tax in the amounts and for the years as follows:

+---------------------------+
                ¦TYE           ¦Deficiency  ¦
                +--------------+------------¦
                ¦June 30, 1978 ¦$765,649.04 ¦
                +--------------+------------¦
                ¦June 30, 1979 ¦1,188,033.02¦
                +---------------------------+
                

The issue for decision in this case is whether respondent's allocations of gross income from Procter and Gamble Espana, S.A., to Procter and Gamble A.G., pursuant to section 482, ² were arbitrary, capricious, or unreasonable.

FINDINGS OF FACT

Some of the facts have been stipulated and are found accordingly. The stipulation and exhibits attached thereto are incorporated herein by this reference.

Procter and Gamble Company (petitioner or P&G), is an Ohio corporation whose principal place of business at the time of the filing of the petition herein was in Cincinnati, Ohio. During the years in issue, petitioner maintained its books and records on the accrual method of accounting with taxable years ending on June 30. Petitioner timely filed its Federal income tax returns for 1978 and 1979 with the Internal Revenue Service Center at Cincinnati, Ohio. At all times relevant to the issues in this case, petitioner was principally engaged in the business of manufacturing and marketing consumer and industrial products. Petitioner operated its business both directly and indirectly through domestic and foreign subsidiaries and affiliates.

Procter and Gamble A.G. (AG) is a Swiss corporation and at all relevant times was a wholly owned subsidiary of petitioner. During each of the years in issue, AG was engaged in the marketing of petitioner's products, generally in those countries in which petitioner did not have a marketing subsidiary or affiliate.

During the years in issue, petitioner and AG were parties to a License and Services Agreement, known as a ‘package fee agreement,‘ under which AG paid royalties to petitioner for the nonexclusive use by AG and its subsidiaries of petitioner's patents, trademarks, tradenames, knowledge, research, and assistance in the fields of manufacturing, general administration, finance, buying, marketing, and distribution. Petitioner executed similar agreements with its other directly owned foreign subsidiaries during the years in issue. The royalty amounts paid by AG to petitioner were based principally on net sales of petitioner's products by AG and its subsidiaries, and certain other companies in Greece, Spain, Austria, Saudi Arabia, Morocco, Iran, Libya, and Lebanon. During the years in issue, AG executed technical assistance and other service agreements, similar to package fee agreements, with its directly owned active subsidiaries.

In 1967, petitioner made preparations to organize a wholly owned subsidiary in Spain to manufacture and sell its consumer and industrial products in that country. At that time, many laws, decrees, and orders were in effect in Spain regulating foreign investment in Spanish companies and limiting the payment or assignment of credits in pesetas in favor of residents of foreign countries.

Article First, paragraphs 14 through 17 of the First Title of the Spanish Law of Monetary Crimes of November 24, 1938 (Law of Monetary Crimes), in effect through 1979, provided broad authority for the regulation of payments from Spanish entities to residents of foreign countries. These provisions required governmental authorization prior to the making of payments or assignment of credits in pesetas in favor of residents of foreign countries. The making of such payments without governmental authorization constituted a crime. The Law of Monetary Crimes was repealed and restated by Law 40/1979 of December 10, 1979.

Decree 16/1959 of July 27, 1959, contained specific regulations concerning investment of foreign capital in corporations organized in Spain. Article 4 of Decree 16 classified investment of foreign capital based on whether the particular business was of ‘preferential economical and social interest.‘ Article 4 provided, inter alia, that a foreign investment could be deemed preferential if directed towards the modernization or enlargement of existing plants. If the foreign investment was found to be of preferential economic interest, Article 6 provided that the company would have the ‘right to transfer abroad in foreign currency and -- without any quantitative limitation, the benefits actually obtained by the foreign capital.‘ Article 5 required prior authorization from the Spanish Council of Ministers in order for foreign participation to exceed 50 percent ownership of the capital of a Spanish corporation.

On September 23, 1967, P&G, upon the advice of competent Spanish counsel, submitted an application letter addressed to the ‘Presidency of the Spanish Government‘ requesting authorization to organize a Spanish company, Espana. The application recited that P&G intended to own directly, or through a wholly owned subsidiary, 100 percent of the capital stock of Espana. The application stated that Espana would have as its purpose the manufacture and sale of high quality consumer and industrial products, including synthetic detergents, soaps and toiletries, and other cleaning and washing products.

In an index attached to the application letter, P&G stated that Espana would employ up to 250 persons for its manufacturing operations and that an additional 120 persons could be employed if P&G were to construct a new synthetic detergent factory. However, P&G indicated that it might purchase an existing plant if one could be found meeting its technical specifications.

Paragraph 8 of the index set forth estimated annual requirements for foreign currency for the first 5 years of Espana's existence. Among the items covered was an annual amount of 7,425,000 pesetas necessary for royalty and technical assistance payments.

The final portion of the index related to P&G's justification for its desire to hold over 50 percent of the capital of Espana. P&G stated that its 100 percent ownership of Espana would allow Espana immediate access to additional foreign investment. Further, P&G indicated that it was in the best position to shoulder the formidable risks associated with mass-produced consumer products, and that 100 percent ownership of Espana would allow P&G to preserve the confidentiality of its technology.

The Spanish government approved P&G's application for a 100 percent interest in Espana by a letter dated January 27, 1968. However, the letter expressly provided that Espana could not pay any amounts for royalties or technical assistance. After receipt of the letter, P&G's Spanish counsel advised that the limitation on royalty payments was within the power of the Spanish government and reflected normal practice. Counsel further advised that there was no realistic possibility of appealing or protesting the decision as long as P&G intended to retain 100 percent ownership of Espana. Consistent with advice of counsel, P&G did not formally appeal the prohibition on royalty payments. At the time of its organization, Espana had several competitors in Spain who likewise could not make royalty payments abroad.

For reasons not clear in the record, a determination was made that AG, rather than P&G, would hold the entire interest in Espana. Espana's Deed of Incorporation was registered in the Mercantile Registry of the Province of Madrid on May 29, 1968.

From 1969 through the years in issue, Espana filed several applications with the Spanish government seeking to increase its capital from the 120 million pesetas originally approved. The first application, filed on October 23, 1969, and approved on January 30, 1970, sought a capital increase of 70 million pesetas due to an expanding work force, the establishment of a laboratory in Madrid for quality control testing, and upcoming fixed asset costs. The letter granting Espana's request stated that Espana ‘will not pay any amount whatsoever in the concept of fees, patents, royalties and/or technical assistance to the investing firm nor to any of its affiliates, unless with the approval of the Administration.‘ Additional applications for capital increases were filed in 1970, 1971, 1975, 1977, and 1978. While the application filed in 1970 was denied, the remaining applications were approved subject to essentially the same prohibition against the payment of royalties as appeared in the first approval for capital increase.

Counsel for Espana and an official from the Spanish Ministry of Industry met on May 19, 1970, to discuss the possibility of Espana's making technical assistance payments to AG. However, the Spanish government would not approve or grant permission for such payments. To the contrary, such applications or...