U.S. v. Caltex Petroleum Corp.
| Decision Date | 16 April 1998 |
| Docket Number | No. 3-96-CV-2726-X.,3-96-CV-2726-X. |
| Citation | 12 F.Supp.2d 545 |
| Parties | UNITED STATES of America Petitioner, v. CALTEX PETROLEUM CORP., et al., Respondents. |
| Court | U.S. District Court — Northern District of Texas |
Loretta C. Argrett, Deborah H. Meland, Rachel D. Cramer, David A. Haimes, Washington, DC, for Plaintiff.
G. Luke Ashley, Emily A. Parker, Thompson & Knight, P.C., Dallas, TX, for Defendant Caltex.
John P. Pinkerton, David R. Nelson, Jones, Day Reavis & Pogue, Dallas, TX, for Defendant Computer Language Research, Inc.
FINDINGS AND RECOMMENDATION OF THE UNITED STATES MAGISTRATE JUDGE
This case has been referred to the United States magistrate judge pursuant to 28 U.S.C. § 636(b) and an order of reference dated January 9, 1997. The findings and recommendation of the magistrate judge are as follow:
I.
This is a summons enforcement action brought under 26 U.S.C. § 7604. Petitioner is the United States of America. Respondents are Caltex Petroleum Corporation ("Caltex") and Computer Language Research, Inc. ("CLR").1
Caltex is a multi-national corporation that refines and markets petroleum products in Asia, Africa, and Australia. The company operates through 11 wholly owned subsidiaries, 17 minority-owned foreign corporations, and 92 controlled foreign corporations. Caltex pays taxes on the income of its foreign subsidiaries in the various countries where they are incorporated. In order to avoid double taxation, Caltex typically reports a foreign tax credit on its consolidated U.S. income tax return. The foreign tax credit is a dollar-for-dollar credit on all taxes paid or "deemed paid" to a foreign taxing authority. Historically, this credit has represented a substantial portion of Caltex's tax return. For example, Caltex claimed $125,795,115 in foreign tax credits against $141,275,301 in total taxable income in 1990. This reduced the effective tax rate of the company to 3.73%. The calculation of this foreign tax credit is at the heart of the present dispute.
The Tax Reform Act of 1986 increased the complexity of calculating foreign tax credits. The taxpayer must divide its income into different categories known as "baskets." There is a separate limitation on the amount of foreign tax credit than can be claimed for each basket of income. Because the Tax Reform Act increased the number of potential baskets, the number of computations necessary to calculate the foreign tax credit also increased. The calculations themselves are mechanical and repetitive, involving mostly addition and subtraction. However, the Act also created perpetual earnings and profit pools within each basket. This further complicated the calculation of foreign tax credits and created the potential problem of computational errors being carried through from year to year.
Caltex used two computer software programs to help calculate its foreign tax credits. These programs are the International Tax Management System and the Foreign Tax Management System, also known as ITMS/FTMS. ITMS/FTMS are modules of a larger software program called the Tax Management System, which was originally developed and licensed by Price Waterhouse. Caltex used the ITMS/FTMS program to calculate the foreign tax credits on its amended 1987 and original 1989 and 1990 tax returns.2 However, the company also relied on other software programs and made manual calculations in certain instances.
The Internal Revenue Service has been engaged in a five-year investigation into the potential tax liability of Caltex. The focus of this investigation is the foreign tax credits reported by the company for the years 1987-1990. In order to verify these credits, the IRS must recreate the "audit trail." This involves tracing the numbers shown on the tax returns back through the various computations used by the taxpayer to the raw data. The IRS typically uses information document requests, or IDRs, to accomplish this task. An IDR is the primary information-gathering tool used to reconstruct an audit trail. The IRS issued 297 of these requests to Caltex between May 1993 and August 1995. During this same time period, the IRS exam team and Caltex proposed more than 80 adjustments to the tax returns. (Resp.Ex. 15).
On December 6, 1993, the exam team assigned to the Caltex audit issued an IDR for an executable copy of the ITMS/FTMS software. (Resp.Ex. 16-101). Caltex refused to comply due to restrictions imposed under its licensing agreement and non-disclosure agreement with Price Waterhouse.3 (Resp.Exh. 16-102). Instead, the company conducted a demonstration of the software for the exam team and produced twelve volumes of input and output reports generated by the program in connection with the 1990 tax return. Caltex offered to provide similar materials for its amended 1987 and original 1989 returns. However, this offer was rejected. Caltex demonstrated the software again in July 1994 and January 1995 using actual Caltex data. Price Waterhouse also conducted demonstrations for members of the exam team using Caltex data in July and September 1994. After the last Price Waterhouse demonstration, the IRS assistant commissioner of international taxation issued a report describing why access to the ITMS/FTMS software was needed to complete the audit trail. The report gave recommendations for obtaining the software and noted that "if a system error is discovered, all taxpayers utilizing [ITMS/FTMS] could be subject to examination." (Govt. Ex. 25 at 12). On October 21, 1994, the IRS issued a summons to Caltex for an executable copy of the ITMS/FTMS software and related documentation. (Petition, Ex. A-1). Caltex refused to comply with the summons, citing its licensing agreement with Price Waterhouse. The company further indicated that it had made available to the IRS all the information necessary to verify the accuracy of the tax returns. (Petition, Ex. A-2).
It appeared that this impasse had been resolved in June 1995 after a meeting between Powell Banning, general tax counsel for Caltex, and Tom Crawford, the IRS audit case manager. Caltex agreed to use ITMS/FTMS to recalculate its foreign tax credits incorporating all proposed adjustments. The IRS would then compare the results with those generated by its own computer software program and try to have the audit completed in three to four months. (Resp.Ex. 5-2-F). However, Crawford was subsequently taken off the audit and the new case manager refused to honor the agreement.
The parties met again in September 1995. Caltex was represented by Banning and Joni Way, its coordinator of U.S. tax audits.4 Glen Duncan, chief examiner for the North Texas office, and Jerry Jones, a computer audit specialist, participated on behalf of the IRS. Jones indicated that the computer specialists working on the Caltex audit wanted access to the source code for the ITMS/FTMS software. "Source code" is the human readable form of the software program. Simply stated, source code instructs the computer how to carry out the various functions the software is designed to perform. Duncan indicated that Caltex might be a "test case" for the IRS's authority to summon source code.
On October 6, 1995, two assistant IRS commissioners issued a memo reaffirming their interest in gaining knowledge of tax preparation software programs. (Govt.Exh. 26). Less than three weeks later, the IRS summoned the ITMS/FTMS source code and related documents from Price Waterhouse. (Petition, Ex. A-5). Price Waterhouse refused to comply with the summons due to the confidential and proprietary nature of these materials. It also argued that the source code and associated documents were not "books, records, papers, or other data" within the meaning of 26 U.S.C. § 7602(a). (Petition, Ex. A-6). Shortly thereafter, Price Waterhouse sold its rights in the ITMS/FTMS software to Computer Language Research, Inc.
On May 8, 1996, the IRS issued another summons to Caltex for an executable copy of the ITMS/FTMS software and related documentation.5 (Petition, Ex. A-7). Price Waterhouse and CLR each received a summons for the source code, an executable copy of the software, and related documents on May 10, 1996. (Petition, Ex. A-8 & A-9). All three respondents refused to comply. (Petition, Ex. A-10, A-11, & A-12). In particular, CLR indicated that it would not produce an executable copy of the software without significant restrictions and that it would not produce the source code under any circumstances.6 (Petition, Ex. A-12). The government filed this summons enforcement action on September 27, 1996. Caltex filed a motion to quash the summonses on December 18, 1996.
An evidentiary hearing was held on October 14-16, 1997. Deborah S. Meland, Rachel D. Cramer and David A. Haimes appeared for the government. G. Luke Ashley appeared for Caltex. John P. Pinkerton and David Nelson appeared for CLR. The issues have been fully briefed by the parties and this matter is ripe for determination.
II.
A district court may enforce an IRS summons if the respondent fails to produce records that are relevant to a legitimate tax inquiry. 26 U.S.C. § 7604; United States v. Wyatt, 637 F.2d 293, 299-300 (5th Cir.1981). The government must prove that: (1) the investigation is being conducted for a legitimate purpose; (2) the summons is relevant to that purpose; (3) the information sought is not already in the possession of the IRS; and (4) all proper administrative procedures have been followed. United States v. Powell, 379 U.S. 48, 57-58, 85 S.Ct. 248, 254-55, 13 L.Ed.2d 112 (1964); Barquero v. United States, 18 F.3d 1311, 1316 (5th Cir.1994). The burden then shifts to the taxpayer to challenge the summons on any "appropriate ground." Powell, 85 S.Ct. at 255; Barquero, 18 F.3d at 1316-17.
III.
The IRS seeks the source code for the ITMS/FTMS program so it can replicate the audit trail used by Caltex in preparing its tax returns. According to the IRS, the...
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...to generate the audited return can certainly be considered a `record' or `other data.'" Id. The court in United States v. Caltex Petroleum Corp., 12 F.Supp.2d 545 (N.D.Tex.1998), arrived at the same conclusion. In Caltex, the IRS sought the source code for tax preparation software used to c......