T . C . Memo . 1993-616
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T . C . Memo . 1993-616
UNITED STATES TAX COURT
EXXON CORPORATION AND AFFILIATED COMPANIES, ET AL.,
Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 18618-89, 24855-89,
18432-90.
Held:
Filed December 22, 1993.
A Saudi crude oil resale pricing
restriction in effect during a period in which Saudi
crude was priced below other comparable crudes
prohibited the sale of Saudi crude oil for an amount in
excess of the Saudi official selling price, and
petitioners complied with the restriction;
consequently, respondent is precluded from allocating
profits purportedly attributable to such excess from
petitioners' refining subsidiaries to petitioners'
offtakers pursuant to either sec. 61, I.R.C., or sec.
482, I.R.C. Commissioner v. First Security Bank, 405
U.S. 394 (1972); Procter & Gamble Co. v. Commissioner,
95 T.C. 323 (1990), affd. 961 F.2d 1255 (6th Cir.
1992), followed.
1 On Jan. 7, 1991, Exxon Corp. and Affiliated Companies
(docket No. 18432-90), and Texaco, Inc., and Subsidiaries (docket
No. 24855-89) were consolidated herewith for purposes of trial,
briefing, and opinion of the Aramco Advantage issue, which is
defined infra p. 3.
BERVED DE0221bb3
Robert L. Moore, II, Jay L. Carlson, John B. Magee, Gerald
Goldman, Thomas D. Johnston, Joseph O. Luby, Bradford J. Anwyll,
and Craig D. Miller, for petitioners in docket Nos. 18618-89 and
18432-90.
Buford P. Berry, Emily Ann Parker, Dennis J. Grindinger,
George V. Larsen, Joseph M. Incorvaia, David R. Wheat, and
Bradley D. Spevak, for petitioners in docket No. 24855-89.
Raymond L. Collins, Ana G. Cummings, Bernard B. Nelson,
Avery B. Cousins, III, John F. Eiman, Allan E. Lang, Alan
Summers, William B. Lowrance, David A. Alavarez, James H. W.
Insley, Roger Osburn, Emron M. Pratt, David J. Mungo, David P.
Monson, Carol Bingham McClure, David E. Whitcomb, Mark Barnes,
and Joyce E. Britt, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
WHITAKER, Judae:
Respondent, in a statutory notice of
deficiency dated June 29, 1989, determined a deficiency in the
1979 Federal income taxes of Exxon Corp. and Affiliated Companies
(docket No. 18618-89) in the amount of $268,721,294.
In another
notice of deficiency dated July 16, 1990, issued to Exxon Corp.
and Affiliated Companies (docket No. 18432-90) for the years
1980, 1981 and 1982, respondent determined deficiencies in
Federal income taxes in the following amounts:
- 3 Year
Deficiency
1980
1981
1982
$2,898,174,073
2,037,809,876
1,599,495,218
In a notice of deficiency dated July 21, 1989, issued to Texaco,
Inc., and Subsidiaries (docket No. 24855-89) for the years 1979,
1980, 1981, and 1982, respondent determined deficiencies in
Federal income taxes in the following amounts:
Year
Deficiency
1979
1980
1981
1982
$230,193,303
925,040,885
420,056,007
579,861
Only the deficiencies for 1979 through 1981 are at issue herein.
This Court's Order, dated January 7, 1991, indicated that
the issues presently before the Court involved the purchase by
petitioners' offtakers' of crude oil from Saudi Arabia at a
below-market purchase price, commonly referred to as the "Aramco
Advantage".
Specifically, we ordered that the issues involved
herein were limited to the following questions:
(1) Whether the transfer price of Saudi Arabian
crude oil paid by petitioners' offtakers was below the
prices charged for non-Saudi crude oil of similar grade
or quality;
(2)
if the answer to question (1) is in the
affirmative, whether the transfer price charged by the
offtakers to the other subsidiaries of each petitioner
or to unrelated third parties was below the price
* As defined in our evidentiary opinion, Exxon Corp. v.
Commissioner, T.C. Memo. 1992-92, an offtaker is the person or
company that physically loads oil obtained under a concession,
contract, or other arrangement.
charged for non-Saudi crude oil of similar grade or
quality;
(3)
if the answers to questions (1) and (2) are
in the affirmative, whether the reduced price was
caused by the restriction(s) imposed by Saudi Arabia
which petitioners, their offtakers, and other
subsidiaries were required to observe in order to have
continued access to Saudi Arabian oil;
(4) whether the consuming country governments
monitored the offtakers' sales of Saudi crude oil into
their countries to assure that such sales were not in
excess of the prices established by Saudi Arabia,
increased only by costs incurred in transporting the
crude oil;
(5) whether the Saudi Arabian pricing
restriction(s) required petitioners and their offtakers
to reflect the pricing restriction(s) in the transfer
price of sales of Saudi crude oil from petitioners'
offtakers to unrelated entities which purchased the
Saudi crude oil for refining;
(6) whether in fact the crude oil pricing
restriction(s) imposed by Saudi Arabia was/were
observed by petitioners and their offtakers;
(7) if a crude oil pricing restriction(s) existed
and petitioners and their offtakers observed the
restriction(s), whether or not the pricing
restriction(s) precludes or preclude a section 482M or
section 61 adjustment to petitioners' income.
.
The parties have stipulated that the answer to the first question
is in the affirmative.
The ultimate question to be addressed in
question (7) arises under the rule of law presented in
Commissioner v. First Security Bank, 405 U.S. 394 (1972), and its
progeny.
Essentially the issues are:
(1) Whether the Saudi
Unless otherwise noted, all section references are to the
Internal Revenue Code in effect for the years in issue, and all
Rule references are to the Tax Court Rules of Practice and
Procedure.
- 6 Texaco, Inc. (Texaco), had its principal place of business in
Texas when the petition in its case was filed.
Texaco is the
common parent corporation of an affiliated group of corporations
that includes all of the petitioners in docket No. 24855-89
(which collectively will be referred to as the Texaco
petitioners).
The Texaco petitioners at all relevant times were
engaged in the production, refining, transportation, and
marketing of crude oil and refined products in the United States
and foreign countries.
Formation of Aramco and the Offtakers
After centuries of upheaval, in September 1932, King Abd alAziz ibn Abd al-Rahman Al Saud (King Abd al-Aziz) proclaimed the
formation of a new state, the Kingdom of Saudi Arabia.
From its
very inception, the law of Islam was the paramount law of the
Saudi State, and the role of the King was paramount in temporal
matters, although he too was subject to the higher authority of
Islamic law.
In May 1933, the SAG signed a concession agreement
(the Concession Agreement) with Standard Oil of California
(Socal, now Chevron Corp. (Chevron)).
Subsequently, the
concession was assigned to the California-Arabian Standard Oil
Co. (CASOC), which in 1944 changed its name to Aramco.
Under the
terms of the Concession Agreement (as subsequently modified),
Socal was permitted to extract petroleum from Saudi Arabia,
subject to the payment of taxes and royalties to.the SAG.
By the end of November 1948, and continuing through the
years at issue, all of the capital stock of Aramco was held
directly or indirectly by four U.S. corporations:
Exxon, Texaco,
Chevron, and Mobil Oil Corp. (Mobil) or their predecessor
corporations.
Through January 1979 the Mediterranean Standard
Oil Co., Inc. (MEDSTAN), a wholly owned subsidiary of Exxon
incorporated in the United States, acquired crude oil from Saudi
Arabia via Aramco.'
Thereafter, the Exxon International Trading
Co., Inc. (EITCO), another wholly owned subsidiary of Exxon
incorporated in the United States, performed this function.
In
January 1981 Exxon International Saudi Arabia, Inc. (EISAI),
another wholly owned subsidiary of Exxon incorporated in the
United States, began to purchase Saudi crude oil from the Saudi
Arabian national oil company.
These purchases occurred pursuant
to an oil incentive contract executed in December 1980 under
which Exxon became entitled to buy additional Saudi crude oil as
a result of its investment in a chemical facility in Saudi
Arabia.
MEDSTAN, EITCO, and EISAI are referred to hereafter as
the Exxon offtakers.
Saudi crude oil was Exxon's largest crude oil source
throughout the period 1977 through 1981.
It constituted
* Petitioners contend that they purchased the Saudi Arabian
crude oil from Aramco. Respondent contends that Aramco served as
a conduit for the Saudi Arabian crude oil and that petitioners
purchased the crude oil from the Saudi Arabian Government with
Aramco acting as an agent. For purposes of this opinion, use of
the phrase "via Aramco" is intended to be neutral as to this
issue, which we need not decide at the present time.
_ 8 approximately 50 percent of Exxon's international crude supply.'
During the period 1979 through 1981 (the period at issue'), the
Exxon offtakers acquired 2,273 million barrels of Saudi crude
oil, of which 2,207 million barrels (or over 97 percent) were
acquired via Aramco by MEDSTAN in January 1979 and by EITCO from
February 1979 through December 1981.
The dispositions of Saudi
crude by the Exxon offtakers during the years 1979 through 1981
are summarized as follows:
Exxon Offtakers
Dispositions
Barrels
Percentage of
Total Dispositions
Sales to Exxon refining/
marketing affiliates
1,816,000,000
79.9%
Sales to
unrelated parties
261,000,000
11.5
"War Relief" sales to
unrelated parties
61,000,000
2.7
Crude oil exchanges with
unrelated parties
132,000,000
5.8
3,000,000
.1
Crude oil losses and
inventory changes
s Internationally traded crude oil is crude oil that is
exported from the country where it was produced. The 50 percent
Exxon figure referred to in the text would be somewhat lower if
Exxon's indigenous production were included in the calculation.
As discussed infra, the period during which the official
selling price of Saudi crude was lower than that of other
comparable crudes began in January 1979 and ended on Oct. 29,
1981. However, the notices of deficiency deal with the tax years
1979 through 1982, and much of the evidence deals with a time
frame that includes all of 1981. For purposes of our holding
here, we do not consider this discrepancy to be critical, and we
treat the period at issue in this opinion as including all of
1979, 1980, and 1981.
-
- 9 -
Total Saudi crude
oil dispositions
(1979-81)
2,273,000,000
100.0%
Exxon had refining affiliates located in Denmark, the
Federal Republic of Germany, Australia, Belgium, Italy, Ivory
Coast, Kenya, Malaysia, the Netherlands, Greece, the United
Kingdom, Japan, Singapore, Argentina, France, Ireland, Thailand,
Canada, Norway, and the United States, which purchased Saudi
crude from at least one of the Exxon offtakers during the years
1979-81.
In pricing crude oil to its affiliates, the Exxon
offtakers from the mid-1970s used interaffiliate billing prices
(IABP's) that were based upon the official selling prices (OSP's)
of the producing governments, regardless of the source or actual
cost of the crude.
The philosophy behind this IABP practice was
that uniformity was necessary for two reasons:
(1) It would be
readily defensible to the consuming countries in their monitoring
of Exxon affiliate crude import prices; and (2) it would be
defensible to the Exxon offtakers' affiliates, since the
financial performance of the refining affiliates depended to a
significant degree upon the cost of the crude they refined and
marketed.
The Exxon offtakers continued this IABP practice
throughout the years at issue, and, with one exception to be
discussed later, all invoices in connection with the Exxon
offtakers' transfers of Saudi crude to Exxon affiliates indicated
that Saudi crude was sold at Saudi OSP.
In their sales to
- 10 unrelated parties, the Exxon offtakers also consistently invoiced
Saudi crude at Saudi OSP during the years 1979-81.
At least some
of the Exxon offtakers' crude oil sales contracts with unrelated
purchasers had "price reopener clauses", whereby the Exxon
offtaker would have been able under the terms of those contracts
to renegotiate the price of the crude sold.
Prior to October 1, 1978, Saudi crude oil received by Texaco
via Aramco was acquired and disposed of by two wholly owned
Delaware subsidiaries, Texaco Operations (Europe) Ltd. (TOE) and
Texaco Export, Inc. (Texport).
Texport obtained crude oil via
Aramco and sold crude oil directly to either (1) certain Texaco
affiliates or (2) TOE generally for resale to Texaco's European
affiliates.
Additionally, Texport and TOE each processed certain
volumes of Saudi crude oil for their accounts during the 1973-78
period.
Texport was merged into TOE on October 1, 1978, and its
corporate name was changed to Texaco International Trader, Inc.
(Textrad).
During the years at issue, Textrad was a wholly owned
Delaware subsidiary of Texaco.
Textrad (and its predecessors in
interest) operated as the international crude trading company for
Texaco.
Most of the crude oil traded internationally by Texaco
during the period 1979-81 was traded by Textrad.
Caltex
Petroleum Corp. (CPC) is a corporation owned 50 percent by
Texaco, Inc., and 50 percent by Chevron.
CPC and its controlled
foreign corporations will hereafter be referred to as Caltex.
Saudi crude constituted approximately 78 percent of Texaco's
- 11 -
international crude supply.'
During the period January 1, 1979,
through June 30, 1981, Textrad purchased a total of 1,872,198,217
barrels of Saudi crude via Aramco.
The dispositions* of Saudi
crude during the years 1979 through 1981 by Textrad are
summarized as follows:
Textrad
Dispositions
Barrels
Percentage of
Total Dispositions
Sales to Texaco Refining/
Marketing Affiliates
780,000,000
34.2%
Sales to
Unrelated Parties
367,000,000
16.1
"War Relief" Sales to
Unrelated Parties
77,000,000
3.4
Sales to Caltex
494,000,000
21.7
Crude Oil Exchanges with
Unrelated Parties
345,000,000
15.2
Processing Agreements
213,000,000
9.4
Total Saudi Crude Oil
Dispositions (1979-81)
2,276,000,000
100.0%
Transfers to Affiliated
Entities Pursuant to
During the period at issue, in addition to several
refineries in the United States, Texaco owned refining
subsidiaries in the United Kingdom, Belgium, the Federal Republic
See suora note 5.
* These amounts represent dispositions of Saudi crude
acquired by Textrad from all sources, including sources other
than Aramco.
- 12 of Germany, the Netherlands, six Latin American countries, and
four Canadian provinces.
Texaco also had equity interests in
refineries located in the Federal Republic of Germany, Ireland,
Italy, Sweden, Switzerland, and five Latin American countries,
and Caltex had equity interests in refineries located in
Australia, Bahrain, Japan, Kenya, South Korea, Lebanon, New
Zealand, Pakistan, the Philippines, Singapore, and South Africa.
Organization and Operation of the Saudi Arabian Government
After the death of King Abd al-Aziz in November 1953, his
son Saud became King and another son, Faisal, became Crown
Prince.
In 1962, King Saud established the state-owned General
Organization for Petroleum and Minerals (Petromin) to take over
petroleum distribution operations within Saudi Arabia from
Aramco.
In November 1964, Crown Prince Faisal became King.
Prince Khalid, another son of King Abd al-Aziz, became Crown
Prince.
Since the reign of King Faisal, the King's formal
titles, in addition to that of King, have included President of
the Council of Ministers (or Prime Minister) and Commander in
Chief of the Saudi Arabian armed forces.
In March 1975 King
Faisal was assassinated, and Crown Prince Khalid became King.
Prince Fahd and Prince Abd Allah, both sons of King Abd al-Aziz,
were named Crown Prince and second deputy prime minister,
respectively.
After King Khalid's death in June 1982, Crown
Prince Fahd became King and Prince Abd Allah became Crown Prince.
- 13 -
The King, members of the Council of Ministers, and all
citizens of Saudi Arabia are subject to Islamic law.
Islamic law
is based upon the Koran, which is the Holy Book of all Moslems,
and the Sunna, which is the recorded account of the Prophet
Muhammad's views of life and society.
The King is the most
prominent figure in the legal hierarchy of, and possesses the
ultimate legal authority in, Saudi Arabia.
He has the ultimate
duty of ensuring that Islamic law is observed.
The senior
princes were the main drivers of policy in the years leading up
to and during the years at issue.
Crown Prince Fahd had been
mandated by King Khalid with executive authority for affairs of
state prior to the years at issue.
During the period at issue,
Crown Prince Fahd was perceived to be ultimately responsible for
matters pertaining to national policy and was a key policymaker
on Saudi oil matters.
In 1953, the King established a Saudi Council of Ministers
composed of the King, the Crown Prince, a Second Vice President,
the heads of the various ministries, and several ministers of
state.
The Council of Ministers later was constituted under the
Council of Ministers' Regulations and was invested with
regulatory, executive, and administrative authority.
Notwithstanding a certain amount of government organization, the
ultimate authority of the Saudi State still rested with the King.
All powers enjoyed by government officers stemmed from a
delegation, either formally or informally, of those powers from
the King.
The Ministry of Petroleum and Mineral Resources
(Petroleum Ministry) was established in 1960 and was the
executive agency that converted the oil policies established by
the King and Crown Prince into specific actions and ensured
implementation of those policies.
The Petroleum Ministry was the
sole Saudi Government agency responsible for supervising the oilrelated affairs of Aramco and its four shareholders and often
communicated its official government positions and directives to
them by letter.
Ministerial directives came into effect upon
issuance by the Petroleum Ministry pursuant to the authority
granted by the King as Sovereign or President of the Council of
Ministers and were considered to be binding unless overridden by
a Royal decree, order, or a resolution by the Council of
Ministers.
In March 1962, King Saud had appointed Sheikh Ahmed Zaki
Yamani (Minister Yamani) to be the Minister of the Petroleum
Ministry.
Minister Yamani served as Petroleum Minister until
October 1986.
Although Crown Prince Fahd occasionally
participated in press interviews or dealt with foreign
dignitaries on Saudi oil policy matters, throughout Minister
Yamani's tenure as Petroleum Minister, he was most commonly seen
as the spokesperson for the SAG with respect to oil-related
issues.
Only rarely did the King or Crown Prince make a personal
statement on oil policy.
Minister Yamani was the SAG official
responsible for consulting with the King or Crown Prince on oil-
- 15 related matters, and there was a widely held understanding that
such consultations occurred and that Minister Yamani regularly
received instructions on Petroleum Ministry matters.
He was
perceived to be--and held himself out as--the authoritative
spokesperson for Saudi Arabia on oil policy matters.
At
important meetings such as the Conference on International
Economic Cooperation held in 1976-77, Minister Yamani was the
Saudi representative.
He participated in negotiations with
petitioners' representatives over the years as the Saudi
representative and was perceived by them as having the full
authority to engage in these negotiations.
He also participated
in discussions with representatives of other countries on behalf
of the SAG.
Many government and industry officials believed that
Minister Yamani spoke for the SAG on policy matters and would not
implement a policy unless it was approved by the SAG leadership.
The Saudi legal system had a judicial body called the Board of
Grievances during the period at issue, which had jurisdiction
over disputes between private parties and the SAG.
It is unclear
whether from a legal standpoint Minister Yamani's ministerial
actions were capable of review by this Board.
However, from a
practical standpoint, in the absence of a clear violation of an
existing contract or law, an adjudication of his actions in such
a forum or otherwise probably would have been futile.
Formation of OPEC
Prior to 1960, multinational oil companies essentially
controlled the production and pricing of crude oil from Middle
Eastern and other oil exporting countries.
In 1959 and again in
1960 the major international oil companies unilaterally reduced
the posted prices for crude oils, which were the prices on which
the oil companies' royalty and tax obligations to foreign
governments were based.
In reaction to the oil companies' 1959
and 1960 posted price reductions, Saudi Arabia, Iran, Iraq,
Kuwait, and Venezuela met in Iraq from September 10-14, 1960, and
formed the Organization of Petroleum Exporting Countries (OPEC).
The SAG had the largest supply of crude of all the OPEC countries
and was a prominent player in OPEC.
Eight other oil exporting
countries subsequently joined OPEC:
Qatar in 1961, Indonesia and
Libya in 1962, Abu Dhabi in 1967, Algeria in 1969, Nigeria in
1971, Ecuador in 1973, and Gabon in 1973 as an associate member
and in 1975 as a full member.
When Abu Dhabi joined other
countries in forming the United Arab Emirates in 1971, the United
Arab Emirates replaced Abu Dhabi as a member of OPEC.
By 1977,
OPEC consisted of 13 countries, which as a group produced between
50 and 55 percent of the world's crude oil, held approximately 68
percent of the world's crude oil reserves, and exported more than
80 percent of all crude oil exports.
Saudi Arabia alone,had
approximately 24 percent of the world's proven oil reserves, and
from 1975 to 1981 it produced about 17 percent of the world's
crude oil and was the world's largest exporter of crude oil.
The Takeover of Pricing Decisions and Oil-Producing
Operations by Producing Countries
In June 1968, OPEC adopted a "Declaratory Statement of
Petroleum Policy in Member Countries", and as sovereign powers
they invoked the doctrine of "changing circumstances", which
asserted a country's legal right to alter concession agreements
to include a government ownership share if there were substantial
changes in the circumstances that prevailed when the concession
agreements were entered into.
During the 1970s the OPEC member
countries and other Middle East and North African countries began
to modify concessionary terms to capture for themselves a greater
share of oil-producing profits and to secure a greater role in
the ownership and management of the oil companies' producing
operations.
From 1967 to 1971, Algeria nationalized the
operations of all non-French foreign oil companies and assumed a
51-percent interest in the operations of the French oil
companies.
With regard to the pricing of crude oil, in December 1970,
the OPEC countries met in Caracas, Venezuela, and resolved that
negotiations would begin with the international oil companies
regarding crude oil prices and other matters.
Representatives of
OPEC's Persian Gulf member countries and the international oil
companies met in Tehran, Iran, in February 1971 and executed an
agreement with respect to posted prices that was designed to
- 18 -
govern prices for a 5-year period.
The international oil
companies subsequently reached agreements with Libya, Iraq, and
Nigeria regarding posted prices.
Negotiations 6 weeks later led
to another agreement between the Libyan Government and 15 oil
companies, which also was intended to last 5 years.
Comparable
agreements with Iraq and Nigeria followed in the ensuing weeks.
On September 22, 1971, OPEC called for increasing the
effective "participation" of the producing countries in the
producing operations of the oil companies located within their
respective countries.
Shortly thereafter, participation talks
commenced between the oil-producing countries and the oil
companies.
route.
Certain OPEC countries took a less conciliatory
In early June 1972, Irag nationalized the oil companies'
(including Exxon's) interests in the Iraq Petroleum Co.
In July
1973, the Iranian Government, through the state-owned National
Iranian Oil Co., formally took over all operating responsibility
within the concession areas covered by a 1954 agreement between
Iran and a consortium of international oil companies, including
Exxon and Texaco.
In the fall of 1973, Libya demanded a 51-
percent participation interest in the Libyan operations of a
number of the major oil companies operating in Libya.
Libyan
subsidiaries of Exxon and Mobil acceded to the Libyan
Government's demands in 1974.
Shell, Socal, Texaco, and Atlantic
Richfield refused to accept Libya's demand for a 51-percent
participation interest and had their operations completely
- 19 nationalized.
In late 1973, Irag nationalized the Exxon, Mobil,
and Partex interests and the Dutch portion of the Royal
Dutch/Shell interest in the Basrah Petroleum Co.
By the end of
1975, Iraq had nationalized the remaining companies' interests in
the Basrah Petroleum Co.
In 1974, Kuwait acquired a 60 percent
participation interest in the Kuwait Oil Co., a partnership of
British Petroleum and Gulf Oil.
By 1976, Kuwait had increased
its participation interest to 100 percent.
In 1973, Qatar
acquired a 25-percent participation interest in the operations of
the country's two producing companies, in one of which Exxon had
an interest.
In 1974, Qatar increased its participation interest
in the two companies' operations to 60 percent.
By 1977, Qatar
had increased its participation interest in the two companies to
100 percent.
In August 1975, Venezuela passed a law
nationalizing the operations of foreign-owned oil companies
(including a subsidiary of Exxon).
Through increased
participation (both actual and anticipated), nationalization, or
expropriation, producer country ownership of OPEC oil increased
from about 2 percent of production in 1970 to almost 60 percent
of production by the end of 1974, and to approximately 80 percent
by the end of 1980.
In 1973, the national oil companies of OPEC
member countries directly had sold about 5 percent of their
countries' exports.
By the end of 1980, this figure had
increased to between 50 and 55 percent of the OPEC countries' oil
exports.
- 20 The Saudi relationship with Aramco developed on a parallel,
but somewhat more moderate course, whereby the Saudis pursued a
policy of "participation" rather than outright nationalization.
In a speech at the American University in Lebanon in 1968,
Minister Yamani discussed the Saudi goal of accomplishing change
in a stable context.
He indicated that, although Aramco
originally resisted the notion of Saudi participation, Minister
Yamani had ways to pressure Aramco into going along with Saudi
participation.
The original Concession Agreement between the SAG
and Aramco continued until the early 1970s when the other
producing countries began nationalizing their oil interests.
Early in 1972, participation negotiations between the Aramco
companies and Minister Yamani on behalf of the SAG commenced.
It
subsequently was publicized that, in the course of these 1972
negotiations, the King had instructed Minister Yamani to warn the
Aramco company negotiators that implementation of participation
was "imperative" and that the Aramco companies should not require
the SAG to "take measures" to put participation into effect.
Although there was significant resistance to participation by the
companies, by early October 1972 a draft agreement, called the
"General Agreement on Participation" (General Agreement), was
reached and later signed by the SAG and two other Gulf States,
whereby the SAG purchased a 25-percent initial government
participation interest in Aramco's production operations, which
was gradually to increase to 51 percent in 1982.
The Aramco
- 21 companies were to be compensated for unrecovered investments on
the basis of book value adjusted for.inflation.
The implementing
agreements called for in the General Agreement were never
executed.
The gradual phasing in of the Saudi share was intended
to give Petromin time to gain experience in marketing, and
Petromin gradually engaged in more and more direct marketing
activities after the General Agreement was signed.
During the
1970s and 1980s, Petromin's role in the intern'ational marketing
of crude oil continued to increase.
It was the intention of the Aramco companies to hold onto as
much equity ownership as possible, but after the rapidly changing
events in the Middle East in the early 1970s, including the Arab
oil embargo and dramatic crude price increases, as well as
nationalizations by the more radical OPEC members, the Aramco
companies were notified in 1974 that the SAG participation was to
be speeded up.
years.
Extensive negotiations occurred over the next few
Dr. James Schlesinger (Dr. Schlesinger), who was the U.S.
Energy Secretary until August 1979, perceived the SAG takeover of
Aramco to be a "lopsided" negotiation whereby the companies did
not wish to be taken over but they had no choice because the~y
were "negotiating" with a sovereign power.
In late 1976 or early
1977, the SAG and the Aramco companies agreed upon the so-called
New Arrangements.
Under the New Arrangements, the SAG assumed
100 percent ownership of Aramco, and the (now former)
shareholders provided services to the SAG's oil business in
- 22 -
exchange for stated fees.
Many of the financial aspects of the
New Arrangements were implemented in a draft crude oil sales
agreement (COSA), but the New Arrangements and the draft COSA
were never signed.
The Arab Oil Embargo and the First Oil Crisis
The following series of events constituted what has come to
be called the "first oil crisis".
On October 7, 1973, the Arab-
Israeli war broke out in the Middle East.
On October 8, 1973,
representatives of the oil companies and the oil ministers of
OPEC's Persian Gulf member countries met in Vienna, Austria, to
discuss revising established prices, which already had been
revised upwards twice by the Geneva Agreements of January 1972
and June 1973 to reflect changes in currency exchange rates and
inflation.
On October 9, 1973, oil industry representatives
proposed a 15-percent increase in posted prices and offered to
negotiate an inflation index provision.
No agreement was
reached, and discussions were broken off shortly thereafter.
On October 16, 1973, OPEC unilaterally announced an
immediate 70-percent increase in posted prices.
This raised the
posted price from $3.01 per barrel to $5.12 per barrel for Saudi
Arabian Light marker crude.'
On October 17, 1973, the
Organization of Arab Petroleum Exporting Countries (which had
* When OPEC met to discuss pricing, since Saudi Arabian
Light was the crude with the largest volume moving in the
international market, that crude was used as the "marker" or
"benchmark" crude, or the crude to which others were compared for
the purpose of determining price.
- 23 been created in January 1968 and whose members included the Arab
member states of OPEC) agreed to impose monthly decreases in
crude oil production of 5 percent.
In the following 2 weeks, the
individual Arab states, including Saudi Arabia, implemented this
agreement by reducing production between 5 and 10 percent.
OPEC
members also announced an embargo on exports to the United States
and the Netherlands.
At a meeting in December 1973, the OPEC
member countries agreed to increase prices again, resulting in a
fourfold increase in crude oil prices since the beginning of
October 1973.
The OPEC price increases during the last quarter
of 1973 substantially increased the oil import costs of the
consuming countries.
By early 1974, the OPEC countries had taken control over
crude oil pricing and production decisions from the multinational
oil companies operating in their countries, and OPEC had
established a unified pricing system for its members' crude oil.
The posted price for Saudi Arabian Light marker crude was
increased to $11.65 per barrel in January 1974, and then later
decreased to $11.25 per barrel in November 1974.
At the
September 1975 OPEC meeting in Vienna, Austria, the OPEC members
again agreed to increase prices by 10 percent, effective
October 1, 1975.
- 24 -
Two-Tier Pricing and the 1977 Saudi Restriction
When an OPEC meeting opened in December 1976 in Doha, Qatar
(Doha meeting), Saudi Arabian Light marker crude was at $11.51.
At the meeting, 11 members of OPEC voted to raise the price by
$1.19, or approximately 10 percent, effective January 1, 1977, to
be followed by an additional 5-percent increase on July 1, 1977.
These countries also planned to add additional fees, or premia,
to certain grades of crude.
The SAG and the United Arab
Emirates, in an effort to moderate crude prices, refused to go
along with the other 11 OPEC members, which resulted in a twotier pricing structure.
The SAG decided that it would raise the
prices of Arabian Light and Arabian Berri by only 5 percent (to
$12.09 and $12.48, respectively), that it would raise the prices
of Arabian Medium by 3.6 percent (to $11.69), and that it would
raise the price of Arabian Heavy by 3 percent (to $11.37), all to
remain in effect for the entire year.
The SAG also increased
production available to Aramco at this time in an effort to force
the other OPEC countries to moderate their prices.
A Saudi
official was quoted in the Middle East Economic Survey, a widely
read weekly news source, on December 26, 1976, as saying:
We shall ensure that the companies concerned keep their
prices to all customers at the official government
levels. If these companies increase their prices for
Saudi crudes above the government levels, we will
consider this a hostile act against Saudi Arabia, and
they will be held to be working against the interests
of the Kingdom.
- 25 This official Saudi statement was known to U.S. officials.
Shortly thereafter, Minister Yamani was quoted in the January 10,
1977, issue of the Middle East Economic Survey as having
participated in an interview in Germany on January 3, 1977, a
portion of which is as follows:
Q:
We would like to return to the split in oil prices.
How can this system really work?
A:
We will make sure that the oil companies do not take
one cent from the cheap Saudi crude and put it in their
own pockets. We want the lowest price for the benefit
of the consumers. On this we will stand firm.
Q:
How do you intend to do that?
A:
First, we have ways and means to do it. The oil
companies need Saudi Arabia. And they know they will
be punished if they do not behave as we expect.
Secondly, the consumers are not stupid. They will be
aware that they can make use of this situation. In any
case, supply and demand will decide what happens. Not
in January, not in February, but at any time in the
future.
In conjunction with these efforts toward price moderation,
the SAG instituted pricing and reporting requirements to ensure
that its lower price was adhered to when the Saudi crude was sold
by the Aramco shareholders.
Minister Yamani sent identical
letters in English to petitioners dated January 10, 1977, which
stated:
This is to inform you that the following conditions will
apply to the additional volumes of crude oil which become
available for export as a result of the Government's
decision to permit Aramco to increase production. You
should take appropriate steps to assure compliance with
these conditions:
1.
The prices charged to the consuming countries
for Saudi Arabian Crude Oil will not be
higher than the FOB Ras-Tanura prices as
- 26 conveyed to Aramco plus transportation cost
to the particular countries concerned.
2.
Such condition will apply also to the buyers
of Saudi Crude Oil through your company.
3.
An audit certificate from a certified public
accountant should be made available to us to
prove compliance with the conditions (1 & 2)
above.
Furthermore, it should be understood that the same
conditions apply to all the Crude Oil lifted by your company
from Saudi Arabia which is expected to flow into its
historical international markets, to buyers-users and
without the utilization of brokers. Hence, an audit
certificate(s) in accordance with the abovementioned
conditions is also required.
With best regards.
(sf
Ahmed Zaki Yamani
Minister of Petroleum
and Mineral Resources
The provisions of these letters will hereafter be referred to as
the source of the 1977 restriction.
The Saudi Petroleum Ministry
statement in connection with the 1977 restriction was published
in the Middle East Economic Survey on January 10, 1977.
The
statement read in part:
The Government of Saudi Arabia, in its desire to pass
on the low prices which it set for its oil to the final
consumer, solicits the cooperation of the governments of the
consumer countries in checking through strict auditing
measures the prices at which Saudi crude oil is sold in
their countries and ensuring that no party other than the
final consumer benefits from the low prices.
Exxon interpreted paragraph 3 of the 1977 restriction to
require that audit certifications encompassing all sales of Saudi
- 27 oil had to be supplied to the Saudis, including those to
affiliates and to unrelated third parties.
The audit
certificates supplied by Exxon under the requirements of the 1977
restriction covered all sales of Saudi oil by Exxon to affiliates
and unrelated entities.
However, Exxon's independent auditor,
Price Waterhouse & Co., apparently having received only partial
information from purchasers of Saudi oil, had not submitted
certificates for all sales.
The SAG characteristically came
forward and drew attention to matters that were not in conformity
with Saudi policies.
As a consequence, the SAG initially
requested from Exxon more complete information and more detailed
reports.
Texaco guidelines indicated that sales of all Saudi oil were
covered by the 1977 restriction.
However, Texaco initially
appears to have supplied audit information only with respect to
the "additional volumes" referred to in the letter containing the
1977 restriction.
Minister Yamani asked for information
regarding all sales of Saudi oil as soon as possible.
Subsequently, Texaco apparently did not supply all of the
information that the SAG had indicated that it expected "in
compliance with H.E. The Minister's instructions", for the SAG in
January 1978 supplied Texaco with lists of crude oil shipments
for which no audit certifications had been received and a request
for expedited response.
Texaco complied with the SAG requirement
for additional information, with the possible exception of 18
- 28 shipments for which it could not locate the appropriate
information.
Texaco viewed the 1977 restriction and the audit
requirements in connection therewith as mandatory and took them
very seriously.
Submissions of the certifications by petitioners to the SAG
continued for the duration of the 1977 two-tier pricing period,
which ended in July 1977 when, following a June 1977 OPEC
meeting, Saudi Arabia and the United Arab Emirates imposed a 5-
percent price increase.
No agreement to increase crude oil
prices was reached at the December 1977 OPEC meeting in Caracas,
Venezuela.
The Iran Crisis; Rising Prices
In October 1978, oil workers in Iran went on strike.
Although oil field workers in Iran returned to work in November
following military intervention, strikes resumed in early
December in response to the urging of Ayatollah Khomeini, the
Iranian opposition leader then in exile in Paris.
Iranian crude
oil production averaged approximately 3.8 million barrels per day
over the last quarter of 1978, as compared to an average of
approximately 5.7 million barrels per day over the first 9 months
of 1978.
Iranian exports of crude oil ceased completely by the
end of December 1978 and did not resume again until March 1979,
and then at a reduced level.
The bulk of lost Iranian production
was Iranian Light, which was one of the lighter types of crude.
- 29 In response to the Iranian takeover of the U.S. Embassy in
Tehran on November 4, 1979, President Carter announced a trade
embargo of Iran, including the importation of Iranian crude oil.
In response to the Iranian shortfall, the SAG increased its crude
production from 7.75 million barrels a day (the average for the
first 9 months of 1978) to 10.4 million barrels a day by December
1978.
Despite the increase in Saudi production, there was a
perception of a shortage in 1979-80.
The SAG briefly reduced
crude oil production in early 1979.
The Iranian shutdown in.
1979, and the uncertainties of supply, were significant causes of
the perception of a shortage at this time.
The Iranian losses
were felt directly, but they also were indirectly felt by Exxon,
which had a long term contract with the British Petroleum Co.
(BP) whereby BP sold between 325,000 and 350,000 barrels per day
of Iranian crude to Exxon.
When the Iranian supplies were cut
off to BP, this significant source of supply to Exxon was
suspended as well.
As a result of the Iranian situation overall,
Exxon lost more than 10 percent of its crude oil supply.
A large
amount of panic trading and stockpiling of inventories occurred
at this time.
Texaco lost approximately 230,000-250,000 barrels
a day because of the Iranian shutdown.
Texaco's dependence upon
Saudi oil went from approximately 75 percent of its liftings"
" A "lifting" is the physical act of loading a quantity of
oil obtained under a concession, contract, or other arrangement.
- 30 prior to the Iranian shutdown to as high as approximately 78 or
79 percent of its liftings after the shutdown.
Mul.titier Pricinq and the 1979 Restriction
The next series of events has come to be known as the
"second oil crisis", a period in which world crude prices almost
tripled, and OPEC members individually established higher and
higher prices for their oil.
OPEC members met in Abu Dhabi on
December 16-17, 1978, and announced that they were raising prices
by an average of 10 percent for the year 1979 (the Abu Dhabi
announcement).
The 10-percent average price hike was to be
accomplished through four quarterly price increases beginning
with a 5-percent increase in the first quarter and ending with a
13.79-percent increase in the last quarter.
Under the announced
increase, the base price of Saudi Arabian Light marker crude was
expected to rise from $13.34 per barrel on January 1, 1979, to
$13.85 on April 1, 1979, to $14.55 a barrel on October 1, 1979,
which would have been an increase of slightly more than 9
percent."
While this announcement applied to all OPEC members,
a broad array of prices resulted, because individual member
countries were free to impose additional premia or surcharges as
they wished.
After the Abu Dhabi announcement, the SAG announced
that it would reduce production again and return to its 8.5
million barrels a day production ceiling.
" At a subsequent OPEC conference in March 1979, however,
the October base price of Saudi Arabian Light marker crude was
instituted early on Apr. 1, 1979.
- 31 Minister Yamani called a meeting with Aramco
representatives in Riyadh on January 15 and 16, 1979.
Because
they were experiencing shortages, representatives of petitioners
urged the SAG at this meeting to increase production from the 8.5
million barrels a day production ceiling to make up to some
extent for the Iranian shutdown.
At the same time the U.S.
Government also was urging the SAG to increase production.
There
was some discussion concerning pricing at this meeting, during
which Minister Yamani apparently was unmoved by petitioners'
arguments against his determination to use fourth quarter 1979
prices on the increased production.
Shortly after the meeting with Aramco representatives,
Minister Yamani issued a directive indicating that the SAG would
increase production but on the increased production the fourth
quarter 1979 prices would apply.
The directive also required
that the SAG efforts toward price moderation be carried through
to subsequent crude purchasers.
The directive was issued by
means of a letter in Arabic dated January 23, 1979, to Aramco's
Chairman of the Board, which was translated (the record does not
indicate by whom) as follows:
Kingdom of Saudi Arabia
Ministry of Petroleum and
Mineral Resources
Office of the Minister
25 Safar 1399
(23 January 1979)
No. 103/Z
Chairman of the Board
- 32 Arabian American Oil Company
Dhahran
Dear Sir:
Further to our letter No. 197/Z, dated 24 Safar 1399 [22
January 1979], you are instructed to implement the following:
1 -
The Kingdom's production of crude oil for the first quarter
of the year 1979 shall be at the rate of nine million five
hundred thousand barrels per day. You should see to it that
the monthly production does not exceed this rate in any of
the said three months. Further, the ratios imposed by the
State on the kind of oil to be produced (65 percent [of
lighter crudes] and 35 percent [of heavier crudes]) should
be observed.
2 -
For purposes of this letter only, the oil which the
companies are entitled to transport shall be fixed at a
daily rate of seven million barrels at the prices
communicated to you by this Ministry's letter No. 8/SS,
dated 1 Safar 1399 [30 December 1978].
3 -
For anything in excess of the first seven million barrels of
the daily production rate, the prices of the fourth quarter
of the year 1979 shall apply. These are as follows:
Kind of Oil
Gravity
Price in Dollars
Arabian Light Oil
Arabian Medium Oil
Arabian Heavy Oil
34
31
27
14.5460
14.0520
13.6434
Berri Oil
39
15.3321
4 -
The oil transporting companies should see that the oil
reaches the areas which have been harmed as a result of the
stoppage of Iranian oil, to the exclusion of areas which are
banned from having access to Saudi oil.
5 -
The companies are to pledge that they will not sell to a
third party at prices in excess of what we have specified
herein.
With kind regards.
Minister of Petroleum
and Mineral Resources
(Sgd)
Ahmed Zaki Yamani
(Tpd)
AHMED ZAKI YAMANI
- 33 -
This letter generally will hereafter be referred to as Letter
103/Z.
Item 5 of Letter 103/Z constitutes the source of the
restriction at issue in this case as it applied to petitioners'
offtakers and will hereafter be referred to as the 1979
restriction.
Resale pricing restrictions similar to the 1979 restriction
occurred in other crude oil sales relationships during the period
at issue, but in most cases they were contained in contracts
between producing countries and private companies.
Similar
resale restrictions sometimes also occurred in contracts between
two private entities.
There was a perception on the part of
several government officials of the consuming countries during
the period at issue that the 1979 restriction was imposed by the
SAG to ensure that Saudi crude reached the oil consuming
countries at the lower Saudi price as part of the SAG's crude oil
price moderation policy.
In February 1979, various producing countries began imposing
surcharges (or premia) of $1.20 per barrel or more over the
prices agreed to in the Abu Dhabi announcement.
The SAG, in its
efforts toward moderation, did not impose such surcharges and
thus maintained prices below those of the other OPEC members with
their differing levels of surcharges.
In March 1979, the OPEC
countries met in Geneva and accelerated the scheduled fourth
quarter 1979 price increase to be effective for the second
quarter and sanctioned additional surcharges.
The SAG once again
- 34 -
refused to impose such surcharges, indicating that it would
follow each barrel of crude to the refinery gate, ensuring that
its official price was adhered to.
Minister Yamani often used his public interviews, which were
disseminated through the press, as a means by which he
communicated a Saudi position.
The following interchange was
quoted in the Middle East Economic Survey on April 2, 1979,
representing a press interview with Minister Yamani after the
Geneva OPEC conference:
There is the question that since the offtakers in Saudi
Arabia will be lifting oil at a lower price than in
other countries owing to the absence of a surcharge in
Saudi Arabia, they might be in a better competitive
position than other companies. Are you thinking of any
measures to deal with this situation?
A:
Yes the measure we will apply is to follow the barrel
of Saudi crude until it lands at a certain refinery and
we know that it is sold at our price through an
auditor's certificate.
Q:
Is this already in force?
A:
We enforced this in 1977 when we had the two-tier
pricing system, and we have asked for it again this
time. But I cannot do anything after that if Exxon,
Mobil or any of the four sell their refined products in
the market at the market price which enables them to
realize a higher rate of profit than is usually
realized by other refiners. That is in their pocket; I
cannot interfere.
Q:
In other words you can deal with the crude but not with
the products?
A:
Right.
Q:
Have you put this measure back into application this
time or are you about to?
- 35 A:
Well we have told them to sell it at our price, but the
measures will be in application.
In the second quarter of 1979, Saudi production reverted to its
8.5 million barrels a day level as Iranian production began to
rise slightly.
The Deputy Minister of Petroleum and Mineral Resources sent
a subsequent letter in Arabic dated April 1, 1979, to Aramco's
Chairman of the Board, which was translated as follows:
Reference is made to [Letter 103/z] * * * and the
provision in item 5 thereof to the effect that the companies
shall pledge not to sell to any third party at prices in
excess of those fixed by the Government.
Please notify the companies transporting Saudi oil of
the necessity of submitting certificates from auditors
confirming the adherence of the companies to the
instructions of the State as of the beginning of this year.
We also request that every company furnish us with a list of
the contracts concluded between it and the developing
countries and the quantities of Saudi oil committed for the
year 1979.
This letter constitutes the source of the audit requirement
imposed by the SAG in connection with the 1979 restriction.
In June 1979, Minister Yamani sent to Aramco's Chairman of
the Board the following letter:
I wish to inform you that we have received a complaint
from the Republic of South Korea to the effect that Caltex,
which has a contract with it for the supply of crude oil,
has reduced the contracted quantities. Therefore, please
urge Caltex to insure that the Republic of South Korea is
supplied with all the contracted quantities and see that
sales to it are made, just like other sales, at the prices
set for you by the state.
Also in June 1979, the OPEC members met and announced
another round of significant price increases.
A press conference
- 36 -
with Minister Yamani after the OPEC meeting was published in the
Middle East.Economic Survey on July 2, 1979, in which the
following question and answer appeared:
Q:
How can you be sure that oil from Saudi Arabia is not
sold at more than official prices?
A:
[Minister Yamani] The only thing we can do - as we are
doing - is to ask for an audited account to show that
the Saudi barrel is supplied to a refinery or sold to a
third party at our price. But the oil companies are
definitely making much higher profits in the downstream
by refining Saudi crude and selling the products at
higher prices. This we cannot control. It is the
consumers' responsibility.
In early July, after repeated requests from the U.S.
Government to do so, the SAG again increased production to 9.5
million barrels a day.
the end of 1979.
This level of production continued beyond
In December 1979, the SAG, in an attempt to
unify OPEC prices, unilaterally raised its crude prices, but at a
meeting of the OPEC members in Caracas, Venezuela, on December
17-19, 1979, OPEC members again failed to reach an agreement on a
unified price structure, and the more aggressive OPEC members
simply raised their prices further, resulting in continued multitier pricing.
In early 1980, the SAG maintained its 9.5 million
barrels a day production level for the first quarter.
Petitioners' Responses to Letter 103/Z
There was a widely held understanding that the Crown Prince
and Minister Yamani consulted on a regular basis and that
Minister Yamani would not have issued the 1979 restriction
without royal approval.
To those of petitioners' employees who
- 37 -
were involved at the time, the substance of the 1979 restriction
was a replay of the 1977 restriction.
Nevertheless, there
apparently were differing interpretations among the Aramco
shareholders concerning the scope of both the 1979 restriction
and the audit requirement in connection therewith.
This was at
least in part because the translation of Item 5 of Letter 103/Z
refers to a pricing requirement in sales to "a third party".
The
transliteration of the original language in Letter 103/Z that was
indicated to be a "third party" in the translation is the Arabic
phrase "taraf thalith", which, although commonly understood to
mean "third party" more precisely means "any other natural or
juridical person that exists".
Thus the phrase "taraf thalith" actually used in the Arabic
version of Letter 103/Z connotes a meaning that is very different
from the meaning of the term "third party" to the Englishspeaking corporate world.
The term "third party" suggested to
some of petitioners' employees the narrower notion of an
unrelated or unaffiliated purchaser, and there was some initial
confusion as to the scope of the 1979 restriction on the part of
Exxon officials from the use of this "third party" language in
the translation of Letter 103/Z.
After he received Letter 103/Z,
Exxon chief executive officer and chairman, Clifton Garvin, Jr.,
realized that the "third party" language in the translation was
confusing, because his understanding of the typical
interpretation of the term "third party" was that it referred to
- 38 an unaffiliated party, and only approximately 15 percent of
Exxon's sales were to unaffiliated entities; thus he felt that
limiting the application of the term to only unaffiliated
entities would not have made sense.
Therefore, he telephoned
Minister Yamani and asked for clarification of the directive.
After that conversation, Mr. Garvin believed that the restriction
applied to all oil that Exxon purchased from the SAG, whether it
was sold to unaffiliated entities or affiliates, used in
exchanges, or otherwise.
Several other pieces of correspondence
from the SAG to Aramco subsequent to the letters containing the
1979 restriction and the audit requirement do not refer to "third
parties" and contain language indicating broader application of
the 1979 restriction than merely to sales of Saudi crude to
unaffiliated parties.
As a result of these or other subsequent
communications with the Saudis, Exxon and Texaco officials came
to understand that the 1979 restriction applied to all sales of
Saudi oil, including those to affiliates as well as those to
unaffiliated entities.
The stated objective in both petitioners' audit certificates
was to certify compliance with the restriction in sales to "third
parties", excluding affiliates from the definition of this term.
Despite the apparent initial confusion among Exxon employees
concerning the interpretation of the "third party" language of
Letter 103/Z, Exxon's response to the audit requirement for the
first quarter of 1979 was to submit figures on the number of
- 39 barrels of Saudi crude oil received and sold to affiliates as
well as to unaffiliated entities.
The other three Aramco
shareholders reported only figures in connection with sales to
parties less than 50 percent owned by them (unaffiliated
entities).
However, Texaco executives understood the 1979
restriction to apply to all sales.
for material on affiliate sales.
The SAG did not ask Texaco
Although they continued to
perform audit activities, petitioners did not submit, and the SAG
did not require them to submit, any audit certificates to the
Petroleum Ministry after the first quarter of 1979.
During the
rest of 1979, petitioners continued to monitor compliance with
the restriction, so that audit certificates could be compiled if
the SAG asked for them.
Later, when internal reporting was felt
to be no longer required, Exxon explicitly advised its personnel
that this was not intended to signal a departure from the pricing
practices previously followed.
There is no evidence that the audit submissions in
connection with the 1979 restriction were considered by the SAG
to be inadequate.
Unlike the series of communications between
petitioners and the SAG in connection with the 1977 audit
requirement, which are described earlier in this opinion, there
is no evidence indicating dissatisfaction on the part of the SAG
with petitioners' submission of audit materials in 1979 or their
subsequent failure to submit audit certificates.
- 40 Mandatory Nature of the 1979 Restriction
There is evidence that there would have been potentially
serious consequences if petitioners had violated the 1979
restriction. Continued access to Saudi crude was critical to
petitioners during the period at issue, because it was their
largest internationally traded crude oil source, representing
about 50 percent of Exxon's and 78 percent of Texaco's crude oil
supply (excluding indigenous production, or crude produced by
petitioners themselves).
As indicated earlier, Minister Yamani
in April 1979 was quoted in the Middle East Economic Survey as
saying in a press conference that the SAG had "enforced [the 1977
restriction] in 1977 when we had the two-tier pricing system, and
we have asked for it again this time."
In May 1980, Minister
Yamani participated in another press conference, and the
following question and Minister Yamani's answer were quoted in
the Middle East Economic Survey on May 19, 1980:
Q:
How will OPEC deal with the situation arising from the
sale by the oil companies of their OPEC oil purchases
at well above OPEC official prices, when at the same
time the consumer governments continue to blame
inflated oil prices on the OPEC countries?
A:
There is little that OPEC can do about this problem.
The most it can do is what Saudi Arabia is already
doing which is to ensure that the barrel of Saudi oil
is sold at Saudi prices until the oil is delivered to
the refineries. After that stage the oil companies are
in a position to make large profits, and these do not
fall within the jurisdiction of OPEC.
The "refineries" referred to in Minister Yamani's answer are
appropriately interpreted to include all refineries, including
- 41 petitioners' affiliated refineries.
The mandatory nature of the
restriction also was noted in a book published in 1980 by Ian
Seymour, an editor of the Middle East Economic Survey, when he
stated what was "very common knowledge at the time" as follows:
The Saudis can, and do, oblige the Aramco companies to sell
the crude (which mostly goes to their own affiliates) at the
cheaper Saudi official price; and they can police these
transactions right up [to] the entrance to the refinery.
But once the oil is processed and marketed as products, the
profit to be gained from having access to cheaper crude
supplies than one's competitors will end up in the pockets
of the US majors which participate in Aramco, and there is
nothing Saudi Arabia can do about it.
The similarity between the 1977 and 1979 restrictions and
the Saudi expectation of compliance was echoed in a letter dated
August 8, 1990, submitted to the Court by petitioners during
trial, from the Minister of Petroleum and Mineral Resources in
1990, stating as follows:
No. 71/H
18 Muharram 1411
(8 August 1990)
Mr. Jack Clarke
Vice President, Exxon
I hereby confirm to you that the Government of the Kingdom
of Saudi Arabia issued directives to Aramco, by letter
No.103/z, dated 25 Safar 1399 (23 January 1979), concerning
prices in the year 1979, that required oil offtakers of
Aramco shareholder companies to sell Saudi crude oil
obtained from Aramco at the Government-established prices.
As in the case of similar pricing directives issued in 1977,
the 1979 directive applied to all Saudi crude oil sales of
offtakers whether related to said parties or otherwise.
The Government expected oil offtakers to continue their
normal operations, including barter deals, using the prices
established by the Government of the Kingdom of Saudi Arabia
for Saudi crude oil. The Government required Petromin also
to sell Saudi crude oil at the Government-established
prices. The Government monitored the oil offtakers'
L
- 42 -
activities in an attempt to assure compliance with pricing
directives.
Minister of Petroleum and Mineral Resources
(Signature)
Hisham Mohiuddin NazerD"
The provisions of this letter will hereafter be referred to as
the first Nazer letter.
Minister Nazer was the Acting Minister
of Petroleum when Minister Yamani was absent from Saudi Arabia
during the years at issue and became the Minister of Petroleum in
1986.
Minister Nazer subsequently confirmed in another letter
(which will hereafter be referred to as the second Nazer letter)
that the first Nazer letter
was written on the basis of my knowledge of the policy of
the Government of the Kingdom of Saudi Arabia in my capacity
as a member of the Council of Ministers and after conducting
a thorough examination of the Ministry of Petroleum &
Mineral Resources documents during the relevant periods.
These statements of Saudi intent in the above-quoted
documents were borne out by the Saudi actions.
As described
above, the SAG had notified petitioners when it had felt that its
requirements in connection with the 1977 restriction were not
adequately followed, and the SAG drew attention immediately to
matters that incorrectly attributed something to one of its
officers.
In addition, by a series of directives beginning in
April 1979, the SAG instructed Aramco and its shareholders to
" In our evidentiary opinion, we admitted the first and
second Nazer letters into evidence under Rule 146, reserving
judgment on the weight to be accorded to them. Exxon Corp. v.
Commissioner, T.C Memo. 1992-92. We discuss this matter infra
note 39.
- 43 maintain their deliveries of Saudi crude to customers in less
developed countries (LDC's) at 100 percent of the quantities
contracted for with these countries.
Although there was a United
Nations definition of LDC's, the SAG defined the list of the
countries subject to the Saudi LDC requirement.
In April and May
1979, Aramco was asked by Minister Yamani to furnish the SAG with
a list of contracts concluded between the Aramco companies and
companies located in LDC's.
In a letter to Aramco dated May 8,
1979, concerning the LDC requested lists, Minister Yamani
indicated:
"Of course, the selling prices of said quantities are
to be the same as other sales made at the prices fixed for you by
the State."
In response, Exxon sent a letter to the SAG dated
May 10, 1979, listing the LDC's to which it was supplying Saudi
oil.
It also explained that, because of the disruption in Iran
it was experiencing a crude oil shortage and therefore was forced
to reduce quantities sold to all its customers, including those
in LDC's.
Minister Yamani responded on June 6, 1979, by
instructing Mr. Garvin that the Aramco companies were to continue
to guarantee to LDC's the quantities of Saudi crude they had
contractually committed to "at the prices set out by the Saudi
Arabian Government", and to advise the SAG of its compliance.
similar letter was sent to Texaco.
A
Minister Yamani also
indicated that "strict" compliance with the Saudi LDC requirement
was "a very important matter" and that "necessary measures" would
be taken "to remedy any deviation from these instructions."
- 44 -
Exxon advised the SAG shortly thereafter that it would do so.
Rather than violate these clear Saudi requirements, in July 1979
an Exxon manager suggested attempting to narrow the list of LDC's
during 1979 in order to increase Exxon's flexibility in cutting
back supplies in times of shortage.
Taiwan and Spain were
considered as suggested countries to be excluded.
Although
listed as an LDC under the United Nations definition, Spain
subsequently was excluded from the list of LDC countries by
Minister Yamani.
There is no evidence explaining the Saudi
reasons for this exclusion.
Minister Yamani subsequently sent
another similar letter dated December 10, 1979, to Aramco's
Chairman of the Board, which indicated that all companies
transporting Saudi oil were to continue supplying LDC's with
their contracted allotments so that, according to the
translation, "we will not be compelled to reduce the quantity of
Saudi oil supplied to any company not observing this strictly by
the amount of contracted oil withheld from any developing
country."
do so.
Exxon responded once again that it would continue to
The implications of noncompliance with the Saudi LDC
requirements were perceived by an Exxon executive as being
"uncertain" and very likely to be "adverse for Exxon".
There was
concern about the possible reduction in Exxon's volumes by more
than its LDC volumes, and "other ways to penalize Exxon for noncompliance".
- 45 -
A legal adviser to the Petroleum Ministry concluded that the
SAG was acting in its sovereign capacity when it set prices of
crude oil during the period at issue.
Petitioners were required
to follow the crude pricing requirements of the SAG if they were
to continue to have access to Saudi oil.
Mr. Garvin felt that
petitioners were always aware that they were dealing with a
sovereign entity that could make decisions at will, without
regard to economics or the marketplace.
Alfred DeCrane, Texaco's
executive vice president during the years at issue, believed that
the most logical sanction the SAG would have used if Texaco had
failed to comply with the restriction would have been reduction
of the amount of crude available to Texaco.
In several other instances the SAG took a strong stance in
connection with its requirements.
For example, just prior to
1979 a U.S. Senate investigative committee subpoenaed materials
from Exxon concerning Saudi production capabilities.
The Saudi
Minister of Petroleum was notified by Exxon that Exxon intended
to comply with the subpoena, and the Minister instructed Exxon
not to comply because such disclosures would be in violation of
Letter 1030/Z (which forms the basis for the protective order in
this proceeding).
Letter 1030/Z provides for the confidentiality
of information pertaining to activities between Aramco and the
SAG.
In his testimony before the Senate committee, Mr. Garvin
expressed his concern about the "security of supply of Saudi oil
to the U.S." if the disclosures became public.
When the
- 46 -
Minister's instruction was not followed by Exxon, and the
disclosures were publicized, Minister Yamani assured Mr. Garvin
that the disclosures "will not pass without leaving its effect on
the relationship of your company with the Government of Saudi
Arabia."
Exxon and Chevron (the other company involved) were
penalized by the SAG by receiving approximately 24,000 barrels
per day less crude than they otherwise were entitled to receive.
This situation lasted for between 6 and 9 months.
While the
number of barrels reduced was not a significant amount,
petitioners thereafter were concerned that this action was a
precedent, and that the Minister would use punitive measures in
other similar disclosure situations or in other areas of even
more concern to them, such as the pricing of Saudi oil.
Pricing restrictions apparently were required by the SAG
with companies other than Aramco, and two other similar incidents
involving punishment of other companies occurred in 1979.
In one
of these incidents, the Italian national oil agency, ENI, had
signed a contract with Petromin in June 1979 to purchase 100,000
barrels per day of Saudi crude at Saudi OSP for a period of 3
years.
Toward the end of 1979, Italian press reports stated that
a fee had been paid to a Panama company in connection with the
contract, and the SAG suspended the contract in December 1979.
subsequent investigation confirmed that ENI had complied with
Saudi pricing requirements and paid Saudi OSP, and the contract
was put back into effect in the third quarter of 1981.
In
A
another unrelated incident, the SAG suspended crude supplies to
Japan in the amount of 140,000 barrels per day for similar
violations.
These incidents conveyed to petitioners the
principle that the SAG requirements were expected to be enforced.
Similarly, there was a perception by the Japanese that the SAG
could stop the flow of Saudi oil into their country if Saudi
pricing requirements were not complied with.
Minister Yamani also corresponded with petitioners when in
another instance he apparently believed that the 1979 restriction
was not being followed.
In that situation, the Minister
indicated that he had been advised that Texaco was planning to
sell Saudi crude in the Philippines at a price in excess of the
restricted price.
There is no evidence indicating that the
Minister's suspicions were justified.
On December 30, 1980,
Minister Yamani sent a letter to Texaco, indicating as follows:
During my recent trip to Philippines I was surprised to
learn that you have informed your affiliates that the price
of Saudi oil supply will be more than what Saudi Government
has established. Should this be true it will certainly be a
breach of your commitment to us which will be seriously
regarded. Saudi oil should always be delivered at Government
established prices and the audit certificate thereof should
be submitted to us.
Furthermore, we reiterate our established policy that
supplies to developing countries should not be decreased at
any rate.
Strict adherence to these guidelines will help
streamline our relationship.
A similar letter describing Minister Yamani's concerns about
possible violations by some of the Aramco partners was sent to
- 48 Exxon.
Because of Texaco's high dependence upon Saudi oil,
Mr. DeCrane was very concerned that the SAG would reduce crude
supplies if it believed that Texaco had failed to comply with the
restriction.
Texaco promptly advised Minister Yamani that it was
not charging, or advising its affiliates to charge, higher prices
than the Saudi established prices.
Exxon officials also advised
Minister Yamani in March 1979 that:
"All Aramco crude sold by
Exxon this quarter, whether to affiliates or to third parties,
has been priced no higher than the * * * [relevant Saudi
prices]."
On various other occasions during the period at issue
Exxon advised the SAG that it was not selling Saudi crude at
prices above Saudi OSP.
Because of these potential consequences, petitioners took
steps to ensure that they complied with the 1979 restriction, and
they invoiced their Saudi crude at Saudi OSP.
There were a few
isolated instances in which petitioners did not do so, but these
instances apparently were not a disregard of Saudi requirements
and occurred inadvertently.
In one incident Texaco sold 129,675
barrels of crude during the period at issue for a price in excess
of Saudi OSP.
This sale constituted approximately .006 percent
of the 2,276 million barrels of Saudi crude disposed of by Texaco
during the period at issue.
Exxon mispriced one sale to a
related entity involving 352,626 barrels of Saudi crude when it
used the Saudi established price in effect on the date the
loading was completed rather than on the date loading commenced.
- 49 -
This sale constituted approximately .016 percent of the 2,273
million barrels of Saudi crude disposed of during the period at
issue.
There is no evidence indicating Saudi knowledge of, or
objection to, these sales.
These incidents are so isolated and
the number of barrels is so small in relation to petitioners'
total sales of Saudi crude that they is,insignificant.
Supply Needs; Shortages
Every grade of crude oil is different in chemical
composition and quality.
The relative value of one crude oil
versus another is affected by, among other things, its physical
and chemical characteristics, locational differences, and the
relative prices of the various refined products that can be made
from the various crude oils.
is sulfur.
One common contaminant in crude oil
Because sulfur is corrosive, a crude oil with a high
sulfur content generally requires more extensive processing than
a crude oil with a low sulfur content.
In addition, during the
years 1979-81, many countries (including the United States)
regulated the level of refinery sulfur emissions and/or the
sulfur content of or emissions from petroleum products.
Another
important characteristic of crude oil is its density, or specific
gravity, which normally is expressed in American Petroleum
Institute (API) degrees.
On the API scale, the lower the density
of crude oil, the higher the degree of API gravity and the
greater the value.
Crude oil ranges from "light" crude
(approximately 34 degrees specific gravity), which is processed
- 50 -
into automobile gasoline, to "medium" crude (approximately 31
degrees), which is processed into home heating oil, to "heavy"
crude (approximately 24-31 degrees), which is consumed by large
power plants.
As reliance upon the automobile increased, the
lighter crudes came increasingly into demand in the late 1970s.
Shortages were anticipated shortly after the first oil
crisis.
As early as 1974-75, Exxon had advised its unrelated
customers to diversify their crude oil sources and not to rely on
Exxon for long-term supply.
the situation.
But subsequent events exacerbated
On February 13, 1978, the SAG issued a directive
requiring a reduction in the amount of Arabian Light crude that
the shareholders could lift from 75 to 65 percent of their total
liftings from the SAG.
The reason for such a directive probably
was that a high percentage of the SAG reserves was in the heavier
grades, and thus the SAG sought to increase its sales of the
heavier crudes.
The crude oil shortages that had occurred after the first
oil crisis became even more acute during the years 1979-81.
Middle East and North African daily crude oil production during
the years 1978-81 was as follows:
DAILY CRUDE OIL PRODUCTION
(in thousands of barrels)
Country
1978
1979
1980
1981
Saudi Arabia
Iraq
8,296
2,629
2,096
1,990
5,197
1,447
9,530
3,450
2,060
2,490
3,110
1,464
9,926
2,646
1,788
1,675
1,467
1,350
9,818
1,184
Libya
Kuwait
Iran
Abu Dhabi
1,180
1,118
1,114
951
- 51 -
Algeria
Egypt
Qatar
Dubai
Oman
Syria
Tunisia
Bahrain
Totals
1,225
482
1,116
506
942
585
900
587
100
53
100
50
100
49
118
44
24,847
25,191
21,796
18,260
485
362
315
170
500
360
295
160
471
349
283
165
405
358
317
166
As discussed earlier, as Iranian and other Middle East
production decreased, there was considerable uncertainty whether
supplies might be further disrupted, and petitioners experienced
shortages of crude, even in some cases for their own
requirements.
As a consequence they tried to cut back deliveries
to unrelated customers.
By early March 1979 Exxon determined
that it would not renew its term crude oil supply contracts with
unrelated customers, which were scheduled to expire at various
times beginning on March 31, 1979.
Exxon's sales of Saudi crude
to affiliates increased from approximately 69 percent of total
Saudi sales in 1978 to 77 percent during the first three quarters
of 1979.
The volume of subsequent sales of Exxon's Saudi crude
to unrelated customers dropped significantly thereafter from 16.5
percent of total sales of Saudi oil in the first quarter of 1979
to 1.1 percent of such sales in the first quarter of 1981.
Texaco's system during the 1970s had become "unbalanced" as
a result of the trend toward higher sulfur, heavier crude
supplies, and changes in demand for lower sulfur products.
of Texaco's crude supply was high-sulfur Saudi crude.
Most
The
situation was exacerbated by the losses of Iranian Light crude in
- 52 late 1978.
By 1979, the Texaco system began to correct this
imbalance by selling high-sulfur crude and purchasing low-sulfur
crude, either outright or through exchanges.
At the same time
that it was attempting to reduce the system's sulfur content,
there was a Texaco management "consideration" to phase out
unrelated customer crude supply agreements in 1979.
However,
during the years 1979-81 Texaco sold Saudi crude to unrelated
customers in a generally consistent pattern as before the
issuance of the 1979 restriction, in amounts of approximately 15
to 20 percent of its Saudi Arabian liftings.
There was a decline
of unrelated customer sales under contracts that had been entered
into by Texaco prior to 1979, primarily as a result of the end of
the terms of these contracts.
There also apparently were seven
specific instances of substitutions by Texaco of non-Saudi crude
for Saudi crude in sales to certain Japanese companies (which
collectively were Caltex's largest crude customer).
However,
Caltex's supply of Saudi crude to those companies remained
basically constant during the period at issue, at approximately
200,000 barrels per day.
In the face of shortages, the four Aramco shareholders sent
a letter to Minister Yamani in May 1980 urging the SAG to
increase production.
They stated in that letter that they had
"relied upon the terms of the present Arrangements as the basis
for our relationships with the [Saudi] Government", and that
Saudi production volumes were far below their expectations under
- 53 those Arrangements.
Because of these shortages, they indicated,
they were not able to meet the needs of their refining facilities
and product outlets throughout the world, and they were forced to
purchase crude on the spot market to meet their requirements,
which was contrary to the SAG stated objectives and policies.
In September 1980, Iraqi forces invaded Iran.
The outbreak
of the Iran/Iraq war resulted in the loss of crude oil production
from Iran and Iraq of approximately 3.9 million barrels per day
on average over the fourth quarter of 1980.
During the latter
part of 1980, Minister Yamani advised petitioners that the SAG
had decided to increase production from 9.5 to approximately 10
million barrels per day in order to "close the gap" brought about
by the Iran/Iraq crude production losses.
Petitioners were
further advised that the SAG would designate the specific
customers, prices, and volumes for petitioners' sales of Saudi
crude.
The countries that were to be sold crude under these
conditions included France, Brazil, Japan, Italy, Greece, Spain,
Morocco, and Turkey.
These sales came to be known as "designated
sales", or "war relief crude sales".
Pursuant to this
requirement, Textrad and the Exxon offtakers sold approximately
77 million and 61 million barrels, respectively, of "war relief"
Saudi crude to unaffiliated entities during 1980 and 1981
combined.
Petitioners were not to suffer any economic loss nor
derive any economic gain from these sales.
The parties were to
provide the SAG with certain information demonstrating
- 54 compliance.
Texaco told its auditor to prepare and submitted to
the SAG audit certificates regarding designated sales.
There is
no evidence concerning Exxon's submission of audit materials on
designated sales.
The prices of Saudi Arabian Light during the period 1979
through 1981 were as follows:
Date Announced
Date Effective
Price Per Barrel
December 30, 1978
January 23, 1979
April 1, 1979
July 4, 1979
December 12, 1979
January 26, 1980
May 13, 1980
September 21, 1980
December 14, 1980
November 1, 1981
January 1, 1979
January 23, 1979
April 1, 1979
June 1, 1979
November 1, 1979
$13.34
14.55"
14.55
18.00
24.00
October 1, 1981
34.00
January 1, 1980
April 1, 1980
August 1, 1980
November 1, 1980
26.00
28.00
30.00
32.00
As discussed earlier, as dramatic as this rise in Saudi prices
was, these prices of Saudi Light were exceeded by the prices of
comparable crudes from the other OPEC members during the years at
issue until October 29, 1981.
Other Saudi crudes (including
Berri, Medium, and Heavy) also were priced below other Middle
Eastern crudes of similar density during the period at issue.
At
a December 1980 OPEC meeting in Bali, Indonesia, the OPEC
ministers again agreed to raise crude oil prices.
OPEC price
unification was finally obtained at an OPEC meeting in Geneva,
Switzerland, on October 29, 1981, when Saudi Arabia agreed to
" Letter 103/Z indicates that this price applied only to
additional production received by Aramco in excess of the first 7
million barrels of daily production received by Aramco out of
total crude oil production.
- 55 raise the price for Saudi Arabian Light crude from $32 to $34 per
barrel.
This constituted the end of the period during which
Saudi crude was sold at prices below other comparable crudes and
thus the end of the so-called "Advantage" period.
By 1982, Saudi crude was more expensive than other similar
crudes, and this period came to be called the "Disadvantage"
period.
In contrast to the 1978-79 period when there were world-
wide crude shortages, during 1982-83 demand for crude generally
was reduced because crude supplies were readily available.
During 1981, when there began to be a reduction in demand, Exxon
reduced its purchases of Saudi oil from approximately 2 million
to 1 million barrels a day.
Exxon's Saudi liftings in 1983 were
approximately 600,000 barrels a day.
Textrad dispositions of
Saudi crude decreased from almost 2 million barrels a day in 1981
to under 1 million in 1982.
U.S. Government Actions and Statements
During the period 1975 through 1981, officials of the U.S.
Government undertook numerous diplomatic efforts to affect or
moderate OPEC crude oil price increases, urging the SAG as well
as other OPEC Governments to moderate crude oil prices and to
increase crude oil production.
Officials of the U.S. Government
met with representatives of the SAG on several occasions during
the period at issue and conveyed their appreciation for Saudi
efforts towards moderation in price as well as its continued
maintenance of high production levels.
Prominent U.S. officials
- 56 believed that the SAG's price moderation policies were designed
to obtain the defense and foreign policy support of the United
States and to meet the need for stability in the world economy.
In August 1973, the U.S. Government had issued refined petroleum
product price controls on motor gasoline and propane.
These
price controls were in effect until January 27, 1981.
The U.S.
Government also issued a regulation concerning crude transfer
pricing standards that refiners were to use to establish the cost
of imported crude purchased in transactions between affiliated
entities.
That regulation was in effect from October 25, 1974,
through January 27, 1981.
After the 1979 restriction was issued, official U.S. policy
was strongly in favor of enforcing the restriction and seeing
that the Saudi policy toward moderation was carried out.
Minister Yamani had a reputation with U.S. officials of being
influential in developing and implementing Saudi oil policy.
He
also had a reputation as a careful and cautious individual who
would not attempt to implement a policy unless it was authorized
by the SAG.
In his personal dealings with Crown Prince Fahd
prior to the years at issue, Richard Cooper, the Under Secretary
of State for Economic Affairs under President Carter, was led to
believe by Crown Prince Fahd that Minister Yamani's position
presented at the Doha conference in late 1976 (establishing the
1977 restriction) represented the official SAG position.
U.S.
officials believed that the 1979 restriction was mandatory, that
- 57 -
it was essentially a replay of the 1977 restriction, and that in
exchanges Saudi crude was required to be sold at Saudi OSP.
There was a perception among U.S. officials that, because the
SAG's ability to market oil directly through Petromin was
increasing during this period, the SAG could feasibly cut off
supplies to the Aramco shareholders if they did not comply with
the restriction.
A violation of the restriction would have been
reported by U.S. officials to the U.S. Department of Energy.
Consuming Country Oil Market Information Systems
As producing country governments preempted more and more of
the functions of the private oil companies, some of the consuming
country governments became more involved in the oil industry's
refining, marketing, and distribution activities, initiating a
variety of controls on usage, imports, and prices.
After the
1973 Arab oil embargo, a mechanism was established whereby
accurate data on the actual prices being charged for crude oil
and petroleum products were collected, in order to provide better
information on the situation in the international petroleum
market.
The foreign ministers of the major consuming countries
met in Washington, D.C., during February 1974 at what came to be
called the Washington Energy Conference.
This Conference led to
an Agreement on an International Energy Program (IEP), which set
forth such objectives as promoting secure oil supplies on
reasonable and equitable terms, creating an international oil
market information system, creating an emergency oil-sharing
- 58 plan, restraining demand for oil, achieving long-term cooperation
on energy matters, and developing constructive relationships with
oil-producing countries.
The IEP, among other things, authorized
the formation of the International Energy Agency (IEA).
By the
end of 1974, the IEA was formed as a 16-nation autonomous body
within the Organization for Economic Cooperation and Development.
Its members were Austria, Belgium, Canada, Denmark, the Federal
Republic of Germany, Ireland, Italy, Japan, Luxembourg, the
Netherlands, Spain, Sweden, Switzerland, Turkey, the United
Kingdom, and the United States.
1975.
New Zealand joined the IEA in
Norway subsequently participated in the IEA pursuant to a
1975 agreement.
Greece joined the IEA in 1976, Australia in May
1979, and Portugal in July 1981.
During the 1974-81 period, the Governing Board of the IEA,
which is composed of delegates from each participating country,
oversaw the activities of four standing groups, one of which was
entrusted with the responsibility of overseeing the development
of a crude oil market information system.
The IEA crude oil
market information system was designed to promote fairness in the
overall distribution of crude oil by providing participating
countries with greater information on the conditions in the
international oil market, to moderate prices (particularly spot
market prices, which were of concern to U.S. officials), and to
reduce suspicion among the member countries by means of the
"transparency" of the system.
The participating countries agreed
- 59 -
to provide oil market information requested by the Secretariat of
the IEA.
The U.S. Department of Energy, together with the
Department of State, supported the creation of the IEA crude oil
information system.
In January 1977, the European Community (EC)
established its own crude oil price information system.
The
following countries were members of the EC throughout the years
1975-1981:
Belgium, Denmark, the Federal Republic of Germany,
France, Ireland, Italy, Luxembourg, the Netherlands, and the
United Kingdom.
Greece joined the EC in January 1981.
In June 1979, the heads of state of the seven largest
industrialized countries met in Tokyo for an economic summit
meeting (Tokyo Summit).
On the first day of the Tokyo Summit,
OPEC announced significant crude price increases, which were
officially deplored by the Tokyo Summit participants.
The Saudi
price moderation policy was discussed at the Tokyo Summit and
praised by the various heads of state.
It was the understanding
of Dr. Schlesinger, who attended the Tokyo Summit with President
Carter, that the 1979 restriction fulfilled the common U.S. and
SAG objectives to have the lower-priced Saudi crude reach the
consuming countries at the lower price.
Officials of the
Governments of the United Kingdom, Italy, the Federal Republic of
Germany, the Netherlands, and France understood the Saudi
objective to be the same.
It was Dr. Schlesinger's understanding
that the leaders of the countries participating in the Tokyo
Summit believed that the 1979 restriction was applicable in all
- 60 of their countries and applied to all sales of Saudi crude,
including sales to petitioners' affiliates in those countries.
He believed that the United States and SAG objectives would not
have been met if the restriction had not applied to affiliate
sales.
He also believed that this was the view of Minister
Yamani.
One of the actions taken by the participating countries
at the Tokyo Summit was to agree to set up a register of
international crude transactions to bring the workings of oil
markets more into the open.
During the period 1979 through 1981
agencies of the Governments of Canada, the Federal Republic of
Germany, France, Greece, Ireland, Italy, Japan, the Netherlands,
Norway, Sweden, the United Kingdom, and the United States had
knowledge of or were aware of the prices at which Saudi crude
oils were imported into their respective countries either through
their own government's crude oil information system, or through
information obtained from the IEA or the EC.
The transparency
created by the information-sharing was important in ascertaining
compliance with the restriction.
This transparency ensured that
all consuming member countries were being treated the same.
Some countries, such as France and the Netherlands,
controlled petroleum product prices and directly monitored the
- 61 prices of imported crude oil."
The same was true in Japan."
During the period at issue, Italy's system established that Saudi
crude was to be imported at Saudi OSP."
The German Government
France had domestic product price controls on certain
refined products, which were fixed by reference to the official
selling prices of a "basket" of crude oils, in which every crude
entered in direct proportion to its share in the supply of French
refineries. While it did not have crude price controls, France
took a very active part in monitoring the prices of imported
crude oil. France did not separately control exchanges. A
portion of the 1979 income attributed to the Exxon offtakers was
from a French Exxon affiliate.
The Netherlands had product price controls and closely
monitored crude prices. It did not separately monitor exchange
transactions because these transactions historically had been
occurring regularly for logistical and supply purposes, and there
was no indication that they were occurring for other reasons
during the period at issue. A portion of the income attributed
to the Exxon offtakers was from a Dutch Exxon affiliate.
" It was common knowledge among the Japanese people that
the SAG had established lower crude selling prices than other
OPEC countries. Japan had a product control system, the Ceiling
Price System, in effect during the years at issue, which would
not have permitted Japanese affiliates of Aramco shareholders to
charge product prices that reflected import costs of Saudi crude
above Saudi OSP. The Japanese Government monitored the
quantities and prices of all imports of petroleum into Japan.
Saudi crude constituted almost one-third of Japan's total oil
imports in the years 1979-81, and, because of the importance of
Saudi crude to Japan, higher prices would not have been permitted
under the Ceiling Price System.
" A close watch was kept by Italy on imports of Saudi crude
because that crude amounted to approximately one-third of Italy's
aggregate imports. Italian officials knew that Saudi crude was
selling for less than other crudes and that petitioners had been
instructed by the Saudis to sell it at OSP. Italy required oil
importers to submit monthly reports on each crude shipment, its
quantity, origin, price, and terms of payment. This monitoring
was intended to keep crude import prices as low as possible. In
1980 a system was adopted in Italy whereby all crude was to be
based on official selling prices and conformity with this
requirement was routinely verified. This system of monitoring in
(continued...)
- 62 encouraged the Saudis to pursue their moderate policies and was
fully aware of Saudi pricing policies during the years at
issue."
The United Kingdom also monitored the flow of crude
into the country."
In the course of this monitoring, officials
from all of these governments were aware of the 1979 restriction
and did not find any violations.
A violation of the restriction
would have been known to these officials, and they would have
required compliance with it, either through informal pressure in
the press and political arena (thereby informing the SAG of such
"(...continued)
Italy was in addition to the monitoring procedures already in
effect by the IEA and the EC. Italy did not monitor separate
price information of exchange transactions but simply verified
the conformity of all import prices with official prices. A
portion of the income attributed to the Exxon offtakers was from
an Italian Exxon affiliate.
Although the German Government did not have official
product or crude price controls, it had a Government price
information system by which it monitored the prices of crude
imported into the Federal Republic of Germany. The Federal
Republic of Germany would have intervened had it become aware
that petitioners' offtakers were transmitting Saudi crude into
the Federal Republic of Germany at prices in excess of Saudi OSP.
The Texaco notice of deficiency allocated income from a German
Texaco affiliate to Textrad.
" The United Kingdom had no formal controls over crude oil
or product prices during the years at issue. It had a basic
policy of allowing market forces and prices to work. However, it
also sought to discourage or restrain price increases that could
not be sustained in the long run and were not justified by the
underlying supply and demand trend. There was a perception that
the high OPEC prices were artificial and thus not in compliance
with free market forces. Therefore, it supported the Saudi price
moderation policies. The oil market information system and the
crude oil register provided it with an ongoing picture for
assessing whether petitioners were selling Saudi crude at the
Saudi OSP.
- 63 -
violation), or by more formal legal means, such as the
withholding of permits and licenses, formal investigations, the
initiation of legislative measures, or the assertion of certain
emergency powers.
Officials of these countries and of the United
States were under the impression that the restriction applied to
all sales of Saudi oil into their countries.
Petitioners had
refining affiliates located in each of these countries.
At various times during the period 1979-81, the IEA and the
EC expressed public concern or interest with respect to:
(1)
Crude oil prices and the rapid escalation of such prices; (2) the
refined product prices of their respective member countries; and
(3) assuring an adequate supply of crude oils to all
participating countries and an equitable distribution of that
crude oil supply.
Exchanges
Reciprocal purchase/sale agreements, or exchanges," were
mechanisms by which oil companies exchanged oil with one another
to accomplish one (or more) of three purposes:
To save
transportation costs (a location exchange), to save storage costs
(a timing exchange), and to solve refinery operating problems or
improve crude quality (a quality exchange).
Sometimes exchanges
" In a reciprocal purchase/sale agreement there are two
"matching" transactions, a sale and a purchase, each subject to a
separate legal document, whereas in an exchange there is a single
transaction, subject to a single legal document. The two terms
are used interchangeably in the industry. For purposes of this
opinion, we use the term "exchange" to refer to both exchanges
and reciprocal purchase/sale agreements.
- 64 were used to obtain specific crudes necessary to meet contractual
commitments.
The intracorporate economic decision whether to engage in an
exchange transaction is based upon whether the internal values of
the crude oils involved result in benefits to both parties to the
transaction.
The internal value is the value to each particular
company of the refined products that could be produced from the
crude in question.'°
One crude oil may be worth more to one
company than another simply because it has refinery capability
that the other does not.
Accordingly, the market price for each
crude oil in an exchange is irrelevant to the economics of the
exchange.
What matters is the value to the company on each side
of the exchange of the finished products that could be produced
from that crude by that company.
Companies tend to divide the
difference in value through negotiation of a "differential" that
is within the range of the difference between the refined values
of the two crudes for each of the parties.
The refined value to
each exchanging party of the crude received necessarily is higher
than the refined value of the crude given up, or the exchange
would not be entered into because it would not be beneficial to
that party.
2° For example, in one transaction involving a disagreement
between Texaco and one of its exchanging partners over who had to
bear the responsibility for retroactive price increases, the
exchanging partner had indicated that the exchange differential
had been calculated based upon "the difference in value of each
crude, in respect of the yields of refined products."
- 65 Because the differential between the internal values of the
two crudes was the focal point of the exchange transaction (not
the differential between the OSP's or market prices of the crudes
being exchanged), it was not uncommon for petitioners' ledgers to
reflect that petitioners obtained non-Saudi oil in an exchange at
a price that was less than that crude's OSP, which respondent has
characterized as a "discount".
This "discount" occurred because
the internal value differential in an exchange during the period
when the 1979 restriction was in effect was different from the
OSP differential between the crude oils involved; consequently,
because the Saudi oil was required to be invoiced at Saudi OSP,
the non-Saudi oil received in an exchange was purchased by
petitioners at a price lower than its OSP.
Nor was it uncommon
for petitioners' records to reflect special credit notes or
memoranda or adjustments in credit terms,'' freight terms, and
the like received by petitioners in exchange transactions, since
For example, in one transaction, the trading partner
insisted for its own reasons that its crude had to be invoiced at
its own OSP, and a "credit note" was used to balance out the
transaction based on the parties' understanding of the profit to
be earned from refining each crude. In another situation, a
telex from Exxon to an exchange partner during the period of the
1979 restriction provides that the 30 days additional credit
Exxon would receive in the negotiation would only partially
offset the effect of the low price of the Saudi crude while
Algerian was at the maximum official price. The telex goes on to
state that: "In evaluating the exchange this point was a
significant consideration and thus we would prefer to maintain 60
days credit on the Algerian".
This would appear to make it clear
that favorable credit terms commonly went into negotiation of the
differential. Other documents show similar adjustments of credit
periods in order to bring the values of the crudes being
exchanged into balance.
- 66 these forms of consideration reflected the differentials in
refined values between the crude given up and the crude received
in an exchange transaction.
The relative values of each crude to
each exchanging party were also affected by other factors,
including the volume ratios," the percentage of Arabian Light in
the total Saudi exchange pool at any one time, payment term
variations, transportation costs, and package exchanges."
Exxon guidelines had been devised for exchanges during the
period of the 1977 restriction.
These guidelines had provided
that there were three basic objectives for engaging in exchanges:
To correct grade imbalances, to reposition crudes geographically,
and to resolve timing problems.
With the 1977 two-tier pricing
system, Exxon guidelines indicated that Exxon should continue in
its historical types and volumes of exchanges, continuing to
" In exchanges, the number of barrels of Saudi crude that
Textrad disposed of often was different from the number of
barrels received, with the difference referred to as the
"exchange ratio" or the "volume ratio". This ratio is defined as
the number of barrels disposed of in an exchange transaction as
compared with the number of barrels received in the exchange.
The evidence indicates that, over the period 1973-1982, on
average, 1.36 barrels of Saudi crude were given up by Textrad for
1 barrel of non-Saudi crude. For the years at issue, on average
1.44 barrels of Saudi crude were given up for 1 barrel of nonSaudi crude.
Package exchanges were employed when Saudi oil was sold
with no offsetting exchange barrels received under that contract.
In some situations these barrels were sold outright by Textrad
and recorded as part of an existing exchange contract, rather
than as an outright purchase. There were a variety of legitimate
reasons for using this method of recording the sale. The
evidence does not indicate whether petitioners took part in such
transactions.
- 67 value them in terms of internal values, with reference to the
Saudi crude.price.
There was seen "no reason to view
continuation of these same practices as a contravention of Saudi
Arabian directives."
The 1977 Exxon guidelines were supplied to
Exxon affiliates.
Exxon's exchange practices under the 1977 guidelines were
discussed with the Saudis.
At a meeting between Exxon officials
and a Petromin representative on July 20, 1977, the Petromin
representative wanted to know why the SAG had been receiving
audit certificates in four different formats and covering
different aspects of the 1977 restriction and why the independent
auditors had not consulted with each other.
He also indicated
that he wanted to "take away with him" certain materials from
Exxon, including a copy of their interpretations of the 1977
restriction provided to affiliates, and that he had made the same
request of Texaco.
A similar meeting between Petromin and Texaco
officials apparently occurred on the same day, and one of the
questions raised by the Petromin representative was "how
exchanges had been handled".
The parties have directed the Court
to no evidence that the SAG objected to Exxon's or Texaco's 1977
exchange policies.
During 1979-81, Exxon updated its exchange guidelines to
govern its transactions involving Saudi crude oil during that
period in a manner very consistent with the earlier guidelines.
In setting out the guidelines for exchanges during the period of
- 68 the 1979 restriction, the corporate instructions were that "The
directives are essentially the same as those received from the
Saudi Arab Government during the two tier pricing environment of
1977."
Mr. Garvin again instructed the Exxon offtakers not to
make any arrangements that had not been made before the 1979
restriction.
Exxon's 1979 exchange guidelines provided that all
Saudi oil given up in an exchange was to be priced at the Saudi
OSP; that exchange volumes were to remain at historical volumes;
that exchanges usually were to be for quality, volume, timing or
location reasons; and that exchanges were preferably not to be
made with companies that were primarily traders (who would be
more likely to violate the restriction by reselling the Saudi oil
at higher prices on the spot market).
Exxon's exchange
guidelines also stated that corporate economics should be
improved by Exxon exchanges, and there was an Exxon policy issued
in September 1979 to obtain non-Saudi crude in an exchange at a
discount.
Exxon also continued the policy of permitting
exchanges where necessary to meet particular commitments.
Exxon
officials discussed with the SAG why exchanges were necessary and
that the Exxon offtakers would continue to engage in exchanges
during the period of the 1979 restriction.
The Exxon guidelines were followed during the years at
issue.
In almost every Exxon exchange transaction, there was a
business reason, a specific operational purpose, for the
exchange.
There was, in other words, a reason for every exchange
- 69 unrelated to a potential to capture the profit from the low cost
of the Saudi. crude.
In one apparently exceptional case, Exxon
engaged in an exchange for the express purpose of obtaining the
non-Saudi crude for resale to an unrelated party to meet a
contractual commitment.
The number of barrels of Saudi crude
exchanged out in the course of this transaction constituted less
than 1 percent of Exxon's total Saudi dispositions during the
period at issue.
Exxon's offtakers transferred 132 million
barrels of Saudi crude to unrelated customers as part of
exchanges.
In each of these transactions, Exxon invoiced the
Saudi crude at prices no higher than the prevailing official
selling prices set by the SAG (plus transportation and other
applicable costs associated with the movement of crude).
If non-
Saudi oil received by Exxon in an exchange was reflected in
Exxon's ledgers as being sold to a unrelated party at a profit,
that profit was reported for U.S. income tax purposes.
Exxon
told its purchasers about the restriction and monitored sales of
its Saudi oil to see if any Saudi oil that it sold or exchanged
was being resold in the spot market at higher prices.
Exxon was satisfied that its exchange practices did not
violate the 1979 restriction because it followed its historical
internal guidelines, which required that all Saudi oil be
invoiced at OSP, and because it kept its exchange levels at
- 70 historical volumes.''
For example, in September 1980, EIC did
not participate in an exchange of Saudi Light for Tapis crude
owned by a company called Petronas because of a concern that the
arrangement could yield a price in excess of Saudi OSP.
The idea
of a noninvoicing exchange was opposed by Esso Middle East
because Saudi crude was involved and because this mechanism had
not been "the historical means of doing business with the crudes
involved."
During 1977, Exxon's liftings of Arabian Light were almost
74 percent of total Saudi liftings.
As discussed earlier, in
February 1978, the SAG reduced to 65 percent of Saudi liftings
the amount of Arabian Light available to Exxon.
Thus, after this
time Exxon needed to obtain lighter grades of oil to satisfy the
requirements of its affiliates, and it accomplished this in part
through an increase in exchanges of the heavier grades of Saudi
oil for lighter grades of non-Saudi oil.
Exxon also had lost
significant sources of low sulfur ("sweeter") crudes by the
beginning of 1979.
The Iranian Revolution in late 1978 further
complicated Exxon's supply situation by cutting off a significant
production source at a time when demand was increasing.
Despite this need for increasing amounts of lighter and
sweeter grade crudes, the amount of Saudi crude given up by Exxon
One Exxon executive expressed concern to another in
September 1979 that exchanges in which Saudi crude was given up
were "risky" because they might damage Exxon's Saudi
relationship, but apparently this person's concerns were not
pursued.
in exchange transactions did not increase during the years at
issue compared to the preceding 2 years.
Over the 5-year period
1977-81 Exxon transferred Saudi crude oil to unrelated customers
as part of crude oil exchanges in the following amounts expressed
in millions of barrels:
Exxon's Saudi Crude Oil Exchange Transactions
Saudi Crude
Given Up
Saudi Crude
Received
Net Saudi Crude
Given Up
Year
MB
MB
MB
1977
1978
1979
1980
1981
46.9
77.5
56.3
41.3
34.8
12.4
7.8
7.6
7.3
13.4
34.5
69.7
48.7
34.0
21.4
The net amount of Saudi crude given up by Exxon in exchanges
expressed as a percentage of total Saudi crude dispositions
during these same years is as follows:
Year
Percentage
1977
1978
1979
1980
1981
4.2
9.2
6.1
4.5
3.0
Crude oil exchanges also were a longstanding business
practice of Texaco.
Textrad was responsible for balancing crude
oil and product supply and demand for the Texaco system by
engaging in international trading activities.
It was Textrad's
responsibility to review the requirements of the various
subsidiaries and affiliates, to arrange for transportation and
acquisition of crude oils to meet the system's requirements, to
- 72 buy products when needed to supplement the refining activities,
and to sell products when products were surplus to Texaco
requirements.
Approximately three-quarters of Textrad's crude sales and
exchanges over the period 1973 to 1982 involved Saudi crude.
As
discussed earlier, during the 1970s the Texaco system had become
"unbalanced" as a result of the Saudi trend toward high sulfur
"heavier" sources in supply," changes in the demand for refined
products, the losses of Iranian exports, and changes in product
specifications, particularly sulfur content.
In 1977 Textrad
estimated that its shortage of low sulfur crude was about 400,000
barrels per day.
Textrad needed Arabian Light purchased from the
SAG for its system requirements.
Accordingly, the largest
portion of Textrad's exchanges was quality exchanges.
Textrad's
exchange practices during the years immediately preceding the
years at issue involved efforts to exchange some of the heavier
grades of Saudi crude for the light, lower sulfur crudes needed
in the Texaco system.
By early 1979, Textrad tried to lighten
the overall quality of its crude supplies through outright
purchases of low-sulfur crude, outright sales of high-sulfur
crude, and exchanges of heavier (usually Saudi) crude for lighter
crude.
Textrad increased the percentage of Arab Medium and Heavy
to total Saudi crude disposed of by exchanges from an average of
" Lighter crude generally tends to be "sweet", or to
contain lower amounts of sulfur, although there are many
exceptions to this tendency.
- 73 20 percent over the period 1973 to 1978 to an average of 39
percent over the period at issue.
Textrad's general exchange policy instruction was to adhere
to the 1979 restriction by engaging in exchanges only in the
ordinary course of business.
Textrad's exchanges during the
years at issue were handled in much the same manner as they had
been handled during the 1977 restriction period, with careful
periodic review to ensure that the number of exchanges remained
consistent with historical levels and were generally for
operational system needs.
Textrad followed a procedure whereby
the numbers of exchanges were reviewed and examined to be sure
that they were for specific needs for particular refineries in
the Texaco system.
Occasionally, both before and during the
period at issue, non-Saudi crude received in exchanges also was
resold to unrelated purchasers.
Texaco officials discussed
Textrad's exchange policies with the SAG, and advised the Saudis
that Textrad intended to continue to engage in exchanges in the
ordinary course of business.
There is no evidence indicating
Saudi dissatisfaction with Textrad's exchange practices.
Pursuant to exchanges, Textrad disposed of 139,780,564,
105,034,926, and 100,382,961 barrels of Saudi crude oil, in the
aggregate," to unaffiliated entities in 1979, 1980, and 1981,
respectively.
In each invoiced exchange transaction during the
These amounts represent dispositions by exchanges of
Saudi crude oil acquired by Textrad from all sources, including
Saudi crude oil acquired other than via Aramco.
years 1979-81 in which Textrad disposed of Saudi crude oil, the
invoiced price of the Saudi crude oil specified in the contract
was the official selling price set by the SAG.
The non-Saudi
crude oil received by Textrad in exchange transactions was
invoiced at a price specified in the contract.
As with Exxon, in
negotiating the price of the crude received for purposes of an
exchange, Textrad determined the value of each crude in the
exchange based on the value of the products that could be refined
from those crudes.
Textrad's exchanges involving Saudi crude were essentially
consistent during the period 1979-81 with historical levels.
They constituted approximately 15 to 17 percent of Textrad's
total sales of Saudi crude over the period 1973 to 1982, and 17
percent over the period at issue.
The same consistency is
present with regard to non-Saudi crude received by Textrad in
exchanges and disposed of in outright sales to third parties
instead of to affiliates for operational purposes.
From 1973 to
1982, Textrad transferred to unrelated entities 7 percent of the
non-Saudi crude acquired in exchange for Saudi crude.
Over the
years 1979-81, Textrad resold to unrelated entities 8 percent of
such crude.
This constituted less than 1 percent of the amount
of Saudi crude disposed of by Textrad during the same period.
In
those situations where Textrad disposed of oil received in an
exchange, it sold the oil at its market price.
Although the 1979
restriction itself did not expressly address exchanges, Texaco
- 75 -
officials were satisfied, after discussions with the Saudis, that
Textrad's exchange practices did not violate the restriction.
As discussed, in Textrad exchanges the differentials between
the exchanged crudes were computed so as to represent the
differences between internal refined values.
In addition, in one
transaction a differential originally negotiated was adjusted to
reflect a particular change in circumstances.
In that
transaction an exchange differential of $3.75, originally
negotiated by Texaco with Koch Industries (Koch), later was
adjusted to $3.57.
However, it appears that Koch purchased from
Textrad an additional 320,000 barrels of Arab Heavy crude after
the original exchange transaction was negotiated.
The
differential adjustment may have been to account for a change in
the price of the Arabian Heavy crude during the period between
the original negotiation of the contract and the purchase of the
additional barrels.
There is some indication that Koch may have
resold the Saudi oil received from Textrad at a profit, but a
Koch official also was aware that petitioners were required to
sell the Saudi oil at OSP.
Internal Texaco documents indicate that various methods were
recognized by Textrad as being useful to adjust the differences
in official prices in order properly to reflect the refined
values in Textrad exchange transactions.
These documents contain
the following language:
As we have discussed, a significant pricing disparity
currently exists when comparing Saudi Arabian crude official
prices to official prices of crudes marketed by other
- 76 producing countries. In our exchange arrangement
negotiations, we have minimized this disparity through a
combination of approaches such as reducing exchange ratios,
reducing the percentage of Arabian Light in the total
Arabian exchange pool, payment term adjustments and
negotiating discounts from the official price of low sulfur
crudes acquired thereby directly reducing Texaco acquisition
costs.
This "disparity" language was repeated in subsequent Texaco
documents.
In a transaction with Gulf summarized in a typical
document containing the above language, the terms of the exchange
were described by a Texaco official as follows:
An advantage to Texaco under this arrangement will be
achieved through a combination of the following factors:
(1)
An Overall exchange ratio of 1 BBL Arabian crude
to 1 BBL of low sulfur crude. The Arabian crude
volume will consist of 65% Arabian Light.
(2)
A discount of $0.35 per barrel from the official
Cabinda and Zaire selling prices of $17.50 and
17.40 per barrel, respectively.
(3)
Gulf will deliver the Cabinda and Zaire crudes to
Texaco refining locations, and absorb the freight
costs associated therewith (about $1.00 per barrel
less the discount in (2) above).
(4)
Payment terms for all of the low sulfur crudes
will be 60 days compared to 30 days on the Arabian
crudes.
This transaction and the language quoted above were consistent
with the normal methods of invoicing exchange transactions, with
exchange ratios, discounts on non-Saudi oil received, freight
costs, and payment terms used to take into account the
differences in the relative internal values of the crudes
exchanged.
In addition, there were certain transactions in which some
of Textrad's exchange contracts had "overlift penalties."
Overlifts were quantities of crude lifted that were in excess of
the amount agreed upon in the exchange contract.
Overlift
penalties were contained in approximately 6 percent of Textrad's
exchange contracts during the years 1979-81.
These penalties
provided that, if excess Saudi oil were inadvertently lifted by
the purchaser of the Saudi oil in an exchange, the excess crude
would be priced at a level that contained a penalty over and
above Saudi OSP.
The penalties were included in contracts during
the period at issue because it was not possible for loading
equipment to lift exactly the precise amount of oil intended in
the exchange contract.
They were not necessary when there was no
multitier pricing system in effect, since the unified OPEC price
would then be used to price the barrels overlifted.
Without
these penalties, the exchanging partner obviously would have had
an incentive repeatedly to overlift and be charged the lower
Saudi OSP on a larger percentage of the exchange transaction,
which would have changed the economics of the exchange.
These
overlift penalties did not constitute prices in excess of Saudi
OSP but were necessary deterrents occasionally used by Textrad to
discourage overlifts.
There is no evidence of SAG
dissatisfaction with the overlift penalties used by Textrad in
these contracts.
- 78 -
Processing Agreements
In furtherance of its role of balancing system requirements,
Textrad as far back as the 1960s entered into processing
agreements with Texaco affiliates.
These processing agreements
allowed Texaco to concentrate international product trading in
Textrad, which is consistent with Textrad's charter.
In almost
all cases, the processing agreements were entered into to serve
the needs of the refining affiliates.
During the period January 1, 1977, through December 31,
1982, Textrad entered into processing agreements with five
affiliated refining entities, which used their excess refining
capacity for the processing of crude oil, some of which included
Saudi oil.
By means of these processing agreements, Textrad
retained title to the crude, paid a fee to the refining entity
that was consistent with fees paid by unrelated entities, and
sold the resulting products for their market value to affiliates
in almost all cases.
Textrad sold the products that had been
refined under these processing agreements to Texaco marketing
affiliates for marketing and distribution outside of the country
in which the processing refinery was located and to unaffiliated
entities.
Textrad realized the full value of the refined
products resulting from these processing agreements.
Any profits
earned by Textrad on sales of products refined from Saudi crude
pursuant to processing agreements with affiliates during the
- 79 years at issue were reported for U.S. income tax purposes.''
The
following crude amounts were delivered for Textrad's account
under processing agreements over the period 1977-82, expressed in
yearly averages of thousands of barrels per day:
Textrad Processing (Yearly Averages)
Year
Saudi
Non-Saudi
1977
1978
1979
1980
1981
1982
220
150
200
220
160
45
320
230
265
260
200
175
The following total barrels of crude were processed for Textrad
at refineries pursuant to processing agreements over the same
period:
Textrad Processing (Total Barrels)
Year
Total Barrels
1977
1978
1979
1980
1981
1982
6,505,255
8,315,384
12,878,616
5,662,980
6,657,871
2,585,642
Respondent alleges that Textrad realized over $598
million in "bargain purchase profits" (profits from refining
Saudi crude in excess of the profits that would have been
realized from refining other comparable crude) from these
processing agreements during the years at issue; petitioners
assert that the offtaker profits from the sale of products
produced pursuant to processing agreements (including the
refining profit) were $160 million less than that figure. The
parties did not present complete information pertaining to
profits (as instructed by the Court several times during trial);
thus a precise finding is not possible, nor is one necessary, as
we explain later in this opinion.
- 80 Over the period 1977-82, an average of approximately 233,000
barrels per day of Saudi and non-Saudi crude were processed for
Textrad.
Over the period 1979-81, an average of approximately
242,000 barrels per day of Saudi and non-Saudi crude were
processed for Textrad.
These volumes constituted less than 10
percent of the total crude moved by Textrad during each of these
periods.
Although there were fluctuations from year to year, the
overall volume of crude processed by Textrad pursuant to
processing agreements during the years at issue was consistent
with Textrad's historical practices, and Textrad's level of
processing of Saudi crude did not increase significantly during
the period at issue.
The Exxon offtakers did not engage in any processing
agreements with refining and marketing affiliates during the
years at issue, but they did supply Saudi crude to five Exxon
affiliates that participated in such agreements.
For example,
during the years at issue Exxon's offtakers sold more than 75,000
barrels of Saudi crude per day to Esso Eastern Products and
Trading Company (EEPTC), and this crude was processed at an
affiliated refinery.
EEPTC's processing agreement with the
refinery affiliate contained a negotiated processing fee, and the
agreement dated back to 1971.
The resulting products were sold
at market prices, earning profits for EEPTC.
Four other Exxon
affiliates that received Saudi crude from Exxon offtakers did not
have refining affiliates, and they participated in processing
- 81 -
agreements with other entities.
Two of these processing
agreements had been entered into several years prior to the years
at issue.
There is no evidence that these arrangements were out
of the ordinary course of business for these affiliates.
Nor is
there any evidence that the SAG objected to these processing
agreements or that they were in violation of the 1979
restriction.
Spot Market Purchases
It came to Exxon's attention during 1979 that a company by
the name of Ultramar, one of Exxon's crude customers under a
long-term contract, had been selling Saudi crude (purchased at
OSP from Exxon) on the spot market at prices in excess of Saudi
OSP.
Because it was experiencing severe shortages at that time,
in August of that year Exxon purchased at a price in excess of
Saudi OSP Saudi crude that it had sold to Ultramar at Saudi OSP.
This crude was then offered for resale by Exxon to an Exxon
affiliate at a price in excess of OSP.
This transaction was
approved by Exxon officials on the basis that it was "in effect
buying out of our commitment to sell the crude to Ultramar".
There may have been other isolated instances of such purchases of
Saudi crude by Exxon affiliates from the open market at prices in
excess of OSP, and these purchases were explained as being
necessary in the face of severe shortages.
There is no evidence
indicating the actual price at which this crude was sold, or any
Saudi objection to these purchases.
Exxon did not profit from
- 82 this Ultramar transaction or other similar purchases or otherwise
benefit from the shortage situation other than to obtain crude
that it needed for supply reasons.
Sales to Canadian Affiliates
Texaco maintained books and records in the ordinary course
of its business regarding all dispositions of Saudi and non-Saudi
crude oil by Textrad.
Prior to and during the years 1979-81,
Texaco maintained a ledger that reflected information regarding
each disposition of crude oil by Textrad, including, among other
things, the name of the purchaser, the contract reference, the
volume and type of crude, the sale date, the revenue from crude
dispositions, the cost of crude disposed of, and miscellaneous
adjustments.
Textrad's Crude Oil Sales Ledgers originally
supplied to respondent showed that in 1979 Textrad sold 5,831,255
barrels of Saudi crude to Texaco's Canadian affiliate at prices
in excess of Saudi OSP.
At trial, Texaco supplied the Court and
respondent with revised summaries of these ledgers, indicating
that the earlier figures were in error because they erroneously
had treated marine revenue (freight) as an element of crude
revenue, thereby making it appear that Textrad had charged the
affiliate a higher price than was actually charged.
Respondent's
counsel indicated at trial that, while he was willing to accept
the revised summary as an accurate summary of Textrad's records,
he would not agree that they contained accurate data.
Respondent's counsel was given an opportunity to verify the
- 83 accuracy of the revised summaries, and he did not thereafter
present any evidence that they were inaccurate.
Profits Earned by Petitioners From the Low Cost of Saudi Oil
There are two types of profits that have been discussed by
the parties as relevant to the issues before us, and these have
been referred to in the record as downstream and upstream
profits.
Downstream profits for purposes of this proceeding are
those profits which are earned by petitioners' processing
subsidiaries at least in part upon the sale of products produced
from crude oil.
The parties have stipulated that profits were
realized by one or more of petitioners' subsidiaries and that
such profits reflected the benefit of the below-market purchase
price of the oil from Saudi Arabia.
Petitioners have indicated a
willingness to make the admission that these profits earned by
their subsidiaries were substantial.
Some of the profits of
petitioners' processing affiliates were beyond the reach of U.S.
taxes.
Consequently, respondent in the notices of deficiency at
issue has allocated a portion of these profits to petitioners'
offtakers, which were U.S. taxable entities.
As discussed earlier, Minister Yamani had been quoted in the
press as saying that he did not believe that downstream profits
such as those involved here were within the scope of Saudi power
as far as the 1979 restriction was concerned.
Press reports
indicated that Minister Yamani had stated publicly in late March
1979 that in enforcing the 1979 restriction the SAG intended to
- 84 -
"follow the barrel of Saudi crude until it lands at a certain
refinery."
Press reports further indicated that Minister Yamani
had stated that the SAG had control over the price of its oil up
to the refinery, but that it could not interfere in sales of
refined products produced from Saudi oil even though they were
sold at a price which enabled one refiner to earn higher profits
than others.
The regulation of product prices, he had stated,
was up to the consuming country governments themselves.
In May
1980, Minister Yamani was quoted in a newspaper as stating that
the SAG decision to increase Saudi crude prices by $2 per barrel
was an attempt to take back some of the profits being realized by
the oil companies, since once the oil was delivered to the
refineries, it was beyond Saudi jurisdiction.
Thus, Minister
Yamani was believed to be of the opinion that petitioners'
downstream profits or earnings were not within the reach of Saudi
control by means of the 1979 restriction or otherwise.
There is
no indication in the record that_Minister Yamani objected to
these statements in the press.
Upstream profits are those profits which were earned up the
chain by petitioners' offtakers before the Saudi crude was
processed.
Profits earned by the offtakers from exchanges came
about when non-Saudi oil received in exchange for Saudi oil was
sold for its fair market value, which was higher than the
purchase price of the Saudi oil exchanged.
We have instructed
the parties that at the present time we are not interested in
- 85 -
precisely quantifying the profits earned by petitioners'
offtakers, except that they may be used by respondent to show
that they were so extensive that the 1979 restriction was
superficial.
92.
See Exxon Corp. v. Commissioner, T.C. Memo. 1992-
To the extent that any profit figures are referred to in
this opinion, they are for this purpose alone and are not
intended to be precise.
The Exxon and Texaco offtakers experienced significant
p:cofits during the years at issue as a consequence of the lower
Saudi price.
One aspect of these profits came about as a result
of processing agreements, which we have already discussed.''
Another portion of petitioners' offtakers' profits arose upon the
sale of non-Saudi crude received in exchanges.
Exxon's
approximate profits from these sales during the period 1977-81
are summarized in the following table:
Year
Profits
1977
1978
1979
1980
1981
$5,500,000
2,800,000
14,000,000
53,000,000
27,000,000
During the years immediately preceding and following the years
1979-81, Textrad experienced losses from sales of non-Saudi crude
received in its exchange transactions.
During the period 1979-
81, Textrad experienced profits in excess of $500 million from
'' See supra note 27.
- 86 the sale of non-Saudi crude received in exchanges.**
Total sales
of Saudi crude to affiliates resulted in losses to Textrad of
more than $2 million during the years 1979-81.
Although there is some indication in the record that
petitioners were concerned that the SAG might not be pleased with
the magnitude of petitioners' profits during the period of the
1979 restriction, there is no evidence that the SAG indicated to
anyone that such profits violated the restriction.
Moreover, the
Saudis apparently were aware of the publicity concerning these
profits.
The Saudi price moderation policies during the period
at issue did not keep crude oil or product prices from rising,
which led to considerable consumer outrage against both OPEC and
the oil companies.
Esso Middle East's President, Charles
Hedlund, sent to Minister Yamani in March and April 1979 two
letters acknowledging press reports about increased profits
earned by the major oil companies and explaining that these
increases were not a result of any violations of the
29 A Texaco in-house document indicates that in 1982 Texaco
estimated its after-tax earnings on Saudi crude to be in excess
of $700 million, excluding downstream earnings. We cannot
determine the basis for these figures, and therefore are more
inclined to rely upon the number admitted to by petitioners,
which is quite close to the figure presented by one of
respondent's experts.
- 87 -
restriction.*°
There is no evidence indicating that Minister
Yamani or any other representative of the SAG responded to these
letters or other reports about profits in any fashion which would
indicate a Saudi belief that these increased oil company profits
during the years 1979-81 violated the 1979 restriction.
Returns, Notices of Deficiency, Petitions
Texaco timely filed consolidated corporate income tax
returns on behalf of itself and the Texaco petitioners for the
taxable years ended December 31, 1979, 1980, 1981, and 1982, with
the Internal Revenue Service Center, Austin, Texas.
A notice of
deficiency for the years 1979, 1980, 1981, and 1982 was issued by
the District Director, Internal Revenue Service, Houston, Texas,
and was timely mailed to Texaco on July 21, 1989.
In the
July 21, 1989, Texaco notice of deficiency, respondent increased
the income of Textrad in the amounts of $402,974,246,
$982,635,616, and $382,457,742 for the years 1979, 1980, and
1981, respectively, stating that respondent was doing so "In
accordance with the provisions of Section 482, and/or Section 61
of the Internal Revenue Code, * * * in order to properly reflect
the substance of the transactions between Texaco International
Trader Inc. (Textrad)" and certain listed Texaco subsidiaries
*° Charles Hedlund's letter indicated that much of the
improvement in Exxon's earnings was due to unrelated factors,
such as the recovery of the dollar, increased sales of natural
gas and heating oil, increased.demand for chemical products,
increased Alaskan pipeline operation, and increased production in
new areas.
- 88 "and in order to prevent the evasion of tax and/or to clearly
reflect the.income of Textrad."**
This allocation from the
refinery to the offtaker level is based upon the theory that, as
articulated in respondent's trial memorandum, the offtakers "were
the entities in the controlled group that exercised the ultimate
direction and control over the earning of the ARAMCO Advantage
profits" and that the offtakers transferred the Saudi crude to
their foreign affiliates at artificially low prices so that the
profits obtained as a result of the lower Saudi price were earned
by entities outside the U.S. tax system.
Texaco timely filed a petition with this Court on
October 16, 1989, contesting the deficiencies in tax proposed by
the respondent for the taxable years 1979 through 1982,
asserting, inter alia, that respondent's determinations were
erroneous because
(i) Texaco and its affiliated and related companies were
subject to pricing restrictions which prevented them from
having the power or control necessary to establish or
determine the transfer prices of the Saudi Arabian crude
oil; (ii) Textrad sold the Saudi Arabian crude oil at arm'slength prices; and (iii) Textrad did not earn the income
attributed to it by the Commissioner.
Exxon timely filed consolidated corporate income tax returns
for the affiliated group's taxable years ended 1979, 1980, 1981,
®' As an alternative adjustment in the same paragraph of the
notice of deficiency, respondent also stated that "in
transactions with Caltex Trading and Transport Corporation
(CTTC), Texaco International Trader Inc. (Textrad) failed to
charge arms-length prices and/or fair market values". Alternate
adjustments pursuant to this theory were also made to Textrad's
income.
- 89 and 1982 with the Internal Revenue Service Center in New York,
New York.
A notice of deficiency for the year 1979, dated
June 29, 1989, was issued by the District Director, Internal
Revenue Service, New York, New York, and was timely mailed to
Exxon.
In the June 29, 1989, notice of deficiency, respondent
increased the 1979 income of Exxon's offtaker MEDSTAN by
$30,363,146 and increased the 1979 income of Exxon's offtaker
EITCO in the amount of $1,118,439,323, under the authority of
sections 61 and 482, stating that respondent was doing so "to
clearly reflect the income of the entities due to the Aramco
Price Advantage".
A notice of deficiency for the years 1980,
1981, and 1982 dated July 16, 1990, was issued by the District
Director, Internal Revenue Service, Houston, Texas, and was
timely mailed.
Also under the authority of sections 61 and 482,
in the July 16, 1990, notice of deficiency, respondent increased
the income of EITCO in the amounts of $2,435,730,020 and
$876,421,474 for the years 1980 and 1981, respectively, and
increased the income of Exxon's offtaker EISAI in the amount of
$2,465,661 for the year 1981.
Exxon filed timely petitions with the U.S. Tax Court on July
26, 1989, with respect to the 1979 tax year, and on August 16,
1990 with respect to the 1980, 1981, and 1982 tax years.
In both
petitions, Exxon stated that respondent's "Aramco" adjustments
under sections 61 and 482 were in error because
the Saudi Arabian government required Exxon and Exxon's
affiliated and related companies to sell Saudi Arabian crude
oil[s] to related and unrelated third parties at the
- 90 Official Selling Price[s] ("OSP['s]") established by the
Saudi Arabian Government. Exxon's and its affiliated and
related companies' transactions were in compliance with
these restrictions and were not undertaken for the evasion
of taxes.
A trial was commenced on April 1, 1991, on the limited
questions raised in the petitions of whether the 1979 restriction
existed and was complied with, and, if so, whether the 1979
restriction precludes respondent from allocating the income in
question to petitioners' offtakers.
After receipt of more than
30 boxes of exhibits, 3,854 pages of transcript, and 1,399
stipulations of fact, the trial was adjourned on May 3, 1991.
On
February 13, 1992, this Court issued an opinion on various
evidentiary matters raised on cross-motions by the parties.
Briefs were filed by the parties thereafter, on March 16, May 15,
and June 25, 1992, concerning the issues addressed in this
opinion.
OPINION
There are many factual disagreements involved at this phase
of the proceeding, as well as disagreements concerning the scope
of the issues to be tried at the present time.
The Court
determined, however, that the scope of the instant "Aramco
Advantage" trial was to be limited to the questions enumerated in
our Order of January 7, 1991, quoted earlier.
In section 482
proceedings taxpayers bear the burden of proving that the
Commissioner's section 482 allocations are arbitrary, capricious,
or unreasonable.
Sundstrand Corp. v. Commissioner, 96 T.C. 226,
- 91 -
353 (1991); Bausch & Lomb, Inc. v. Commissioner, 92 T.C. 525, 582
(1989), affd. 933 F.2d 1084 (2d Cir. 1991).
In this phase of the
proceeding, petitioners' burden involves essentially three
questions:
(1)
Whether the rule of Commissioner v. First
Security Bank, 405 U.S. 394 (1972), its assignment of income
predecessors, and its progeny is appropriately applied to the
instant cases; (2) if so, whether the 1979 restriction prohibited
the sale of Saudi crude for an amount in excess of the Saudi OSP;
and, (3) if so, whether petitioners complied with the 1979
restriction.
For the reasons discussed later in this opinion,
this case is controlled by our holding in Procter & Gamble Co. v.
Commissioner, 95 T.C. 323 (1990), and by the Court of Appeals
opinion affirming our holding, 961 F.2d 1255 (6th Cir. 1992).
I.
Law To Be Applied
We begin by discussing the law that is to be applied to the
questions before us.
With respect to respondent's allocation
under section 482, petitioners contend that the legal principle
espoused in the Supreme Court case of Commissioner v. First
Security Bank, supra, and the cases that follow it, applies to
the facts at issue herein.
Specifically, petitioners urge us to
conclude that the 1979 restriction prohibited the sale of Saudi
crude for an amount in excess of Saudi OSP and, consequently,
that respondent's reallocation of income under section 482 from
the affiliates to the offtakers is inappropriate.
Respondent
argues both that the legal principle of First Security should
- 92 not, as a policy matter, be applied in this context and also that
the facts of this case do not fall within its scope.
We first
discuss respondent's legal argument.
Respondent's regulations provide that the purpose of section
482-is to place a controlled taxpayer on a tax parity with an
uncontrolled taxpayer, by determining, according to the
standard of an uncontrolled taxpayer, the true taxable
income from the property and business of a controlled
taxpayer. The interests controlling a group of controlled
taxpayers are assumed to have complete power to cause each
controlled taxpayer so to conduct its affairs that its
transactions and accounting records truly reflect the
taxable income from the property and business of each of the
controlled taxpayers. * * *
The standard to be applied in
every case is that of an uncontrolled taxpayer dealing at
arm's length with another uncontrolled taxpayer.
Sec. 1.482-1(b), Income Tax Regs.
In a case under the
predecessor to section 482, this Court stated that the
Commissioner has "no authority to attribute to * * * [taxpayers]
income which they could not have received."
L.E. Shunk Latex
Prods., Inc. v. Commissioner, 18 T.C. 940, 961 (1952).
In that
case manufacturers of.prophylactics sold their products to a
distributor that was held under common control with the
manufacturers.
The distributor raised the prices of its products
(earning substantial profits therefrom) but the manufacturers did
not; we recognized that, if there had been no ties of common
control between them, it was reasonable to believe that the
manufacturers would have raised their prices to the distributor.
Id. at 958.
When World War II broke out, the U.S. Government
retroactively prohibited the manufacturers but not the
- 93 distributors from instituting price increases.
Id. at 959.
We
held that, because of this prohibition, an allocation by the
Commissioner of profits from the distributor to the manufacturers
under the predecessor to section 482 was improper, stating:
There is no basis in the record for believing that * * *
[the manufacturers] would have raised their prices to * * *
[the distributor] in the absence of these regulations, and
we can only infer that the respective prices of the
controlled entities, in relation to each other, would not
have been any different even if the price regulations had
never come into being. To say, therefore, that because of
the price regulations an improper shift of income is to be
insulated from the corrective provisions of the statute [the
predecessor to section 482], is to permit * * * [the
manufacturers] to enjoy an unexpected piece of good fortune
in reduction of their taxes. But we can see no logical
basis on which * * * [the manufacturers] can be denied this
windfall, in view of the uncontroverted effect of those
regulations in prohibiting * * * [the manufacturers] from
receiving the very income sought to be attributed to them.
We think that the Commissioner had no authority to attribute
to * * * [the manufacturers) income which they could not
have received.
Id. at 960-961 (emphasis added).
Subsequently, the Supreme Court addressed a very similar
issue.
In Commissioner v. First Security Bank, suora, certain
affiliated banks referred their customers to an independent
insurance company for purposes of obtaining credit life
insurance.
Credit life insurance policies were written by the
independent insurance company, which then reinsured the policies
with an affiliate of the banks pursuant to a "treaty of
reinsurance".
The independent insurance company retained 15
percent of the premiums for providing actuarial and accounting
services, and the affiliated insurance company retained 85
- 94 -
percent of the premiums for assuming the risk under the policies.
No sales commissions or referral fees were paid to the affiliated
banks.
These banks could not legally receive such commissions
pursuant to a Federal law which prohibited banks from acting as
insurance agents in locations with a population in excess of
5,000 inhabitants.
During the years at issue, 85 percent of the
premiums paid by the customers were reported by the affiliated
life insurance company on its tax returns.
The Commissioner
allocated 40 percent of the affiliated life insurance company's
net premium income to the banks as compensation for originating
and processing the credit life insurance.
The Tax Court upheld
the Commissioner's allocation,** but the Court of Appeals for the
Tenth Circuit reversed.**
The Supreme Court affirmed the Court
of Appeals on the ground that, since the banks could not legally
receive the commissions under Federal law, the Commissioner could
not reallocate them to the banks.
The Court stated that it had
never found a taxpayer to have income "that he did not receive
and that he was prohibited from receiving" and premised this on
** First Security Bank v. Commissioner, T.C. Memo. 1967-256.
This result was based on the decisions in Local Finance Corp. v.
Commissioner, 48 T.C. 773 (1967), affd. 407 F.2d 629 (7th Cir.
1969), which were held to have been "erroneously decided" by the
Supreme Court in Commissioner v. First Security Bank, 405 U.S.
394, 406 n.22 (1972).
** First Security Bank v. Commissioner, 436 F.2d 1192 (10th
Cir. 1971). The Court of Appeals held the Commissioner's sec.
482 allocations to be arbitrary because the banks at issue had
not received, and in all probability never could receive, the
income in question. Id. at 1198.
- 95 the underlying assumption that, "in order to be taxed for income,
a taxpayer must have complete dominion over it."
First Security Bank, 405 U.S. at 403.
Commissioner v.
The Court further observed
that one of the Commissioner's regulations under section 482 also
recognized the concept that "income implies dominion or control"
by providing:
"The interests controlling a group of controlled taxpayers
are assumed to have complete power to cause each controlled
taxpayer so to conduct its affairs that its transactions and
accounting records truly reflect the taxable income from the
property and business of each of the controlled taxpayers."
Id. at 404 (emphasis added) (quoting
Tax Regs.).
sec. 1.482-1(b)(1), Income
The Court concluded therefrom that the parent
holding company
must have 'complete power' to shift income among its
subsidiaries. It is only where this power exists, and has
been exercised in such a way that the 'true taxable income'
of a subsidiary has been understated, that the Commissioner
is authorized to reallocate under § 482. But Holding
Company had no such power unless it acted in violation of
federal banking laws. The 'complete power' referred to in
the regulations hardly includes the power to force a
subsidiary to violate the law."4
Id. at 404-405.
Thus, the Supreme Court has indicated that,
where the receipt of income is prohibited by law, the
We note here that respondent contends that the "power" at
issue also constituted the power of the offtakers to earn
profits, which in this case, respondent contends, was not
affected by the 1979 restriction. This argument incorrectly
states the function of sec. 482. The power at issue here is the
power artificially to move profits from one entity to another
affiliated entity. Commissioner v. First Security Bank, suora at
404. Thus, the earning of profits by the offtakers is not
relevant to the issue of power, although it may be relevant to
whether the restriction was complied with, as we discuss later in
this opinion.
- 96 Commissioner is prohibited from allocating such income pursuant
to section 482.
The most recent pronouncement in this area came from the
case of Procter & Gamble Co. v. Commissioner, 95 T.C. 323 (1990),
affd. 961 F.2d 1255 (6th Cir. 1992).
In Procter & Gamble, this
Court took the holding of First Security and applied it in the
context of a foreign--as opposed to a domestic Federal or State--
law.
In that case, Procter & Gamble A.G. (AG) was engaged in
marketing the consumer and industrial products of the Procter &
Gamble Co. (P & G) in certain countries where P & G did not have
a marketing subsidiary or affiliate.
AG was a Swiss corporation
and at all relevant times was a wholly owned subsidiary of P & G.
During the years at issue, AG and P & G were parties to a License
and Services Agreement under which AG paid royalties to P & G for
use of P & G's patents, trademarks, knowledge, research, and
marketing and distribution assistance.
In early 1968, P & G
received approval from the Spanish Government to operate a 100-
percent-owned company, Espana.
The approval letter expressly
provided, however, that Espana could not pay any amounts for
royalties or technical assistance.
It was then determined that
AG would own Espana, rather than P & G.
On its tax return AG did
not report any royalty income from Espana.
Pursuant to section
482, the Commissioner allocated to AG a royalty of 2 percent of
Espana's net sales for the years at issue, which in turn
increased P & G's subpart F income.
P & G argued under First
- 97 Security that, because Spanish law prohibited royalty payments
from Espana to AG, section 482 did not apply.
In holding for the
taxpayer, we stated our understanding of the law to be that
"section 482 simply does not apply where restrictions imposed by
law, and not the actions of the controlling interest, serve to
distort income among the controlled group."
v. Commissioner, supra at 336.
Procter & Gamble Co.
Finding that Spanish law
prohibited the royalty payments at issue, thereby depriving P & G
of the requisite power to shift income among its subsidiaries, we
concluded that the Commissioner's allocation under section 482
was inappropriate.
In a motion for reconsideration in Procter & Gamble, on the
issue of the materiality of foreign law, the Commissioner cited
United States v. Goodyear Tire & Rubber Co., 493 U.S. 132, 145
(1989), for the proposition that "tax provisions should generally
be read to incorporate domestic tax concepts absent a clear
congressional expression that foreign concepts control."
In
denying the Commissioner's motion, we indicated that our earlier
ruling was premised upon the important domestic tax concept, as
espoused by the Supreme Court in First Security, that a section
482 allocation cannot be made when receipt of the income at issue
is prohibited by law.
We saw no sound basis for refusing to
apply this principle where receipt of the income in question was
precluded by foreign as opposed to domestic law.
Gamble Co. v. Commissioner, T.C. Memo. 1990-638.
Procter &
'
- 98 On appeal, the Court of Appeals for the Sixth Circuit
affirmed, agreeing with the Tax Court that there is no reason not
to apply the First Security analysis in the context of a foreign
law.
Procter & Gamble Co. v. Commissioner, 961 F.2d 1255 (6th
Cir. 1992).
The Court of Appeals noted that, in order for the
Commissioner to have authority to make a section 482 allocation,
the Commissioner's regulations and the Supreme Court in First
Security had focused on whether the controlling interests used
their control to distort income.
Id. at 1258-1259.
There was no
reason, they indicated, to alter this analysis because foreign
law was involved.
Id. at 1259.
In applying this analysis, the
Court of Appeals noted that there was no evidence that P & G or
AG used its control over Espana to manipulate or shift income.
To the contrary, the Court stated that "Because Spanish law
prohibited royalty payments, P & G could not exercise the control
that section 482 contemplates, and allocation under section 482
is inappropriate."
Id.
Respondent attempts to distinguish Procter & Gamble from the
facts of this case or otherwise convince the Court not to follow
it here by means of several arguments.
Respondent first attempts
to distinguish the two cases by citing the existence of a statute
in Procter & Gamble, the Spanish Law of Monetary Crimes, which
could have exposed the parent and the subsidiary to criminal
prosecution, whereas in the case before us there was no enabling
legislation, operative statute, or other formal statutory
- 99 provision under which the restriction was issued and under which
criminal penalties could have been imposed.
This, however, is
merely a formal rather than a substantive distinction.
If we
find that, under the Saudi legal system, the 1979 restriction was
the virtual equivalent of law notwithstanding the absence of a
specific statute authorizing its promulgation, the Procter &
Gamble requirement will have been satisfied.
In Procter &
Gamble, in response to the Commissioner's argument that the
approval letters did not constitute adequate "law" or
"legislation" for application of the First Security holding, we
stated as follows:
In light of the consistency with which the royalty
prohibition was applied, there is no need to identify a
specific constitutional or statutory provision codifying the
prohibition in order to treat the prohibition as law. See
U.S. Padding Corp. v. Commissioner, 88 T.C. 177, 187-188
(1987), affd. 865 F.2d 750 (6th Cir. 1989) * * *.
Procter & Gamble Co. v. Commissioner, 95 T.C. at 337.
In our
opinion in U.S. Padding Corp. v. Commissioner, 88 T.C. 177
(1987), we made a similar judgment on the relevance of informal
general practice in contrast to formally codified law.
There we
were presented with the question of whether a Canadian
corporation was eligible to file a consolidated return with a
U.S. company under section 1504(d).
Under that subsection,
consolidated returns with foreign corporations were permitted
where the foreign corporation was a subsidiary organized and
maintained solely for the purpose of complying with foreign law.
U.S. Padding Corp. organized a Canadian corporation in order to
- 100 expedite the receipt of approval from the relevant Canadian
agency for the Canadian company to do business.
It was thought
by members of the Canadian bar at the time that, although there
was no statutory or regulatory requirement that a business
incorporate in order to do business in Canada, the agency was
more likely to recommend approval if the enterprise was
incorporated.
Id. at 180-181.
Canadian counsel's advice to
incorporate was merely "in line with the general practice at that
time."
Id. at 180.
Finding no legislative history indicating
that the "foreign law" referred to in subsection 1504(d) had to
be limited to a statutory or constitutional provision as
contended by the Commissioner, we interpreted it to include "any
existing practice or policy" of the foreign government.
187-188.
Id. at
Later in this opinion we discuss the consistency with
which the 1979 restriction was or was not applied as well as its
mandatory nature.
As with our holding in U.S. Padding Corp., we
see no reason here not to acknowledge the restriction solely
because it was not a formally issued law.
As petitioners
correctly point out in their brief, the proper focus of this
Court should not be upon the semantic question of whether the
restriction constituted a "law", but upon whether petitioners had
sufficient power or control to warrant a section 482 allocation.
Commissioner v. First Security Bank, 405 U.S. 394, 405-406
(1972).
Therefore, if the evidence shows that the Saudi system
constituted a system whereby petitioners lacked such control
- 101 because they were required by the Saudi Government to comply with
Saudi requirements or suffer the dire consequences of reduced
supplies or worse, then the holding of Procter & Gamble is
appropriately applied in this case.
Respondent makes the additional argument that, because the
requirement at issue here was mandated by a foreign government,
we should refuse to apply the rule of Procter & Gamble to the
facts of this case.
Petitioners state that it is irrelevant
whether the restriction is imposed by the U.S. Government or some
other government.
They cite in support thereof Salyersville
Natl. Bank v. United States, 613 F.2d 650, 655-656 (6th Cir.
1980) (involving a Kentucky law barring the taxpayer's receipt of
credit life insurance commissions); Bank of Winnfield & Trust Co.
v. United States, 540 F. Supp. 219, 220-221 (W.D. La. 1982) (same
under Louisiana law), and the Supreme Court's holding in
Commissioner v. First Security Bank, 405 U.S. at 406 n.22, that
Local Finance Corp. v. Commissioner, 407 F.2d 629, 633 (7th Cir.
1969), was erroneously decided.
These cases stand for the
proposition, discussed above, that "in order to be taxed for
income, a taxpayer must have complete dominion over it."
Commissioner v. First Security Bank, suora at 403.
They do not
involve the application of the doctrine to situations involving
foreign law, and there are no cases other than Procter & Gamble
that do.
However, we see no reason not to follow Procter &
Gamble here unless respondent provides us with cogent reasons to
- 102 -
conclude that Procter & Gamble was wrongly decided.
attempts to do so by means of three arguments:
Respondent
The legislative
history of section 482, the difficulty of applying foreign law,
and the policy argument that foreign governments should not
dictate U.S. tax policy.
Respondent first contends that the predecessors to sections
482 and 1504(d) were enacted.at the same time, and that section
1504(d) has a specific reference to foreign law, whereas section
482 does not.
From this respondent infers that Congress did not
intend for foreign law to affect proposed allocations under
section 482.
Other than a reference by respondent to Senate
testimony in connection with section 1504(d) expressing concerns
about U.S. tax officials having to become experts in foreign law,
there is no evidence that would indicate that Congress directly
considered the question and intended to preclude a foreign law
from affecting proposed reallocations under section 482.
We
therefore see no foundation for respondent's argument.
Respondent further argues that the rule set forth in First
Security should not be applied to the situation before us because
of the difficulty in determining foreign law.
Citing concerns
about the subjective manner in which the determination of foreign
law is made, as well as "historical judicial standards of
reliability and trustworthiness", respondent argues that domestic
and foreign law should not be treated as "of equal stature".
agree in part with respondent's argument.
We
The Court of Appeals
- 103 in Procter & Gamble indicated that, particularly in light of the
possibility that the taxpayer might be responsible for the
restriction on payment, a "heightened scrutiny" of the evidence
might be required.
F.2d at 1259.
Procter & Gamble Co. v. Commissioner, 961
We will continue to take great pains to analyze
the evidence of the 1979 restriction in this case carefully
before relying upon it.
However, this does not mean, as
respondent would have us believe, that the restriction at issue
here is an "inappropriate barrier to respondent's allocation"
under section 482.
Respondent also contends that foreign governments should not
be permitted to dictate U.S. law.
We remind respondent, however,
that the Supreme Court in First Security concluded that, if a
taxpayer is prohibited by law from allo
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