UNITED STATES TAX COURT

108 T.C. No. 9

UNITED STATES TAX COURT

GENERAL DYNAMICS CORPORATION AND SUBSIDIARIES, Petitioner

v. COMMISSIONER OF INTERNAL REVENUE, Respondent

GENERAL DYNAMICS FOREIGN SALES CORP., Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 19202-94, 19203-94.

Filed March 26, 1997.

P formed wholly owned corporations (one a DISC,

the other an FSC). P computed and reported its Federal

income using the completed contract method. P elected,

under sec. 1.451-3(d)(5)(iii), Income Tax Regs., to

annually deduct certain period costs. In computing the

base (combined taxable income) for the statutorily

conferred tax benefit to promote exports, P did not

account for period costs, which it had elected to

deduct annually in prior years. R determined that sec.

994 and/or 925, I.R.C., and the regulations thereunder,

required P to include prior years' period costs that

are attributable to the gross receipts from foreign

exports in computing the base for P's deferral or

exemption from income.

P manufactured specialized ocean-going vessels for

the transport of liquefied natural gas. Sec. 1.9933(d)(2)(i)(b), Income Tax Regs., requires that to

- 2 generate qualified export receipts the export property

must be used in foreign commerce prior to 1 year after

its sale. For reasons beyond P's control the vessels

were not so used. P contends that the regulation is

not a proper interpretation of the statutory provision.

Held: Sec. 1.994-1(c)(6), Income Tax Regs.,

interpreted to require P to reduce gross export

receipts by related period costs even though P is

permitted to elect to deduct those costs in years prior

to the combined taxable income computation.

Held, further, P's vessels are not qualified

export property because they fail to meet the

requirements of sec. 1.993-3(d)(2)(i)(b), Income Tax

Regs. Sim-Air, USA, Ltd. v. Commissioner, 98 T.C. 187,

190-197 (1992), followed in upholding the validity of

the regulation.

David C. Bohan, Richard T. Franch, James M. Lynch, Philip A.

Stoffregen, David D. Baier, Scott Schaner, Gregory S.

Gallopoulos, and Debbie L. Berman, for petitioner in docket No.

19202-94.

David C. Bohan, James M. Lynch, Philip A. Stoffregen, and

David D. Baier, for petitioner in docket No. 19203-94.

William H. Quealy, Jr., Alice M. Harbutte, Jeffrey A.

Hatfield, Thomas C. Pliske, and William T. Derick, for

respondent.

GERBER, Judge:

General Dynamics Corp. and its consolidated

subsidiaries (GENDYN) (docket No. 19202-94) and its foreign sales

corporation, General Dynamics Foreign Sales Corp. (GENDYN/FSC)

(docket No. 19203-94), are petitioners in these consolidated

cases.

Respondent determined corporate income tax deficiencies

- 3 for GENDYN in the amounts of $26,118,976 and $291,218,973 for its

1985 and 1986 taxable years, respectively.

With respect to

GENDYN/FSC, respondent determined a $586,533 corporate income tax

deficiency for its 1986 taxable year.

Although these cases are

consolidated and related, for purposes of briefing and opinion

the issues have been divided into two generalized categories:

Domestic and foreign.

This opinion addresses the foreign issues.

The parties have settled some of the foreign issues, and the

following controversies remain for our consideration and

decision:

(1) Whether in computing combined taxable income

attributable to qualified export receipts under sections 9941 and

925 petitioners must, in addition to current year period costs,

deduct prior year period costs, as determined by respondent; and

(2) whether two liquefied natural gas tankers manufactured by

petitioner and sold to an unrelated third party for foreign use

constitute export property under section 993(c)(1) even though no

foreign use occurred during the first year and/or domestic use

occurred on one occasion prior to any foreign use.

FINDINGS OF FACT

The parties have stipulated most of the facts bearing on the

foreign issues, and those facts are found and incorporated by

this reference.

1

GENDYN was incorporated on February 21, 1952,

Unless otherwise indicated, section references are to the

Internal Revenue Code as amended and in effect for the taxable

years in issue.

- 4 and, at all relevant times, was the common parent of a group of

corporations that filed consolidated corporate Federal income tax

returns.

At the time the petitions were filed in these cases,

GENDYN's and GENDYN/FSC’s principal places of business were in

Falls Church, Virginia.

GENDYN engineered, developed, and

manufactured various products for the U.S. Government and, to a

lesser extent, foreign governments, including military aircraft,

missiles, gun systems, space systems, tanks, submarines,

electronics, and other miscellaneous goods and services.

GENDYN

was also involved in business activities, including design,

engineering, and manufacture of general aircraft; mining coal,

lime, limestone, sand, and gravel; manufacture and sale of readymix concrete, concrete pipe, and other building products;

production of commercial aircraft subassemblies; design,

engineering, and manufacture of commercial space launch vehicles

and services; and shipbuilding.

GENDYN, for the taxable years

1977 through 1986, used the completed contract method to report

Federal income and the percentage of completion method for its

financial accounting purposes.

GENDYN, on February 25, 1972, incorporated an entity

(GENDYN/DISC)2 to serve as an export sales representative.

2

The issues in these consolidated cases span a time period

within which the statutory provisions relating to domestic

international sales corporations were replaced by those related

to foreign sales corporations. Due to these statutory changes,

GENDYN ended use of its specially formed domestic international

(continued...)

- 5 GENDYN owned 100 percent of GENDYN/DISC's sole class of voting

stock.

GENDYN/DISC had no employees or business operations and

existed for the sole purpose of receiving commissions from

GENDYN.

On the date of the incorporation, GENDYN and GENDYN/DISC

entered into an Export Sales Commission Agreement.

On May 24,

1972, GENDYN/DISC elected to be treated as a domestic

international sales corporation (DISC) under section 992(b), and

it filed Federal income tax returns (Forms 1120-DISC) on the

basis of a fiscal year ended March 31.

GENDYN/DISC, through the period ended December 31, 1984,

reported the commissions it earned on GENDYN's sales of export

property based on the completed contract method of accounting in

accordance with section 1.993-6(e)(1), Income Tax Regs.

At the end of each year, commissions on export property

sales involving long-term contracts were deducted by GENDYN and

included in income by GENDYN/DISC in its appropriate taxable

period.

Commissions were normally computed under the 50-50

combined taxable income method (50-percent method) provided for

2

(...continued)

sales corporation and began use of a foreign sales corporation.

Although some differences exist between the two sets of statutory

provisions and the entities created to comply with the statutes,

for purposes of resolving the issues in this case we need not

make any distinctions. The foreign sales corporation became a

petitioner in these consolidated cases because it was the

surviving entity. Accordingly, the domestic international sales

corporation will be referred to as GENDYN/DISC and the foreign

sales corporation will be referred to as GENDYN/FSC. When

referred to generally, they will be referred to, along with the

other entities collectively, as petitioners.

- 6 in section 994 because that method yielded the largest

commission.

On certain rare occasions, the 4-percent gross

receipts method of section 994 was utilized.

Petitioners computed combined taxable income for each longterm contract under the 50-percent method, as follows:

(a)

Add:

gross receipts from the contract as determined

under the completed contract method of accounting;

(b)

Less:

direct costs allocated to the contract under

section 1.451-3(d)(5)(i), Income Tax Regs.;

(c)

Less:

indirect costs allocated to the contract under

section 1.451-3(d)(5)(ii), Income Tax Regs.;

(d)

Less:

period costs incurred in the year of completion

allocated to the contract under section 1.451-3(d)(5)(iii),

Income Tax Regs.

In computing combined taxable income, petitioners did not

make a reduction for period costs, as defined in section 1.4513(d)(5)(iii), Income Tax Regs., incurred and allocated to the

contract prior to the year of contract completion.

Respondent

determined that petitioners incorrectly computed combined taxable

income under the 50-percent method.

In particular, respondent

determined that petitioners were required to aggregate and

deduct, in the year of completion of each long-term contract, all

period costs allocated to the contract, including those deducted

for prior years.

- 7 GENDYN/DISC ceased performing as GENDYN’s commission agent

on December 31, 1984, and was dissolved on October 23, 1992.

On December 27, 1984, GENDYN incorporated petitioner General

Dynamics Foreign Sales Corp. (GENDYN/FSC) in the U.S. Virgin

Islands to serve as GENDYN’s export sales representative.

GENDYN

owned the sole class of voting stock and entered into a Foreign

Sales Commission Agreement with GENDYN/FSC.

On March 22, 1985,

GENDYN/FSC elected under section 927(f) to be treated as a

foreign sales corporation (FSC).

During 1985 and 1986,

GENDYN/FSC functioned as GENDYN’s export sales representative and

was involved in no other trade or business.

GENDYN/FSC filed

Federal Forms 1120-FSC and used the completed contract method of

accounting to report the commissions earned on GENDYN’s sales of

export property involving long-term contracts.

At the end of each year, commissions on export property

sales involving long-term contracts were deducted by GENDYN and

included in income by GENDYN/FSC in its appropriate taxable

period.

With rare exceptions, the 23-percent combined taxable

income method (23-percent method) was used because it produced

the largest commission.

In a few instances, the 1.83-percent

gross receipts method was used.

Petitioners computed combined taxable income for each longterm contract under the 23-percent method as follows:

(a)

Add:

gross receipts from the contract as determined

under the completed contract method of accounting;

- 8 (b)

Less:

direct costs allocated to the contract under

section 1.451-3(d)(5)(i), Income Tax Regs.;

(c)

Less:

indirect costs allocated to the contract under

section 1.451-3(d)(5)(ii), Income Tax Regs.;

(d)

Less:

period costs incurred in the year of completion

allocated to the contract under section 1.451-3(d)(5)(iii),

Income Tax Regs.

In computing combined taxable income, petitioners did not

make a reduction for period costs incurred prior to the year of

contract completion that had been allocated to the contract in

years prior to completion under section 1.451-3(d)(5)(iii),

Income Tax Regs.

Respondent determined that petitioners

incorrectly computed combined taxable income under the 23-percent

method.

In particular, respondent determined that petitioners,

in the year of completion of each long-term contract, were

required to aggregate all period costs allocated to the contract,

including those deducted for prior years, and reduce combined

taxable income by the aggregated amount.

Respondent also determined that GENDYN was not entitled to

deduct commissions on sales involving two ships because they did

not qualify as export property under section 993.

In the

alternative, if the ships are found to qualify as export property

under section 993, respondent determined that petitioners

incorrectly computed the commissions attributable to the ships,

in the same manner as described above.

- 9 Pantheon, Inc. (Pantheon), is a wholly owned domestic

subsidiary of GENDYN.

Pelmar Co. (Pelmar) and Morgas, Inc.

(Morgas), are wholly owned domestic subsidiaries of corporations

unrelated to petitioners.

On May 7, 1976, Pantheon, Pelmar, and

Morgas formed the Lachmar Partnership (Lachmar), a general

partnership.

Pantheon and Pelmar each owned 40 percent, and

Morgas owned the remaining 20 percent of Lachmar.

Lachmar was

organized for the purpose of purchasing, owning, and operating

two specialized vessels (LNG tankers) that were designed and

built for transoceanic transport of liquefied natural gas (LNG).

LNG is made by cooling natural gas to a temperature below

minus 256 degrees Fahrenheit.

It is then transported at that

temperature in special-purpose tankers.

After delivery from the

tankers, the LNG is returned to a state in which it can be

distributed through pipelines.

The construction of LNG tankers

incorporates specialized and expensive technology which when

installed in a tanker renders it economically unusable for other

transportation purposes.

Due to the cost to specially build them

and the lack of economically feasible convertibility, LNG tankers

are normally constructed for well-defined long-term projects, and

there is virtually no open market for LNG tankers.

There are four LNG terminals within the contiguous United

States and one in Alaska, all of which are capable of landing and

receiving the type of LNG tanker under consideration in this

case.

Throughout the period under consideration, it was not

- 10 economically suitable to ship LNG between Alaska and the other

four domestic locations.

Throughout the period under

consideration, it was not economically suitable to domestically

ship LNG where it is accessible in gas form through a pipeline.

Trunkline LNG Co. (Trunkline), a wholly owned subsidiary of

Pelmar’s parent, was organized to purchase LNG from Algeria and

to arrange for its transportation to Lake Charles, Louisiana, for

U.S. distribution.

On September 17, 1975, Pelmar’s parent

entered a contract (LNG contract) with an Algerian national gas

producer to purchase 7,700,000 cubic meters of LNG annually for

20 years.

The purchaser was required to provide trans-Atlantic

transportation for 3,200,000 cubic meters of LNG each year.

On

January 2, 1976, the contract rights and obligations were

assigned to Trunkline.

Trunkline contracted with Lachmar (transportation contract),

on May 7, 1976, to transport LNG from Algeria to Louisiana over a

20-year period beginning in the first quarter of 1980.

On May 7,

1976, Lachmar entered into two contracts with GENDYN for the

construction and purchase of two LNG tankers to transport the

LNG.

Because of the combined 60-percent control by Morgas and

Pelmar, GENDYN did not control Lachmar, so the transactions

between GENDYN and Lachmar were on an arm’s-length basis.

GENDYN

manufactured the LNG tankers in the ordinary course of its

business for sale to Lachmar.

The LNG tankers were to be

delivered on December 4, 1979, and March 18, 1980.

On May 7,

- 11 1976, Lachmar entered into a contract with an affiliate of Morgas

to oversee the construction and then to maintain and operate the

LNG tankers.

Bonds, guaranteed by the U.S. Government, were issued by

Lachmar to finance the construction of the tankers, and the

Federal Government also subsidized the construction of the

tankers.

A portion of the subsidy was eventually repaid to the

Federal Government because one of the tankers was used for

domestic transportation.

The tankers were delivered and

transferred to Lachmar on May 15 and September 25, 1980.

Morgas’

affiliate was prepared to begin transportation of LNG at the time

of the tankers’ delivery.

To satisfy its obligations under the LNG contract, the

Algerian national LNG company was to construct a terminal

facility for the tankers.

For technical, financial, and

political reasons, the facility was not completed until the fall

of 1982, and the Algerian company could not deliver sufficient

quantities of LNG to fulfill its obligations to Trunkline.

Accordingly, the initial uses of the LNG tankers outside the

United States were on September 3 and November 16, 1982,

respectively.

Prior to that time, Lachmar bore the expense of

storing the tankers at various locations.

During 1980 through 1982, there was overcapacity in the

world market for LNG tankers, and Lachmar was able to find only

limited use for the tankers prior to their use under the

- 12 transportation contract.

That use occurred between June and July

of 1981, when one of the tankers transported LNG from

Everett/Boston, Massachusetts, to Elba Island, Georgia.

being transported was originally from Algeria.

The LNG

For that

transportation, Lachmar received gross compensation of

$2,038,468, which resulted in a gross profit of $588,228.

The

$2,038,468 was paid $1,349,581 in 1981 and $688,887 in 1982.

Due

to the domestic use of one of the tankers, Lachmar obtained an

exception from the Federal Government; otherwise it would have

risked losing all of its Government subsidies.

The two tankers

made voyages between Algeria and Louisiana a total of four times

during 1982 and seven times during 1983 under the transportation

contract.

Thereafter, the LNG and transportation contracts were

breached, and the tankers were stored in Virginia until 1988 and

1989, at which time they no longer belonged to Lachmar and began

service transporting LNG in foreign commerce.

On Lachmar’s Federal partnership returns, for purposes of

claiming credits and depreciation allowances, Lachmar reported

that one of the tankers was placed in service in 1980 and the

other in 1981.

Respondent questioned the placed-in-service dates

reported by Lachmar, and after the tax audit, the parties agreed

that one tanker was placed in service on January 1, 1981, and the

other on July 1, 1981.

OPINION

- 13 The issues under consideration arise in connection with

GENDYN and its foreign sales corporations.

One issue concerns

the manner in which petitioners compute the amount of commission

income that may be deferred or excluded under the foreign sales

corporation statutes and regulations.

That issue is one of first

impression, involving the interpretation of certain statutes and

regulations.

The other issue concerns whether either of two

ships is export property under section 993(c)(1) so as to enable

petitioners to include it in the computation of commission income

under the foreign sales corporation statutes and regulations.

We

first consider the former issue.

I. Petitioners’ Treatment of Period Costs in Computing Combined

Taxable Income

Petitioners were on the completed contract method of

accounting for long-term contracts for Federal income tax

purposes.

In the process of computing corporate Federal income

tax under the completed contract method, GENDYN, under section

1.451-3(d)(5)(iii), Income Tax Regs., elected to expense rather

than capitalize certain period expenses.

Normally, under the

completed contract method, the income and expenses connected with

long-term contracts are not reported or claimed until the

completion of the contract.

In computing the allowable amount of deferral or exclusion

of DISC or FSC commission income, petitioners did not include the

period costs that were deducted in prior years' domestic Federal

- 14 income tax computations (prior year period costs).

Instead, in

computing the amount of foreign sales corporation commission

income to be deferred or excluded, petitioners used only the

period costs incurred in the year of completion (current period

costs) and allocated to the particular contract under section

1.451-3(d)(5)(iii), Income Tax Regs.

Respondent determined that petitioners’ approach resulted in

a permanent exclusion and/or distortion in the form of

exaggerated amounts of deferral or exclusion of DISC or FSC

income because of an understatement of the amount of cost.

The

additional deferral or exclusion claimed by petitioners, in

respondent's view, does not harmonize with Congress' intent.

The

parties, to a great degree, rely on the same statutes and

regulations but arrive at opposite conclusions.

First, we

analyze the pertinent statutory and regulatory material.

A.

Statutory Background and Framework for DISC’s and FSC’s

In 1971, Congress enacted3 the DISC provisions4 as a tax

incentive to encourage and increase exports.

The legislation

allowed domestic corporations to defer taxes on a significant

portion of profits from export sales similar to the tax benefits

available to corporations manufacturing abroad through foreign

3

Revenue Act of 1971, Pub. L. 92-178, sec. 501, 85 Stat.

497, 535.

4

Secs. 991-997.

- 15 subsidiaries.

H. Rept. 92-533, at 58 (1971), 1972-1 C.B. 498,

529; S. Rept. 92-437, at 90 (1971), 1972-1 C.B. 559, 609.

A

domestic corporation that conducts its foreign operations through

a foreign subsidiary generally does not pay domestic Federal tax

on the income from those operations until the subsidiary's income

is repatriated to the domestic parent.

In 1984, Congress enacted the FSC provisions5 to replace and

cure some shortcomings in the DISC provisions.

Deficit Reduction

Act of 1984, Pub. L. 98-369, sec. 801(a), 98 Stat. 494, 990; S.

Rept. 98-169, at 636 (1984).

Under the FSC provisions, a

taxpayer may permanently avoid Federal income tax on a portion of

its profits on qualifying export sales.

The DISC and FSC provisions reallocate income generated by

export sales from the parent corporation to its DISC or FSC.

DISC’s are generally not subject to tax.

Sec. 991.

However, the

parent corporation is taxed on a specified portion of the DISC

profits as a deemed distribution.

Sec. 995; L & F Intl. Sales

Corp. v. United States, 912 F.2d 377, 378 (9th Cir. 1990).

The

remaining profits are tax-deferred until distributed

(repatriated) to the parent or until the corporation ceases to

qualify as a DISC.

Secs. 995(a) and (b) and 996(a)(1).

The FSC

provisions permanently exempt a portion of FSC profits from tax.

Sec. 923(a).

5

The amount of the deferral or exemption is in

Secs. 921-927.

- 16 controversy here.

For purposes of this case, the DISC and FSC

provisions are generally similar, and the parties do not argue

that the outcome should vary depending on which of the provisions

apply.

The focus here is whether petitioners must consider period

costs attributable to the gross receipts from export sales of the

foreign sales corporation, even though the period costs were

deducted in prior years.

There is a direct relationship between

the quantity of DISC income and the tax benefit available to a

domestic corporation under the DISC provisions.

The greater the

costs allocated to export sales, the lower the combined taxable

income attributable to the DISC or FSC, and thus the smaller the

tax deferral or exclusion.

Ordinarily, taxpayers seek ways to reduce the amount of

their reportable income, such as by means of deductions.

In

computing combined taxable income (CTI) of a foreign sales

corporation, however, taxpayers benefit where the amount of

export sales is larger or maximized to take advantage of the

congressionally intended deferral or exclusion of income.

We are

therefore presented with the somewhat unusual circumstance where

petitioners argue that the amount of income should be larger, and

respondent argues it should be smaller.

Petitioners assert that

they should not be required to reduce CTI by the portion of their

costs that was deducted in prior years.

- 17 B.

Allocation of Income From Export Sales to DISC’s

1.

Statutory Requirement

Under the DISC provisions, Congress created intercompany

pricing rules for the purpose of limiting the amount of income

that the parent can allocate to the DISC and thereby limiting the

amount of tax incentive by means of income deferral.

The pricing

rules provide for the price at which the parent corporation is

deemed to have sold its products to the DISC, regardless of the

price actually paid.

152, 163 (1981).

Bently Labs., Inc. v. Commissioner, 77 T.C.

Section 994(a) provides three alternative

pricing methods for DISC’s:

(1) 4 percent of qualified export

receipts on the sale of export property; (2) 50 percent of the

combined taxable income of the DISC and its related supplier (the

parent corporation); or (3) the arm's-length price, computed in

accordance with section 482.6

Taxpayers may use the method that

produces the largest amount of income allocation to the DISC’s.

Similarly, section 925 provides three pricing methods for FSC’s:

(1) 1.83 percent of foreign trading gross receipts; (2) 23

percent of combined taxable income; and (3) the arm's-length

price, computed in accordance with section 482.

Sec. 925(a).

The CTI methods are at issue in this case.

6

Under the first two methods, the DISC is entitled to

include 10 percent of its export promotion expenses as additional

taxable income. Sec. 994(a)(1) and (2); sec. 1.994-1(a)(1),

Income Tax Regs.

- 18 The parent corporation either sells its product to the DISC

for resale in foreign markets, a buy-sell DISC, or pays a

commission to the DISC for selling goods in foreign markets, a

commission DISC.

Brown-Forman Corp. v. Commissioner, 94 T.C.

919, 926 (1990), affd. 955 F.2d 1037 (6th Cir. 1992).

in this case is a commission DISC.

The DISC

Although the section 994(a)

pricing rules literally apply only to a buy-sell DISC, they have

been adopted for commission DISC’s pursuant to statutory

authority granted to the Secretary.

Sec. 994(b)(1); sec. 1.994-

1(d)(2)(i), Income Tax Regs.; see sec. 925(b)(1); sec. 1.925(a)1T(d)(2), Temporary Income Tax Regs., 52 Fed. Reg. 6447 (Mar. 3,

1987).

In the case of a commission DISC, CTI is computed using

the gross receipts on the sale, lease, or rental of the property

on which the commissions arose.

2.

Sec. 993(f).

Regulatory Requirement

CTI equals the excess of the DISC's gross receipts from

export sales over the total costs of the DISC and the parent that

relate to the DISC's gross receipts.

Sec. 1.994-1(c)(6), Income

Tax Regs.; see sec. 1.925(a)-1T(c)(6)(i), Temporary Income Tax

Regs., 52 Fed. Reg. 6446 (Mar. 3, 1987).

Section 1.994-1(c)(6),

Income Tax Regs., provides rules for determining which costs

relate to export sales:

In determining the gross receipts of the DISC and the

total costs of the DISC and related supplier which

relate to such gross receipts, the following rules

shall be applied:

- 19 (i) Subject to subdivisions (ii) through (v) of

this subparagraph, the taxpayer's method of accounting

used in computing taxable income will be accepted for

purposes of determining amounts and the taxable year

for which items of income and expense (including

depreciation) are taken into account. * * *

(ii) Costs of goods sold shall be determined in

accordance with the provisions of section 1.61-3

[Income Tax Regs.]. See sections 471 and 472 and the

regulations thereunder with respect to inventories.

* * *

(iii) Costs (other than cost of goods sold) which

shall be treated as relating to gross receipts from

sales of export property are (a) the expenses, losses,

and other deductions definitely related, and therefore

allocated and apportioned, thereto, and (b) a ratable

part of any other expenses, losses, or other deductions

which are not definitely related to a class of gross

income, determined in a manner consistent with the

rules set forth in section 1.861-8 [Income Tax Regs.].

See sec. 1.925(a)-1T(c)(6)(iii), Temporary Income Tax Regs., 52

Fed. Reg. 6446 (Mar. 3, 1987).

3.

Application of Regulations by the Parties

Petitioners contend that subdivision (i) of the regulation

requires the computation of CTI in accordance with the method

they use to account for domestic taxable income.

Section 1.451-

3(d)(5)(iii), Income Tax Regs., permits a variation from the

completed contract method for electing taxpayers to currently

deduct period costs even though the related income is not

reportable until a later taxable year when the contract is

completed.

Due to their election to currently deduct period

costs, petitioners argue that, in the year of contract

completion, they should not be required to reduce foreign gross

- 20 receipts by period costs that were deducted in computing prior

years' income taxes.

Because they cannot deduct prior year

period costs in the years in issue, petitioners contend that

those period costs need not be utilized in computing CTI.

Conversely, respondent argues that, in accord with the

congressional intent as reflected in the legislative history, the

regulations require a taxpayer to account for all costs that

relate to export sales, including period costs deducted in prior

years.

Respondent further argues that petitioners' accounting

method and any permissible variations therefrom do not control in

determining the statutory limitations for computing CTI.

We

agree with respondent.

C. Whether Section 1.994-1(c)(6), Income Tax Regs., Is a

Reasonable Interpretation of the Statute

The regulation in controversy was intended to define the

statutory phrase "combined taxable income".

defined in the Internal Revenue Code.

That phrase is not

The regulation promulgated

by the Secretary is couched in broad terms, leaving room for the

parties to advance differing interpretations.

In this regard,

petitioners have not questioned the validity of the regulation

under consideration.

The regulatory formula for CTI is the

"excess of the gross receipts * * * over the total costs * * *

which relate to such gross receipts."

Tax Regs.

Sec. 1.994-1(c)(6), Income

The regulation also provides that the taxpayer may in

certain circumstances use the same method of accounting in

- 21 computing CTI as used during the taxable year for which CTI is

being computed.

Sec. 1.994-1(c)(6)(i), Income Tax Regs.

The term "total costs" is ambiguous and does not delineate

whether the "total" is for the year, as petitioners contend, or

all costs relating to the gross receipts, including those

incurred and deducted in a prior year.

Accordingly, petitioners

and respondent are both placed in the position of advancing, for

purposes of this litigation, their respective interpretations of

the language of the regulation.

Normally, we defer to regulations which “implement the

congressional mandate in some reasonable manner.”

United States

v. Vogel Fertilizer Co., 455 U.S. 16, 24 (1982) (quoting United

States v. Correll, 389 U.S. 299, 307 (1967)); Rowan Cos., Inc. v.

United States, 452 U.S. 247, 252 (1981); National Muffler Dealers

Association, Inc. v. United States, 440 U.S. 472, 476 (1979).7

7

The deference given to a regulation depends on the source

of authority under which the Secretary promulgated it. Less

deference is given to a regulation promulgated under the general

authority of sec. 7805(a), an interpretative regulation, and

greater deference to a regulation promulgated under a specific

statutory grant of authority, a legislative regulation. United

States v. Vogel Fertilizer Co., 455 U.S. 16, 24 (1982).

Pursuant to sec. 994(b)(1), the Secretary issued sec. 1.9941(d), Income Tax Regs., which subjects commission DISC’s to the

pricing rules set forth in sec. 994(a). See sec. 1.925(a)-1T(d),

Temporary Income Tax Regs., 52 Fed. Reg. 6447 (Mar. 3, 1987).

Sec. 1.994-1(d)(2), Income Tax Regs., refers to par. (c) of that

regulation for the proper method to apply the pricing rules.

However, that reference may not automatically make par. (c) a

legislative regulation when applied to commission DISC’s.

Congress did not specifically grant the Secretary authority to

promulgate regulations with regard to buy-sell DISC’s.

(continued...)

- 22 Respondent's litigating position is not afforded any more

deference than that of petitioners.

By way of example, proposed

regulations and revenue rulings are generally not afforded any

more weight than that of a position advanced by the Commissioner

on brief.

Laglia v. Commissioner, 88 T.C. 894, 897 (1987);

Estate of Lang v. Commissioner, 64 T.C. 404, 407 (1975), affd. in

part and revd. in part 613 F.2d 770 (9th Cir. 1980).

That is

especially so here, where respondent did not publish her position

prior to this controversy.

Accordingly, we proceed to decide

which party's approach harmonizes with the statutory intent.

Section 994(a)(2) presents the somewhat ambiguous and

completely undefined term "combined taxable income."

The

regulation in question does not conflict with the language of the

statute it interprets.

In addition, the regulatory definition of

costs related to export sales is consistent with legislative

history, which states:

the combined taxable income * * * 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

7

(...continued)

Subdivision (iii) of sec. 1.994-1(c)(6), Income Tax Regs.,

applies equally to buy-sell DISC’s and commission DISC’s.

Accordingly, portions of the regulation in question may be

legislative or interpretative or a mix of legislative and

interpretative elements. The parties’ disagreement, however,

does not focus on the source of the Government's authority for

issuance of the regulation in question, and it is unnecessary to

decide whether the regulation in question is interpretative,

legislative, or a mixture of both.

- 23 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. [Fn. ref. omitted;

emphasis added.]

H. Rept. 92-533, at 74 (1971), 1972-1 C.B. 498, 538; S. Rept. 92437, at 107 (1971), 1972-1 C.B. 559, 619.

The regulation in

issue defines an ambiguous term and reflects congressional intent

as to the types of costs taxpayers must allocate to export sales

in calculating CTI.

Thus, the regulatory definition of CTI in

section 1.994-1(c)(6), Income Tax Regs., is a reasonable

interpretation of section 994.

D. Interpretation of the Regulatory Definition of "Combined

Taxable Income"

Regulations that are valid exercises of the powers of the

Secretary have the force and effect of law.

v. Commissioner, 98 T.C. 187, 198 (1992).

Sim-Air, USA, Ltd.

The rules for

interpreting a valid regulation are similar to those governing

the interpretation of statutes.

KCMC, Inc. v. FCC, 600 F.2d 546,

549 (5th Cir. 1979); Intel Corp. & Consol. Subs. v. Commissioner,

100 T.C. 616, 631 (1993), affd. 67 F.3d 1445 (9th Cir. 1995).

When construing a statute, or in this case a regulation, we are

to give effect to its plain and ordinary meaning unless to do so

would produce absurd results.

Green v. Bock Laundry Mach. Co.,

490 U.S. 504, 509 (1989); Exxon Corp. v. Commissioner, 102 T.C.

- 24 721 (1994).

The most basic tenet of statutory construction is to

begin with the language of the statute itself.

United States v.

Ron Pair Enters., Inc., 489 U.S. 235, 241 (1989).

When the plain

language of the statute is clear and unambiguous, that is where

the inquiry should end.

Id.

Where a statute is silent or

ambiguous, we look to legislative history to ascertain

congressional intent.

Peterson Marital Trust v. Commissioner,

102 T.C. 790, 799 (1994), affd. 78 F.3d 795 (2d Cir. 1996).

We

apply these rules to interpret the regulations promulgated under

section 994.

An integral part of calculating CTI is determining the costs

of the export sales.

Sec. 1.994-1(c)(6), Income Tax Regs.

The

regulations under section 994 require taxpayers to account for

the "total costs" related to export sales.

Sec. 1.994-1(c)(6),

Income Tax Regs.; see sec. 1.925(a)-1T(c)(6)(ii), Temporary

Income Tax Regs., 52 Fed. Reg. 6446 (Mar. 3, 1987).

Total costs

include costs that definitely relate to the export sales and a

ratable share of costs that do not definitely relate to any class

of gross income.

Sec. 1.994-1(c)(6)(iii), Income Tax Regs.; see

sec. 1.925(a)-1T(c)(6)(iii)(D), Temporary Income Tax Regs.,

supra.

Thus, taxpayers must allocate their costs between export

sales and domestic sales to compute CTI.

Sec. 1.994-

1(c)(6)(iii), Income Tax Regs.; see sec. 1.925(a)1T(c)(6)(iii)(D), Temporary Income Tax Regs., supra.

- 25 Rather than creating a new method of cost allocation within

the DISC provisions, Congress intended that taxpayers use the

method for allocating costs under section 1.861-8, Income Tax

Regs.

The intended method for allocating expenses in the CTI

computations appears consistent throughout the legislative

history of the DISC provisions, which states:

the 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. * * * [Emphasis added.]

H. Rept. 92-533, supra at 74, 1972-1 C.B. at 538; accord S. Rept.

92-437, supra at 107, 1972-1 C.B. at 619.

Consistent with

legislative history, the regulations provide that taxpayers must

allocate and apportion their costs (other than costs of goods

sold) "in a manner consistent with the rules set forth in §

1.861-8."

Sec. 1.994-1(c)(6)(iii), Income Tax Regs.; see sec.

1.925(a)-1T(c)(6)(iii)(D), Temporary Income Tax Regs., supra.

In general, section 1.861-8, Income Tax Regs., provides

geographic sourcing rules to allocate and apportion expenses

between the United States and foreign countries.

It also

provides rules for determining taxable income from specific

activities and for allocating income and deductions to those

activities under other sections of the Code referred to as

- 26 "operative sections".

Tax Regs.

Sec. 1.861-8(a)(1),(f)(1)(i)-(vi), Income

Operative sections define the categories of income

between which taxpayers must allocate their deductions and gross

income.

Section 994 is an operative section wherein income is

grouped into two categories; i.e., income from export sales,

referred to as the statutory grouping, and all remaining gross

income, referred to as the residual grouping.

St. Jude Medical,

Inc. v. Commissioner, 97 T.C. 457, 465 (1991), affd. in part and

revd. in part and remanded 34 F.3d 1394 (8th Cir. 1994); sec.

1.861-8(f)(1)(iii), Income Tax Regs.

Under section 1.861-8,

Income Tax Regs., taxpayers must allocate their deductions to a

class of gross income and, then, if necessary to make the

determination required by the operative section, apportion the

deductions within the class of gross income between the statutory

and residual groupings.

Sec. 1.861-8(a)(2), Income Tax Regs.

The apportionment must be accomplished in a manner that reflects

to a "reasonably close extent" the factual relationship between

the deduction and the income grouping.

Sec. 1.861-8(c)(1),

Income Tax Regs.

Similar to the related costs definition in section 1.9941(c)(6)(iii), Income Tax Regs., section 1.861-8, Income Tax

Regs., requires allocation of deductions to definitely related

classes of gross income.

Any deductions that do not definitely

relate to a class of gross income are ratably apportioned to all

- 27 gross income based on the ratio of gross income from each class

to the taxpayer's total gross income.

Sec. 1.861-8(a)(2),

(b)(1), and (c)(3), Income Tax Regs.

A cost is "definitely

related" to a class of gross income if it is incurred as a result

of, or incident to, an activity or in connection with property

from which that class of gross income is derived.

8(b)(2), Income Tax Regs.

Sec. 1.861-

In general, period costs benefit and

relate to the taxpayer's business as a whole and are not incident

to or necessary for the performance of a particular contract.

McMaster v. Commissioner, 69 T.C. 952, 955 (1978).

Thus, period

costs are costs that do not definitely relate to any class of

gross income, as defined by sections 1.994-1(c)(6)(iii) and

1.861-8, Income Tax Regs., and must be ratably apportioned to all

gross income.

Additionally, section 1.861-8, Income Tax Regs., does not

distinguish period costs from other costs that relate to export

sales.

Furthermore, section 1.861-8, Income Tax Regs., does not

excuse taxpayers from allocating costs to a class of gross income

unless the costs are definitely related to another class of gross

income.

Section 1.861-8(a)(2), Income Tax Regs., provides:

“Except for deductions, if any, which are not definitely related

to gross income * * * and which, therefore, are ratably

apportioned to all gross income, all deductions of the taxpayer

* * * must be so allocated and apportioned.”

Thus, consistent

with the section 994 regulations, section 1.861-8, Income Tax

- 28 Regs., requires taxpayers to prove that the prior year period

costs definitely relate to gross income from a source other than

export sales, which petitioners have failed to do, to avoid

having to account for those costs in determining CTI.

The regulations under section 994, which incorporate section

1.861-8, Income Tax Regs., are consistent with the statutory

intent and legislative history.

By requiring taxpayers to

account for all costs incurred to produce export property in

calculating CTI, the regulations limit the deferral or exclusion

of income to the actual income from foreign sales after

considering "total costs".

In addition, the regulations do not

permit the exclusion of any particular costs, such as prior year

period costs, from the computation of CTI, unless the costs

definitely relate to a class of gross income other than export

sales.

Sec. 1.994-1(c)(6), Income Tax Regs.; sec. 1.925(a)-

1T(c)(6)(iii), Temporary Income Tax Regs., supra.

Implicit in petitioners' position that they are following

the completed contract method is that the total costs are only

those claimed in the computation year.

Petitioners do not

provide us with a logical or reasonable definition of "total

costs" and/or "related costs" that would harmonize with the

statutory limitation intended by Congress.

Nor have petitioners

shown that the prior year period costs definitely relate to a

class of gross income other than export sales.

It has not been

argued that the prior year period costs are unrelated to

- 29 petitioners' export sales.

In addition, petitioners previously

allocated the prior year period costs to particular export sales

contracts as they accrued.

Thus, we find that the regulatory

definition of related costs includes prior year period costs that

have previously been deducted.

Petitioners must account for both

current and prior year period costs in determining their CTI.

E. The Effect of the Taxpayer's Method of Accounting on the

Computation of Combined Taxable Income

Petitioners also argue that they are properly applying their

method of accounting by not reducing CTI by prior year period

costs.

Rather than suggesting an alternative definition of total

costs that excludes prior year period costs, petitioners rely on

subdivision (i) of section 1.994-1(c)(6), Income Tax Regs.

That

subdivision permits taxpayers to use their normal method of

accounting in computing CTI.

Petitioners interpret that

regulation to require taxpayers to compute CTI in accordance with

their method of accounting.

Accordingly, petitioners contend

that whether costs related to export sales, as defined in section

1.994-1(c)(6)(iii), Income Tax Regs., are allocable to those

export sales for purposes of determining CTI depends on their

accounting method.

Section 1.994-1(c)(6)(i), Income Tax Regs., provides:

(i) Subject to subdivisions (ii) through (v) of

this subparagraph, the taxpayer's method of accounting

used in computing taxable income will be accepted for

purposes of determining amounts and the taxable year

- 30 for which items of income and expense (including

depreciation) are taken into account. * * *

See sec. 1.925(a)-1T(c)(6)(iii)(A), Temporary Income Tax Regs.,

supra.

Use of the taxpayer's accounting method is expressly

subject to subdivision (iii)'s definition of related costs that

taxpayers must take into account in calculating CTI.

Sec. 1.994-

1(c)(6)(i), Income Tax Regs.; see sec. 1.925(a)-1T(c)(6)(iii)(D),

Temporary Income Tax Regs., supra.

Thus, section 1.994-

1(c)(6)(iii), Income Tax Regs., defines the costs related and

allocable to petitioners' export sales; such costs are not

defined by petitioners' method of accounting.

In addition to their misplaced reliance on subdivision (i)

of section 1.994-1(c)(6), Income Tax Regs., petitioners also

assert that section 1.861-8, Income Tax Regs., supports their

position that they are not required to account for prior year

period costs.

As stated above, Congress intended taxpayers

exporting through DISC’s to allocate their income and costs to

export sales pursuant to the requirements of section 1.861-8,

Income Tax Regs.

Rather than address the substantive allocation

requirements of section 1.861-8, Income Tax Regs., as described

above, petitioners again concentrate their argument on their

accounting method.

Petitioners argue that section 1.861-8,

Income Tax Regs., requires that the principles of annual

accounting apply to income and cost allocations.

Petitioners

deducted the period costs in prior years in accordance with the

- 31 completed contract method.

Therefore, petitioners contend that

requiring them to account for the prior year period costs in the

year of contract completion to compute CTI is inconsistent with

the principles of annual accounting.

Under the principles of annual accounting, a transaction

must be accounted for under the taxpayer's method of accounting

on the basis of the facts in the year the transaction occurs.

Security Flour Mills Co. v. Commissioner, 321 U.S. 281 (1944);

Burnet v. Sanford & Brooks Co., 282 U.S. 359 (1931); Landreth v.

Commissioner, 859 F.2d 643 (9th Cir. 1988), affg. in part, revg.

in part, and remanding T.C. Memo. 1985-413.

Section 461(a)

requires that a deduction be taken in the taxable year that is

proper under the taxpayer's method of accounting.

The completed contract method requires income and deductions

from long-term contracts to be reported in the year in which the

contracts are completed.

Sec. 1.451-3(d)(1), Income Tax Regs.

However, section 1.451-3(d)(5)(iii), Income Tax Regs., provides a

variation or exception to the requirement that deductions be

deferred.

A current deduction is allowed, at the taxpayer's

election, for period costs.

Texas Instruments Inc. v.

Commissioner, T.C. Memo. 1992-306; sec. 1.451-3(d)(5)(iii),

Income Tax Regs.

Period costs include marketing and selling

expenses, distribution expenses, general and administrative

expenses attributable to the performance of services that benefit

the taxpayer's activities as a whole, casualty losses, certain

- 32 pension and profit-sharing contributions, and costs attributable

to strikes, rework labor, scrap, and spoilage.

Sec. 1.451-

3(d)(5)(iii), Income Tax Regs.

Petitioners' use of the completed contract method of

accounting to report income and deductions for their long-term

contracts has not been questioned.

This method of accounting

provides an alternative to the annual accrual method of

accounting for long-term contracts for which the ultimate profit

or loss is not ascertainable until the contract is completed.

See RECO Indus., Inc. v. Commissioner, 83 T.C. 912, 921 (1984).

The method allows a taxpayer to account for the entire result of

a long-term contract at one time.

Id.

The purpose of the

completed contract method is to match the costs of generating

income with the income produced.

In this case, however,

petitioners try to use the completed contract method to avoid the

matching of costs with income from export sales for purposes of

computing CTI as required by the regulations under sections 994

and 925.

As a result, petitioners did not subtract all the costs

related to their export sales as defined in section 1.9941(c)(6)(iii), Income Tax Regs., from the export income that the

expenditures generated.

The completed contract method of accounting does not

necessarily conflict with requiring taxpayers to account for all

related period costs in determining CTI.

The completed contract

method is an accounting method that allocates to a particular

- 33 taxable year the items of income and expenses that must be

reported within that year.

It is relevant only to the timing of

deductions and income recognition.

Commissioner, supra at 922.

RECO Indus., Inc. v.

Like other accounting methods, the

completed contract method relies on other sections of the Code,

such as the DISC provisions, to determine the amount of income to

be recognized and the amount of allowable deductions.

The

purpose of the pricing rules in the DISC provisions is to

determine the amount of income that taxpayers engaged in export

activities must recognize and the amount of income that is tax

deferred.

The completed contract method has a different purpose.

It determines the taxable year in which a related supplier

recognizes the income attributable to export sales, the amount of

income to be recognized having been determined by the DISC

provisions.

Thus, the variations or exceptions to the completed

contract method here do not govern which costs are allocable to

long-term export contracts for purposes of determining CTI.

In addition, requiring taxpayers to account for prior year

period costs in calculating CTI does not interfere with the

current deduction allowed for period costs under the completed

contract method.

Petitioners' interpretation of the completed

contract method gives taxpayers benefits in addition to their

ability to currently deduct period costs.

There is no indication

that Congress intended the limitation on deferral or exclusion to

promote foreign exports to include a double or extra benefit only

- 34 for those taxpayers on the completed contract method who elected

to deduct period costs on an annual basis.

Accepting petitioners' argument would mean that taxpayers

using the completed contract method of accounting would calculate

their CTI in accordance with section 1.451-3, Income Tax Regs.,

as opposed to the regulations under sections 994 and 925.

Under

section 1.861-8, Income Tax Regs., the costs to be allocated are

defined by the operative section which references that

regulation.

Thus, we look to sections 994 and 925 and the

related regulations to determine which costs are allocable to

export sales for purposes of determining CTI, not the regulations

under section 451 as petitioners contend.

Although period costs

are not required to be allocated to long-term contracts for costdeferral purposes under section 1.451-3(d)(5)(iii), Income Tax

Regs., sections 994(a) and 925(a) and the related regulations

require that all costs, including prior year period costs, be

accounted for in determining CTI.

Requiring petitioners to account for all period costs in

determining CTI is consistent with the completed contract method

of accounting.

Allowing taxpayers to use their normal method of

accounting to compute CTI does not necessarily cede to the

accounting methodology the computation of the limitation of the

benefit to be generated by foreign exports.

Petitioners must

account for all related costs, including period costs, of both

- 35 current and prior years in determining their CTI from export sales.

II.

Regulatory Definition of "Export Property"

Petitioners manufactured two specialized vessels that were

designed and built for transoceanic transport of liquefied

natural gas.

The tankers were manufactured under contract for

sale to a company for direct use outside the United States.

After the completion, but before the tankers could be used for

foreign purposes, unforeseen delays caused some domestic use of

one of the tankers.

The delay also caused both tankers not to be

used in foreign commerce prior to 1 year after their sale.

In order for petitioners' DISC to retain its statutory

status, 95 percent of its gross receipts must consist of

qualified export receipts.

Sec. 993(e).

Qualified export

receipts include gross receipts from the sale, exchange, or other

disposition of export property.

"Export property" is statutorily

defined, in pertinent part, as "property * * * manufactured * * *

in the United States by a person other than a DISC, * * * held

primarily for sale, * * * in the ordinary course of trade or

business * * * for direct use, consumption, or disposition

outside the United States”.

Sec. 993(c)(1).

The regulations in connection with the definition of "export

property" provide for a "destination test".

Property satisfies

the destination test "only if it is * * * directly used * * *

outside the United States * * * by the purchaser * * * within 1

- 36 year after such sale".

Regs.

Sec. 1.993-3(d)(2)(i)(b), Income Tax

Petitioners contend that the destination test of the

regulation is not a proper interpretation of the statutory

provision and hence is invalid.

We have already addressed the destination test and found

valid section 1.993-3(d)(2)(i)(b), Income Tax Regs., in Sim-Air,

USA, Ltd. v. Commissioner, 98 T.C. 187, 190-197 (1992).

There is

nothing in petitioners' argument here that would warrant a change

in our reasoning or conclusion concerning the validity of that

aspect of the DISC regulations.

Petitioners also raise factual

distinctions between this case and Sim-Air.

Factual differences

between cases, however, do not address the question of whether a

particular regulation is a proper interpretation of a statutory

provision.

Petitioners also argue that they should be relieved of the

1-year destination requirement because of the unforeseen factual

circumstances that caused them not to meet the regulation's

requirement.

The taxpayer in Sim-Air made a similar argument

that was rejected.

Id. at 197-198.

Once a regulation is found

valid, it has the force and effect of law.

That law (both the

statute and the regulation in question here) does not provide any

exception for reasonable delay or unforeseen events.

Nor is

there room to interpret the statute or regulation to permit

petitioners' factual circumstances different treatment by means

- 37 of a waiver or exemption from the requirement under

consideration.

Petitioners also question the validity of other subparts of

the export property regulation, but we find it unnecessary to

consider that and other positions of the parties because

petitioners' failure to satisfy the 1-year test is dispositive of

this issue.

To reflect the foregoing,

An appropriate order will be

issued reflecting the resolution of

the foreign issues in controversy.