Petition for Writ of Certiorari — Boeing Co. v. United States

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\ Supreme Court, U.S.

FILED

01120 9 FEB 15 2002

No. OFFICE OF THE CLERK

In the Supreme Court of the Gnited States

THE BOEING COMPANY AND CONSOLIDATED SUBSIDIARIES,

Petitioners,

Vv.

UNITED STATES OF AMERICA,

Respondent.

On Petition for a Writ of Certiorari to the

United States Court of Appeals for the Ninth Circuit

PETITION FOR A WRIT OF CERTIORARI

JOEL V. WILLIAMSON KENNETH S. GELLER*

WAYNE S. KAPLAN CHARLES ROTHFELD

ROGER J. JONES BRITTON B. GUERRINA

MARJORIE M. MARGOLIES Mayer, Brown, Rowe & Maw

Mayer, Brown, Rowe & Maw 1909 K Street, N.W.

190 South LaSalle Street Washington, D.C. 20006

Chicago, Illinois 60603 (202) 263-3000

(312) 701-7229

* Counsel of Record

Counsel for Petitioners

QUESTION PRESENTED

Whether the Ninth Circuit, in direct conflict with the Eighth

Circuit, correctly concluded that Treas. Reg. § 1.861-8(e)(3),

which governs the allocation of research and development costs

between foreign and domestic income, may be applied to the

computation of taxable income for export subsidiaries entitled

to special tax treatment under the Internal Revenue Code.

(I)

RULES 14.1 AND 29.6 STATEMENT

The parties to this proceeding are The Boeing Company and

Consolidated Subsidiaries and Boeing Sales Corporation.

Boeing Sales Corporation is a wholly-owned subsidiary of The

Boeing Company. No publicly held company owns 10% or

more of The Boeing Company’s stock.

TABLE OF CONTENTS

Page

QUESTION PRESENTED .............0000000eeee: I

RULES 14.1 AND 29.6 STATEMENT ..............-. ii

TABLE OF AUTHORITIES .................-0000: iv

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STATUTORY AND REGULATORY PROVISIONS

SE bivbddois Seddbecdeeseeetise totes. 1

Ne canes 1

REASONS FOR GRANTING THE PETITION ........ 13

A. There Is An Express Conflict In The Circuits

On Whether Treas. Reg. § 1.861-8(e)(3) May

Be Applied To The Computation Of CTI ....... 13

B. The Decision Below Is Wrong ...........,.... 16

C. The Issue Presented Here Is A Recurring One

Of Great Practical Importance ............... 23

PE ebchbdGcdbasceeteeseoddecccceoccess 28

TABLE OF AUTHORITIES

Page(s)

CASES

5 MF 2d 1040 (CC cL we LN Tor! 2

St. Jude Medical, Inc. v. Commissioner

Internal Revenue, 34 F.3d 1394 (8th Cir. 1994) . passim

Turnbow v. Commissioner, 368 U.S. 337 (1961) ....... 16

STATUTES AND REGULATIONS

Internal Revenue Code, Title 26, U.S.C.:

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EE 66n6460¥eredsensedenecevecesecensanl 5

PP OhbbodeccetdeedsdeSes sl ficdenksseetecs 5

ee yO ED occcnnceccesé «tb ceseusedee 21, 26

SP ED Sbcéccscéennsaccaeeaseeee 21, 26

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PET 40 cc cccananaenenesensnnsonnin’ passim

PPE ceccccesstccsveccdadeoedaneeesdeaees 3

PP GED wendescesecnsindbeceadaveetsibess |

Deficit Reductior Ac: of 1984, § \ ocean

Pub. L. No. 98-369, 98 Stat. 494.000... 2.00... e 3

41 Fed. Reg. 49,161 (Nov. 8, 1976)... ... 2.6... 6c eae. 18

Treas. Reg. (26 C-F.R.) § 1.861-8 ............... passim

TABLE OF AUTHORITIES — Continued

Page(s)

Treas. Reg. (26 C.F.R.) § 1.861-8 (1957) .............. 5

Treas. Reg. (26 C.F.R.) § 1.861-17 2.2.2.0... 0. ccc uuee 7

Treas. Reg. (26 C.F.R.) § 1.994-1 ...........055. passim

Prop. Treas. Reg. § 1.861-8 (1973) ............00005. 19

MISCELLANEOUS

Hi on Trade Relations with Europe

the New Transatlantic Economic Partnership

Comm. on Ways and Means, 105th Cong. (1998) .. 2, 25

H.R. Rep. No. 533, 92d Cong., Ist Sess. (1971) .... passim

Cynthia Belmonte, F. fo

1996, STATISTICS OF

Spina 2h pubabed byte inter Res 24

ion of Tax

Committee Prat 107th ayy ea 25, 26

Office of and

Sa tere es Pao,

Table 32-4, Tax by Function

for Fiscal Years 1999-2005, February 7,2000....... 24

Joint Committee on Taxation, Estimates of

Federal ee rien

2002-2006, JCS-1-02, January 17,2002 ........... 24

TABLE OF AUTHORITIES — Continued

Page(s)

S. Rep. No. 437, 92d Cong., Ist Sess. (1971) .......... 21

Technical Memorandum

§ 1.861-8, 1974 TM Lexis 30 (cte29. 19 isa shoe 19

WTO Report of the llate Body on

of the Communities

Foreign Sales Coneations” Dat Ren ie

Executives, No. 10, at L-1 Gan 15. 15,2 2),

available at <www.wto.org/english/tratop_e/

dispu_e/distabase_wto_members4_3.htm>.......... 26, 27

PETITION FOR A WRIT OF CERTIORARI

OPINIONS BELOW

The opinion of the court of appeals (App., infra,la-14a) is

reported at 258 F.3d 958. The opinion of the district court

(App., infra, 15a-24a) is unreported.

JURISDICTION

The judgment of the court of appeals was entered on August

2, 2001, and a timely petition for rehearing was denied on

November 19, 2001 (App., infra, 25a). The jurisdiction of this

Court is invoked under 28 U.S.C. § 1254(1).

STATUTORY AND REGULATORY

PROVISIONS INVOLVED

The relevant provisions of 26 U.S.C. § 994, 26 U.S.C.

§ 861, 26 C.F.R. § 1.994-1, and 26 C.FR. § 1.861-8 are

reprinted in the appendix to this petition at 26a-53a.

STATEMENT

This case concerns successive sets of tax provisions enacted

by Congress to encourage exports by partially deferring or

exempting taxation of income from export sales. Two

principles control the measurement of the export income

eligible for this special tax treatment. First, expenses are to be

deducted from the export sales income to which those expenses

are factually related, rather than from other gross income to

which the expenses are not factually related. Second, to

maximize tax benefits and thus to enhance the export

incentives, taxpayers are permitted to group their income and

expenses by recognized industry product line classifications.

The decision below departs from both of these principles.

Under the rule announced by the Ninth Circuit, taxpayers are

required to allocate or apportion research and development

(“R&D”) expenses according to broad groupings rather than

product lines, and they must do so in ways that result in

substantial R&D costs being deducted from income to which

the R&D is not factually related. In this case, the court of

appeals’ holding resulted in the reallocation of some $2 billion

of petitioner Boeing’s R&D costs, thereby increasing Boeing’s

tax liability by more than $400 million. This decision frustrates

the Nation’s trade policy by diluting a significant economic

stimulus measure; it also expressly conflicts with a decision of

another court of appeals and therefore leaves companies

uncertain of the tax benefits they may obtain by expanding their

export activities. Further review is plainly warranted.

1. In 1971, Congress enacted a set of provisions that were

desigr~‘ “to provide tax incentives for U.S. firms to increase

their exports,” a program that was thought important both for

its “stimulative effect” and “to remove a * * * disadvantage of

U.S. companies engaged in export activities.” H.R. Rep. No.

533, 92d Cong., Ist Sess. 58 (1971). See Caterpillar Tractor

Co. v. United States, 589 F.2d 1040, 1044 (Ct. Cl. 1978). The

“provisions were designed to neutralize some of the tax

advantages for [European] exporters inherent in European

territorial-type tax systems, which generally exempt all income

earned outside the country from income tax and all exports

from value-added and other consumption taxes.” Hearings on

Trade Relations with Europe and the New Transatlantic

Economic Partnership Before the Subcomm. on Trade of the

House Comm. on Ways and Means, 105th Cong., at 116 (1998)

(statement of Jeremy O. Preiss, Chief International Trade

Counsel, United Technologies Corporation).

Under the U.S. program, corporations were permitted to

create special subsidiaries known as “Domestic International

Sales Corporations” (“DISCs”’). Income from export sales made

- through DISCs received partial tax deferral. IRC §§ 991-997.'

' In particular, a parent corporation could assign a portion of its

otherwise taxable export income to its DISC subsidiary. The parent

then was taxed only on the income it retained and a specified portion

As aconsequence, “[t}he greater the DISC profit, the larger the

amount of tax-deferred income * * * . Thus, a [corporation

creating a DISC] had an incentive to maximize DISC profit.” St.

Jude Medical, Inc. vy. Commissioner of Internal Revenue, 34

F.3d 1394, 1397 (8th Cir. 1994) (emphasis added).

In 1984, the DISC regime was replaced by one making use

of Foreign Sales Corporation (“FSC’”’) subsidiaries. See Deficit

Reduction Act of 1984, §§ 801-805, Pub. L. No. 98-369, 98

Stat. 494. After the FSC regime, like the DISC regime, was

declared to violate global trade rules, Congress responded by

enacting the Extraterritorial Income Exclusion Act of 2000

(“ETI”). Each of the three regimes differs slightly from its

predecessor, but none of the differences is relevant to the issues

presented in this case. In each regime the mechanics of

determining tax-favored income are substantially identical; in

particular, each regime provides for grouping of income and

deductions by product or product line.’

Under each of the three regimes, it is crucial to determine

the income that is attributable to export sales and therefore

qualifies for favorable tax treatment. The DISC statute

“permitted a taxpayer to use one of three methods for

determining the amount of deemed profit allocated to the DISC

and its parent as a result of export sales. The taxpayer/parent

of the DISC’s income. Tax was deferred on the DISC’s remaining

income either until it was distributed to the parent corporation or until

the DISC ceased to meet statutory requirements (see IRC § 995(a),

(b)). In 1984, Congress granted complete exemption from taxation to

all DISC income that had not yet been taxed at that time. See Deficit

Reduction Act of 1984, § 805(b)(2), Pub. L. No. 98-369, 98 Stat. 494.

? The years at issue in this case involve the DISC and FSC

provisions. Because the parties have agreed that there are no

differences between DISC and FSC relevant to this case, for purposes

of clarity we limit our discussion to DISC and refer to the Internal

Revenue Code (26 U.S.C.) as in effect in_1979, unless otherwise

indicated. The court below did this as well. See App., infra, 6a n.3.

could choose the method resulting in the greatest amount of

profit [for the DISC].” St. Jude Medical, 34 F.3d at 1397. See

IRC § 994; H.R. Rep. No. 533, supra, at 59 (“special pricing

rules in the bill permit a DISC to earn a larger relative amount

of the profit on sale: by the DISC of its parent company’s

export products”). One of these methods, which was used by

petitioner Boeing in this case, is known as the “combined

taxable income” (or “CTT’) method. IRC § 994(a)(2).

The DISC statute provides generally that, under the CTI

method, a DISC is allocated a set portion of “the combined

taxable income of [the] DISC and [its parent corporation]

which is attributable to” export sales. IRC § 994(a)(2). The

statutory language does not define “attributable to” or

“combined taxable income” — and, in particular, does not

explicitly address how expenditures are to be deducted from

gross export receipts when calculating net export income. See

St. Jude Medical, 34 F.3d at 1398. But that question is

addressed in detail both by the legislative history of the DISC

Statute and by regulations prescribed by the Secretary of the

Treasury pursuant to the statute.

The committee reports accompanying the DISC legislation

contemplate that all expenses fall into one of two categories

that receive differing treatment in the calculation of CTI. CTI

is to be “determined by deducting from the DISC’s gross

receipts” [1] all “expenses * * * which are directly related to

the production or sale of the export property and [2] a portion

of the * * * expenses not allocable to any specific item of

income, such portion to be determined on the basis of the ratio

of the combined gross income from the export property to the

total gross income of the [parent corporation] and the DISC.”

H.R. Rep. No. 533, supra, at 74 (emphasis added). This

directive was faithfully implemented by the DISC regulations,

which define CTI as “the excess of the gross receipts * * * of

the DISC * * * over the total costs of the DISC * * * which

relate to such gross receipts.” Treas. Reg. § 1.994-1(c)(6)

(emphasis added). The DISC regulations then provide specific

guidance on how to conduct this calculation, explaining that

costs

which shall be treated as relating to gross receipts from

sales of export property are (a) [those] definitely related,

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

ratable part of other expenses * * * which are not definitely

related to a class of gross income, determined in a manner

consistent with the rules set forth in § 1.861-8.

Treas. Reg. § 1.994-1(c)(6)(iii) (emphasis added).

This cross-reference in the DISC regulations to Treas. Reg.

§ 1.861-8 also grew out of the statutory background and harked

back to the legislative history of the DISC statute. The

committee reports explain that combined taxable income is to

be determined “generally in accordance with the principles

applicable under [IRC] section 861,” one of the statutory

provisions that classify income as either U.S. or foreign source

income for U.S. income tax purposes. H.R. Rep. No. 533,

supra, at 74. As the DISC legislative history emphasizes, IRC

§ 861 includes rules for determining the net income from a

given source by “generally allocat[ing] to each item of gross

income all expenses directly related thereto, and then

apportion[ing] other expenses among all items of gross income

on aratable basis.” /bid.’ Treas. Reg. § 1.861-8, which is cited

in the DISC cost allocation regulation, “provided specific

guidance for applying the allocation and apportionment rules

referred to in IRC §§ 861, 862, and 863.” St. Jude Medical, 34

F.3d at 1398. At the time the DISC legislation was enacted,

Treas. Reg. § 1.861-8 “reiterated [IRC]. § 861(b)’s language.”

Id. at 1402. See Treas. Reg. § 1.861-8 (1957).

> IRC § 861(a) identifies income that is United States source gross

income. IRC § 861(b) provides for determining net, taxable U.S.

source income by subtracting from gross income “the expenses,

losses, and other deductions properly apportioned or allocated thereto

and a ratable part of any expenses, losses, or deductions which cannot

definitely be allocated to some item or class of gross income.”

The DISC regulations also address a second issue that is

relevant to the calculation of tax-deferred export income, In

allocating and apportioning costs so that they may be deducted

from revenue, the regulations provide that the determinations

may be made either on a transaction-by-transaction basis or, “at

the annual choice of the taxpayer[,] * * * on the basis of groups

consisting of products or product lines.” Treas. Reg. § 1.994-

1(c)(7)(i). The taxpayer’s choice of a product or product line

for these purposes is conclusive so long as it conforms either to

“recognized industry or trade usage” or to “the 2-digit major

groups * * * of the Standard Industrial Classification * * * of

the Office of Management and Budget.” Treas. Reg. § 1.994-

1(c)(7)(ii). Thus, “[t]he taxpayer’s choice [as to grouping] * *

* shall be controlling, and costs deductible in a taxable year

shall be allocated and apportioned to the items or classes of

gross income of such taxable year resulting from such

grouping.” Treas. Reg. § 1.994-1(c)(6)(iv). Accordingly, when

a taxpayer chooses to group its export sales by product, costs

that definitely relate to each particular product group must be

specifically allocated to that group, while costs that do not

definitely relate to a particular product group must be

apportioned among all relevant classes of income. Costs (that

relate to a particular product or product group cannot be

allocated to any other product group, on a pro rata basis or

otherwise.* These grouping procedures were contemplated by

* To illustrate, suppose that Megacorp, a U.S. conglomerate, makes

and sells $100 worth of space shuttles, $100 worth of scooters, and

$100 worth of pogo sticks during a particular year. All of the space

shuttles are sold domestically to NASA, and all of the scooters and

pogo sticks are exported through Megacorp’s DISC. During the same

year, Megacorp spends $30 to research fuel alternatives for its space

shuttles, $10 to research scooter wheel technology, and nothing for

pogo stick research. Megacorp also spends another $20 attempting to

develop a new automobile that would recycle engine exhaust and $15

to research the impact of solar-generated neutrinos on the motion of

all objects. Megacorp anticipates that its neutrino research might lead

to improvements in any of its products or to entirely new products.

Congress. See H.R. Rep. No. 533, supra, at 74 (“Although * * *

the pricing rules provided by the bill generally are to be applied

on a product-by-product basis, the rules may be applied on the

basis of product lines.”).

2. The dispute now before the Court stems from a provision

added to the IRC § 861 “sourcing” regulations in 1977, six

years after enactment of the DISC statute and two years after

issuance of the final DISC regulations in 1975. As a general

matter, the 1977 revision of Treas. Reg. § 1.861-8 continued to

“emphasize the factual relationship between the deduction and

a class of gross income.” Treas. Reg. § 1.861-8(b)(1). Revised

Treas. Reg. § 1.861-8(e)(3), however, established a special rule

for the allocation of research and development expenses,

providing that such expenses “shall ordinarily be considered

deductions which are definitely related to all income reasonably

connected with the relevant broad product category * * * of the

taxpayer” set forth in the Office of Management and Budget’s

Standard Industrial Classification (“SIC”) Manual.’ This

regulation thus “deemed a definite relationship [to exist]

Under the DISC regulations, Megacorp can treat each of its four

existing or nascent products as a separate group and calculate its total

DISC income by adding up the separate net income (i.e., CTI)

attributable to its exported scooter and pogo stick groups. It does that

by assigning its “definitely related” $10 of scooter R&D exclusively

to its scooter group sales and apportioning its $15 of “indefinitely

related” neutrino R&D in proportion to all of its current sales — $5 to

scooters and $5 to pogo sticks (in each case, $15 x $100/$300).

Megacorp’s other R&D cost=, for space shuttles and automobiles, are

not relevant to the CTI calculations, because all oi these costs

“definitely relate” to existing or future products that Megacorp’s

DISC does not sell. Ignoring Megacorp’s other costs, scooter CTI is

thus $85 ($100 minus $10 minus $5), pogo stick CTI is $95 ($100

minus $5), and total CTI is $180.

* The provisions of Treas. Reg. § 1-861-8(e)(3) were renumbered in

1996 and, with amendments not relevant to this petition, were

republished as Treas. Reg. § 1.861-17. See App., infra, 9a n.7.

between an expenditure for R&D and ai/ income reasonably

connected with a specific broad product category” (St. Jude

Medical, 34 F.3d at 1399 (emphasis added)) — no matter how

narrow or product-specific the actual focus of the R&D

expense.°

3. For over 40 years, petitioner Boeing has been a world

leader in commercial aircraft development and a major U.S.

exporter of commercial aircraft. During the period at issue in

this litigation, DISC-eligible export sales constituted

approximately 70% of Boeing’s commercial aircraft sales by

dollar volume. Boeing exported commercial aircraft through a

qualified export subsidiary. Before 1984, that subsidiary was

Boeing International Sales Corporation, a qualified DISC;

between 1984 and 1987, that subsidiary was Boeing Sales

Corporation, a qualified FSC.

Boeing has maintained its leadership position by

continuously developing new commercial aircraft. Consistent

with industry practice, Boeing organizes its internal operations

along product lines (e.g., the 727, 737, and 757), each of which

constitutes a separate “Program” within the Boeing

organization. Management and staff for each Program are

responsible for developing and managing a particular product

line, including the line’s various models and derivatives (for

*° Again consider Megacorp. Because all of Megacorp’s diverse

R&D pertains to products falling within SIC classification 37, which

broadly covers all “transportation equipment,” Treas. Reg. § 1.861-

8(e)(3) would place the entirety of that R&D into a single pot and

allocate the undifferentiated sum among all products in proportion to

current sales. Thus, the exported scooters and pogo sticks each would

attract $25 of R&D (total R&D of $75 x $100/$300), the CTI deemed

attributable to each of those groups would be $75 ($100 minus $25),

and total CTI would be $159 — in contrast to the $180 of total CTI

that would result from applyine the DISC regulations. This difference

occurs because Treas. Reg. § 1.861-8(e)(3) mechanically reassigns to

all products portions of all of Megacorp’s R&D that in fact are

“definitely related” to particular products.

example, passenger and cargo versions of the 747). App., infra,

16a.

As a leader in aviation technology, Boeing spends billions

of dollars on research and development. Boeing allocates its

R&D costs both across airplane Programs and directly to

particular Programs, depending on the type of research. Some

of Boeing’s research is broad-based and aimed at advancing the

state of the art for commercial aviation technology, including

general avionics and aerodynamics research (such as wind

tunnel tests to study wing airfoil designs and engineering

analysis seeking ways to improve the weight and strength of

airplanes). Boeing also conducts research to create and develop

new products. Such research includes, for example, sketching

and analyzing alternative fuselages, wings, and engines, as well

as other technologies that could eventually be configured into

a new commercial aircraft. Boeing refers to both of these types

of general research and development as “Blue Sky R&D.”

App., infra, 2a-3a, 16a-17a.

In addition to this general R&D, Boeing engages in

extensive R&D for each particular product line or type of

aircraft that the company has decided to produce. Research and

development to design, develop, test, and qualify the new

aircraft for commercial service is a major component of each

Program. For example, because each new aircraft has a unique

configuration, Boeing engineers must specially design

thousands of parts to fit the new aircraft’s configuration and

aerodynamic requirements. Similarly, Boeing must conduct

extensive research and testing to ensure that a new aircraft will

meet national and international safety standards. Research

directly related to particular Programs constituted over 75% of

Boeing’s total R&D expenditures for the years at issue in this

litigation. Boeing refers to the Program-specific research and

development as “Program R&D” (or “Company Sponsored

Product Development R&D”), because it is product-specific

and generally not transferable to other Programs or aircraft.

App., infra, 3a, 17a.

Mirroring its internal organizatior<] structure, Boeing’s

accounting practices track costs and revenues along Program

lines. Specifically, Boeing’s cost accounting system allocates

costs to the activity to which they are most closely related.

Each airplane Program is a separate “final cost objective,” and

the accounting system allocates to each Program those costs

directly related to it. The same is true for revenues. So, for

example, the costs and sales of the 727 are accounted for

separately from the 767, which are accounted for separately

from the 777. In keeping with this framework, Boeing’s cost

accounting system allocates all research and development that

is directly associated with a particular product line (the

Program R&D) to that Program. However, costs for general

research and development that are not directly related to a

particular program (the Blue Sky R&D) are apportioned among

Programs on a pro rata basis. For financial accounting and

federal income tax purposes, Boeing deducts all research and

development costs — including costs relating directly to a

particular Program and those that must be apportioned among

Programs — in the period in which they are incurred. This is true

even if there are no corresponding sales in that period. App.,

infra, 3a, 17a-18a.

For DISC and FSC purposes, Boeing elected to treat each

of its Programs as a separate product group, as permitted by

Treas. Reg. § 1.994-1(c). Boeing used the CTI method to

calculate the relevant income of each group. To determine CTI

in each case, Boeing started with the product group’s gross

export receipts and subtracted from them the total combined

costs of its export subsidiary and its United States operations

that directly related to those export receipts, as well as a portion

of its costs that did not directly relate to any Program. See

App., infra, 3a, 17a. As part of this process, Boeing subtracted

research and development costs from the revenues of each

product group. Program R&D was attributed directly to the

relevant Program; Blue Sky R&D was apportioned across

Programs. /d. at 3a, 17a-18a.

4. After conducting an audit and reviewing Boeing’s taxes

for the years at issue (1979-1987), the IRS disallowed Boeing’s

method of allocating and apportioning its R&D costs and

reallocated those expenses pursuant to Treas. Reg. § 1.861-

8(e)(3). As noted above, that provision deems all of Boeing’s

R&D in any given year to be related to sales of ail airplane

models in that year, because all of Boeing’s various commercial

aircraft product lines fall into the single SIC Code 37

(transportation equipment). The IRS treated all R&D costs the

same, without regard to their factual relationship to a particular

product line. For example, the IRS allocated portions of the

Program R&D costs that were attributable solely to aircraft still

in the developmental stages (as were the 757 and 767 during

some of the years at issue) to export sales generated by other

Programs under which aircraft were actually in production and

being sold during the years in question (such as the 747). The

IRS apportioned costs in this manner even though the R&D

expenditures associated with developing a new product line

(such as the 767), obtaining FAA certification, and bringing it

to market do not in any way contribute to the development of

existing product lines (such as the 747). By reallocating $2

billion of research and development costs related to specific

Boeing Programs and charging them against the revenues from

other Programs, the IRS decreased the CTI upon which

Boeing’s export tax benefits were based and thereby increased

Boeing’s overall tax obligation for the years 1979 to 1987 by

some $ 419 million. App., infra, 3a-4a, 18a.

Boeing paid the additional tax demanded by the IRS and

filed suit seeking a refund. The district court ruled for Boeing,

relying heavily on the Eighth Circuit’s decision in St. Jude

Medical and holding that Treas. Reg. § 1.861-8(e)(3) is invalid

as applied to CTI computations. App., infra, 15a-24a. The

district court pointed to three considerations supporting this

conclusion. First, the court explained that, by mandating that

export sales be grouped according to the broad SIC

classifications, Treas. Reg. § 1.861-8(e)(3) conflicts with Treas.

Reg. §§ 1.994-1(c)(6)(iv) and (7), which provide that taxpayers

may group income and allocate costs by product or product

line. App., infra, 2la-22a. Second, the court reasoned that

Treas. Reg. § 1.861-8(e)(3) creates an artificial “deemed”

relationship between sales and R&D that conflicts with

Congress’s ir*wmt *> “‘generally allocate to each item of gross

income allexge.: ‘irectly related thereto.’” App., infra, 22a

(quoting St. Jude Medical, 34 F.3d at 1401 (quoting H. Rep.

No. 533, supra, at 74)) (emphasis in St. Jude Medical). And

third, the court determined that Congress intended DISCs to

deduct only those costs “‘directly related to the production or

sale of the export property’”; charging unsuccessful R&D that

is never actualized as a successful product to current export

sales of successful products through an artificial “deemed”

relationship is “inconsistent” with that expressed intent. App.,

infra, 22a (quoting St. Jude Medical, 34 F.3d at 1401 (quoting

H. Rep. No. 533, supra, at 74)). The district court thus

concluded that the IRS erred in applying Treas. Reg. § 1.861-

8(e)(3) to Boeing’s CTI calculation, holding that Boeing was

entitled to group its export sales by product line and allocate

research and development expenditures accordingly.

On appeal, the Ninth Circuit reversed. App., infra, la-14a.

The court of appeals opined that Treas. Reg. §§ 1.861-8(e)(3)

and 1.994-1(c)(7) “can be harmonized by recognizing that the

more narrowly a taxpayer chooses to define income items, the

more costs become ‘indirectly’ or ‘indefinitely’ related to

specific items of income. The taxpayer is required, nonetheless,

to apportion these costs to broader categories of income and

allocate them between the taxpayer’s export and domestic sales

by the proportional method set forth in Treas. Reg. § 1.861-

8(e)(3).” App., infra, 12a. The Ninth Circuit also suggested that

application of Treas. Reg. § 1.861-8(e)(3) in this context is

supportable because, at the time of the enactment of the DISC

statute, “Congress recognized [that] some of the costs incurred

in a given tax year would not be ‘directly related’ to specific

income items.” App., infra, 1la. The court therefore held that,

as applied in this case, “Treas. Reg. § 1.861-8(e)(3)* * * isa

reasonable interpretation of the applicable statutes and

regulations.” App., infra, 13a. In reaching this conclusion, the

Ninth Circuit expressly “decline[{d] to follow the reasoning of

St. Jude Medical.” App., infra, 10a.

REASONS FOR GRANTING THE PETITION

The decision below creates an express conflict with the

holding of the Eighth Circuit on an important and recurring

issue of federal law. This conflict plainly warrants the Court’s

attention. The existence of contrasting standards governing the

treatment of R&D expenses in different circuits results in

identically situated taxpayers being treated differently on the

basis of geography; will generate a substantial volume of

litigation; and creates considerable confusion in the operation

of a tax incentive statute, an area where predictability and

certainty are essential. The issue, moreover, is one of enormous

practical importance: this case alone involves more than $400

million in tax liability, with billions of dollars potentially at

stake across the Nation. Finally, the Ninth Circuit’s decision

frustrates the manifest intent underlying the DISC and related

tax regimes, which Congress established to effectuate a vital

international trade policy. Review by this Court therefore is

imperative.

A. There Is An Express Conflict In The Circuits On

Whether Treas. Reg. § 1.861-8(e)(3) May Be Applied

To The Computation Of CTI

Review by this Court is necessary because there is a clear

and irreconcilable conflict in the courts of appeals on a

significant issue of federal law. The conflict is indisputable:

the Ninth Circuit expressly, and candidly, “decline[d] to follow

the reasoning of St. Jude Medical.” App., infra, 10a.

On this point, the Ninth Circuit was correct: St. Jude

Medical is indistinguishable from this case. In St. Jude

Medical, as here, the taxpayer produced a number of devices

that were stipulated to be “separate products or product lines

under recognized industry or trade usage.” St. Jude Medical, 34

F.3d at 1401. In that case, as in this one, these separate products

all fell into a single SIC classification. See ibid. In St. Jude

Medical, as here, the taxpayer separately allocated R&D costs

to each of the products with which they were actually

associated, instead of apportioning them generally across the

SIC category. See id. at 1396, 1400. And in that case, as in this

one, the IRS disapproved the taxpayer’s allocation of the R&D,

contending that, under Treas. Reg. § 1.861-8(e)(3), all of the

R&D costs relating to a// products within the SIC classification

had to be spread across the export receipts from a// products

within the classification. Jd. at 1396, 1400.

The outcome in St. Jude Medical, however, was quite

different from the one here. The Eighth Circuit rejected the

IRS’s position, “hold{ing] that § 1.861-8(e)(3) is invalid as

applied to DISC CTI computations.” 34 F.3d at 1396. The court

reasoned that “[mJandating use of the SIC categories is

inconsistent with Congress’s intent to allow costs to be

allocated on a product-by-product basis or on the basis of

product lines.” Jd. at 1401. Moreover, the Eighth Circuit found

that “the deemed relationship mandated by § 1.861-8(e)(3)(i) is

inconsistent with Congress’s intent to ‘generally allocate to

each item of gross income all expenses directly related

thereto.”” Ibid. (quoting H.R. Rep. No. 533, supra, at 74

(emphasis added by the court)). And the court noted that

mandatory use of the SIC categories, which had the effect of

requiring that income from successful R&D ““bear the cost of

unsuccessful research and development” (ibid. (quoting Treas.

Reg. § 1.861-8(e)(3)(i)), would be “inconsistent with Con-

gress’s stated intent” to deduct from DISC gross receipts those

expenses that “‘are directly related to the production or sale of

* * * property.”” Jbid. (quoting H.R. Rep. No. 533, supra, at

74).

In reaching that conclusion, the Eighth Circuit

acknowledged “a conflict between two Treasury regulations:

§ 1.994-1 and § 1.861-8. Section 1.994-1 allows the taxpayer’s

choice regarding the manner of grouping transactions to

control. Section 1.861-8 mandates a specific method of

grouping transactions.” St. Jude Medical, 34 F.3d at 1402. In

resolving this conflict, the court looked to the principles

generally applicable under IRC § 861, concluding:

An examination of § 861(b)’s language does not allow us to

infer that Congress intended to impose mandatory SIC

transaction grouping in CTI computations related to R & D

expenditures. * * * In fact, § 1.861-8, at the time the DISC

legislation was enacted, did not contain the SIC categories,

but rather reiterated § 861(b)’s language.

St. Jude Medical, 34 F.3d at 1402 (footnote omitted). After

examining “the origin and the purpose of the DISC statute,” the

Eighth Circuit accordingly helc “that § 1.861-8 is unreasonable,

and thus invalid, as applied to DISC CTI computations. * * *

We believe Congress intended in CTI computations to allocate

costs, such as R & D expenditures, to definitely related gross

export receipts.” /bid.

In this case, the Ninth Circuit reached precisely the opposite

conclusion. The Ninth Circuit expressly recognized the Eighth

Circuit’s holding “that Treas. Reg. § 1.861-8(e)(3) was invalid

as applied to DISC CTI computations” and “did not control the

computation of DISC combined taxable income.” App., infra,

10a. As we have explained, however, the Ninth Circuit went on

to reject the Eighth Circuit’s analysis. See ibid. The court below

reasoned, instead, that “[the] statutory text does not confine the

relevant costs to those ‘definitely related’ to sales of a

particular product” (id. at 11a (emphasis added)); that “[t}here

is no conflict between Treas. Reg. § 1.861-8(e)(3) and Treas.

Reg. § 1.994-1(c)(6)” (id. at 12a (emphasis added)); and that

Treas. Reg. § 1.861-8(e))(3) “is a reasonable interpretation of

the applicable statutes and regulations.” App., infra, 13a

(emphasis added).

The Ninth Circuit made no attempt to, and plainly could

not, reconcile its holding with that of the Eighth Circuit in Sv.

Jude Medical. Deciding cases that in all relevant respe:ts are

identical, the Eighth Circuit held that taxpayers are entitled to

allocate R&D expenses on the basis of the specific product or

product-line groupings that the DISC regulations authorize,

while the Ninth Circuit held that same treatment impermissible,

concluding ‘hat taxpayers instead must apportion R&D

expenses on the basis of broad SIC classifications. As a result,

identically situated taxpayers located in different parts of the

country must bear dramatically different tax burdens. Because

of the great need for “uniform application of the Internal

Revenue laws” (Turnbow v. Commissioner, 368 US. 337, 339

(1961)), this intolerable situation warrants review by this Court.

B. The Decision Below Is Wrong

The need for review is particularly acute because the

decision below is plainly wrong. The background and

contemporaneous understanding of the DISC statute

unmistakably establish two fundamental principles: (a)

expenses that are directly related to a particular class of gross

income must be allocated to that class and no other; and (b)

taxpayers are entitled to select the grouping of products or

product categories that they believe to be most advantageous.

The court of appeals’ decision departs from both of those

principles. It thus frustrates the congressional intent and

undermines the purposes of a significant federal tax incentive.

1. There is no denying that the Ninth Circuit’s approach

leads to perverse results. Under the court of appeals’ holding,

Boeing’s R&D that relates exclusively to one specific airplane

model has to be allocated, in large part, to revenue from the sale

of other, unrelated models. Thus, if Boeing incurred a research

expense in 1987 that was directed solely to improving a

component unique to a new 767 model that was not yet in

production, the Ninth Circuit would require treating the

expense as part of the cost of that year’s 747 sales — even

though that model of aircraft had been introduced years earlier

and did not benefit at all from the R&D relating to 767s.

Indeed, the court of appeals’ holding would require that

research expenses incurred in the development of scooters or

boats be allocated, in part, to the production of aircraft or

space vehicles because they all fall within the SIC Code (37)

for “transportation equipment.”

When it enacted the DISC statute, Congress certainly did

not contemplate requiring such an outcome. To the contrary,

the DISC regime was premised on the understanding that the

income “attributable to” export sales under IRC § 994 would be

calculated by allocating expenses to the class of income with

which they are factually associated. The statute was enacted

against the background of IRC § 861(b), which defines taxable

income as gross income less [1] “the expenses * * * properly

apportioned or allocated thereto and [2] a ratable part of any

expenses * * * which cannot definitely be allocated to some

item or class of gross income.” Plainly, this scheme postulates

that, if an expense can “definitely be allocated to some item or

class of gross income,” it falls into the first of these categories

and therefore may not be ratably apportioned across all classes

of income.

The legislative history of the DISC statute makes this point

explicit, taking pains to spell out precisely the expense

allocation scheme that Congress intended. The committee

reports expressed Congress’s intent that expense allocations

under DISC “be determined generally in accordance with the

principles applicable under section 861,” observing that those

IRC § 861 rules “generally allocate to each item of gross

income all expenses directly related thereto.” H.R. Rep. No.

533, supra, at 74. Applying this principle in the DISC context,

the committee reports went on to declare that CTI is to be

computed by subtracting from export revenue those “expenses

* * * which were directly related to the production or sale of

the export property and a portion of the * * * expenses nor

allocable to any specific item of income.” Ibid. (emphasis

added). This system leaves no room for taking a portion of the

expenses that are in fact related to particular export property

and apportioning them to other, unrelated property.’

This understanding is confirmed by the DISC regulations

that were promulgated almost contemporaneously with the

enactment of the DISC statute. These rules identify the costs

that “shall be treated as relating to gross receipts from sales of

export property” as including both expenses that are “definitely

related, and therefore allocated and apportioned, thereto,” and

“a ratable part of other expenses * * * which are not definitely

related to a class of gross income.” Treas. Reg. § 1.994-

1(c)(6)(iii) (emphasis added). Again, this structure plainly

contemplates that costs that are definitely related to particular

products may not be allocated or apportioned to other products.

Moreover, at the time these regulations were promulgated

it was clearly understood that a factual relationship had to exist

between R&D expenditures and any “definitely related”

income-producing activity to which those expenditures might

be exclusively allocated. The final DISC allocation and

apportionment regulation issued in 1975, Treas. Reg. § 1.994-

1(c)(6)(iii), provides that these determinations are to be made

“in a manner consistent with the rules set forth in [Treas. Reg.]

§ 1.861-8.” As we have explained (at page 5, supra), the

”? Aside from Treas. Reg. § 1.861-8(e)(3), the aberrational R&D

regulation at issue here, Treasury regulations have themselves

consistently recognized that the IRC § 861 regime contemplates a

factual relationship between an expense and the class of income to

which it is allocated. Treas. Reg. § 1.861-8(b) specifically notes that

the allocation “rules emphasize the factual relationship between the

deduction and a class of gross income.” Indeed, the preamble

accompanying the proposal of the Section 861 regulations on which

the government relies in this case states: “If a proper allocation and

apportionment of deductions on the basis of factual relationships is

not accomplished, taxable income attributable to various sources will

not be properly reflected under the applicable operative provisions of

the Code.” 41 Fed. Reg. 49,161 (Nov. 8, 1976) (emphasis added).

version of § 1.861-8 contemporaneously in force simply

reiterated IRC § 861(b)’s language, distinguishing between

expenses that can and cannot “definitely be allocated” to a class

of income. And the proposed § 1.861-8 regulations in place in

1975 unambiguously applied the factual relationship principle

to R&D in the DISC context. Those proposed regulations set

forth the general rule as follows:

Expenditures for research and development which a

taxpayer deducts * * * shall be considered deductions

which are definitely related to the class of gross income to

which such research and development activity gives rise or

is reasonably expected to give rise and shall be allocated to

such class.

Prop. Treas. Reg. § 1.861-8(e)(3)(i) (1973). Example (1) in this

proposed regulation illustrated the rule by treating four-, six-,

and eight-cylinder gasoline engines as separate products, each

with separate and directly allocable R&D. Example (2)

extended this tracing of R&D to a DISC CTI computation in

which four- and six-cylinder engines were grouped separately.*

Against this background, the Ninth Circuit plainly erred in

holding that Treas. Reg. § 1.861-8(e)(3) could validly be

applied in the circumstances of this case. That regulation

irrebuttably deems all R&D expenses to be definitely related to

all income within a broad SIC Code, so that the expenses must

be spread over all products and product groups falling within

that Code. This “deemed” relationship ignores the actual

* The Secretary of the Treasury evidently relied on these exampl

when including the reference to Treas. Reg. § 1.861-8 in the DISC

regulations. The Technical Memorandum accompanying the final

DISC regulations indicated that they did not include their own

examples “for determining the portion of certain expenses of the

[parent corporation] to be deducted in determining combined taxable

income of the DISC and [the parent corporation]” because the

drafters anticipated that the examples in the 1973 proposed § 1.861-8

regulations would apply. 1974 TM Lexis 30, at *20 (Oct. 29, 1974).

relationship between expense and income that Congress

explicitly intended to govern CTI calculations under the DISC

statute. The rule established by § 1.861-8(e)(3) also is contrary

to the undisputed facts in this case, which establish that the

research at issue here related to the design of particular

airplane lines; it implements a regime in which narrowly

focused research relating to the details of a new airplane is

treated as a cost of selling an airplane that has been in

production for 20 years; and it perverts the DISC scheme’s

central purpose by reducing the incentives that encourage

exports. For these reasons, as the Eighth Circuit correctly held,

“§1.861-8[(e)(3)] is unreasonable, and thus invalid, as applied

to DISC CTI computations.” St. Jude Medical, 34 F.3d at 1402.

2. The Ninth Circuit’s holding that CTI must be calculated

by apportioning expenses across all products within a broad

SIC Code also is insupportable for a second, closely related

reason: the DISC regulations emphatically state that the

taxpayer is entitled to choose whether or not CTI

determinations will be made on a product-by-product basis.

The taxpayer is entitled to make this choice annually (see

Treas. Reg. §1.994-1(c)(7)(i)) and its “choice [as to grouping]

* * * shall be controlling.” Treas. Reg. § 1.994-1(c)(6)iv)

(emphasis added). Indeed, the regulations specifically provide

that the taxpayer’s choice “will be accepted by [the IRS]” so

long as it conforms either to “recognized industry or trade

usage” or to “the 2-digit major groups * * * of the Standard

Industrial Classification * * * of the Office of Management and

Budget.” Treas. Reg. § 1.994-1(c)(7)(ii). The DISC regulation,

moreover, makes clear that the taxpayer’s choice in this regard

will determine the cajegory of income. to which expenses

should be allocated in computing CTI: “costs deductible in a

taxable year shall be allocated and apportioned to the items or

classes of gross income of such taxable year resulting from

such grouping.” Treas. Reg. § 1.994-1(c)(6)(iv) (emphasis

added). This grouping rule was sufficiently important that

Congress expressly incorporated it into both the FSC and ETI

statutes that succeeded DISC. IRC § 927(d)(2)(B) (1984); IRC

§ 943(b)(1)(B) (2000).

The Ninth Circuit’s approach is flatly at odds with this

principle. Rather than allocate costs to the classes of income

“resulting from [the taxpayer’s] grouping,” as the DISC

regulation mandates, the court of appeals requires that costs be

allocated according to SIC Code. As the Eighth Circuit

explained, “[mJandating use of the SIC categories is

inconsistent with Congress’s intent to allow costs to be

allocated [either] on a product-by-product basis or on the basis

of product lines.” St. Jude Medical, 34 F.3d at 1401. Indeed,

“[Treas. Reg.] § 1.861-8, at the time the DISC legislation was

enacted, did not contain the SIC categories, but rather reiterated

§ 861(b)’s language.” 34 F.3d at 1402. The decision below thus

works a significant, and unwarranted, change in the incentives

provided by the DISC statute and regulations.

The DISC provisions were specifically designed to

encourage manufacturers to locate their productive facilities in

the United States and to export their goods, rather than to

supply their foreign markets from overseas factories. See H.R.

Rep. No. 533, supra, at 58; S. Rep. No. 437, 92d Cong., 1st

Sess. 90 (1971). To accomplish that result, Congress offered

relief from taxation for a portion of the manufacturer’s income

“attributable to” (IRC § 994(a)(2)) sales of the exported goods.

But by attributing millions of dollars of R&D expenses to

export sales, even though the expenses in fact bore no

relationship to those sales, the decision below artificially

understates Boeing’s true export sales income and reduces the

incentive of U.S. companies to expand their domestic

manufacturing operations. By contrast, the Eighth Circuit

understood that this approach “may improperly decrease the

profits allocated to a DISC, thus thwarting Congress’s intent

when it promulgated the DISC intercompany pricing rules.” 34

F.2d at 1402-1403.

3. The rationales advanced by the Ninth Circuit cannot

support its holding. First, the court of appeals opined that

Treas. Reg. § 1.861-8(e)(3) and § 1.994-1(c) “can be

harmonized by recognizing that the more narrowly a taxpayer

chooses to define income items, the more costs become

‘indirectly’ or ‘indefinitely’ related to specific items of

income.” App., infra, 12a. This perplexing statement disregards

both the controlling facts and the controlling law. The statement

is flatly wrong as a factual matter, because it is undisputed that

the R&D costs for each Boeing Program were definitely related

to that Program and that Program alone, and were completely

unrelated — “indefinitely” or otherwise — to other Programs.

The Ninth Circuit’s statement is equally indefensible as a legal

proposition, because Treas. Reg. § 1.861-8(e)(3)(i) manifestly

did not transform any R&D expenses into costs ““‘indefinitely’

related to specific items of income.” Instead, the regulation

explicitly deems all R&D costs to be “definitely related to all

income reasonably connected with the relevant [SIC] category”

(emphasis added). Either way, the Ninth Circuit’s purported

“harmonization” of the regulations was nothing but rhetorical

alchemy.

Second, the court of appeals may have meant to adopt the

government’s suggestion (see U.S. 9th Cir. Br. 11) that it was

impermissible for Boeing to allocate R&D expenses to

Programs that had no current gross income from which those

expenses could be deducted. See App., infra, 3a (stating that

such costs “simiply ‘disappeared’”’). If so, the court plainly was

incorrect. There is nothing inherently wrong in having the costs

directly related to a particular product line exceed the gross

income generated by that line in a given year. To the contrary,

Treas. Reg. § 1.861-8(d) explicitly states that “[e]ach deduction

which bears a definite relationship to a class of gross income

shall be allocated to that class in accordance with paragraph

(b)(1) of this section [which emphasizes the “factual

relationship between the deduction and a class of gross

income’’] even though, for the taxable year, no gross income in

—$—=_

such class is received” (emphasis added). Indeed, this principle

was recognized even by the R&D allocation pon itself

See Treas. Reg. § 1.861-8(e)(3)(ii)(B) (“[a]mounts apportioned

vader this paragraph (e)(3) may exceed the amount of gross

income related to the product category within the statutory

grouping.”). See also IRC § 174 (general R&D incentive

provision that allows R&D to be deducted in current year even

though it may not generate income until future years); Treas.

Reg. § 1.861-8(c)(1) (“In apportioning deductions, it may be

that, for the taxable year, there is no gross income in the

Statutory grouping”).

Third, the court of appeals found it significant that

‘Congress recognized [that] some of the costs incurred in a

given tax year would not be ‘directly related’ to specific income

items.” App., infra, 11a. But that observation, while doubtless

correct, is simply beside the point. That certain costs (i.e.

overhead) are not directly related to specific products hardly

means that the costs that are directly related to specific

products should be apportioned to other products. The Ninth

Circuit’s sleight-of-hand thus cannot obscure its departure from

the fundamental principles underlying the DISC statute and

regulations.

C. The Issue Presented Here Is A Recurring One Of

Great Practical Importance

The question presented in this case has enormous practical

rar at The Ninth Circuit’s decision severely undermines

¢ efficacy of an important export tax incentive pro

gram that

has been used for decades by thousands of major U.S.

manufacturers.

In its most recent (year 2000) analysis, the IRS

‘ reported that

the number of FSC returns had risen to well over 4,000 in 1996,

a 42% increase over the 3,073 FSC returns just filed four years

earlier.’ Not only is the number of these taxpayers on the rise,

but the amount of tax benefits is increasing as well. These

companies’ aggregate annual FSC tax benefits were estimated

_ in February 2000 at approximately $4 billion for the year 2000,

with a projected increase to $5.5 billion by the year 2005."°

Estimates of total annual tax benefits from ETI, which replaced

the FSC regime, begin at $4.8 billion for 2003, with the number

projected to rise to $6.5 billion by the year 2007."

Nearly 90% of all FSC returns filed for 1996 reported

manufactured product exports, with nearly two-thirds of these

revenues coming from exports of non-electrical machinery,

transportation equipment; electrical machinery, equipment, and

supplies; and chemicals and allied products.'? Thus, thousands

of FSCs are in industries with significant R&D expenditures,

and the method of allocation of those expenditures can have a

substantial effect on the amount of their tax-based export

incentive. The resolution of the issue in this case will

significantly affect many U.S. exporters that made substantial

R&D expenditures during the years for which the FSC regime

was in effect; as evidenced by the $419 million at issue in this

case, the amounts at stake for any given taxpayer with regard

to the R&D allocation issue can be very large. Equally

* Cynthia Belmonte, Foreign Sales Corporations, 1996, STATISTICS

OF INCOME BULLETIN, Spring 2000 (published by the Internal

Revenue Service).

Government, Fiscal Year 2001, Table 32-4, Tax Expenditures by

Function for Fiscal Years 1999-2005, February 7, 2000.

'' Joint Committee on Taxation, Estimates of Federal Tax

Expenditures for Fiscal Years 2002-2006, JCS-1-02, January 17,

2002.

'2 Cynthia Belmonte, Foreign Sales Corporations, 1996, STATISTICS

OF INCOME BULLETIN, Spring 2000 (published by the Internal

Revenue Service).

important, resolution of the issue will affect the behavior of

thousands of taxpayers that must decide both whether to make

substantial R&D expenditures on exports under the ETI regime

and whether the tax incentives are sufficient to warrant an

increase in exports.

Congress has long evidenced a concern for the

competitiveness of the U.S. economy in the world market and

has consistently sought to improve the U.S. balance of

payments. Three decades ago, Congress determined that strong

export incentives would promote those goals. In enacting the

DISC provisions in 1971, Congress deviated from the general

residence-based tax system of the U.S. (i.e., taxing U.S.

taxpayers on their worldwide income) and adopted a feature of

territorial taxation (taxing only income earned in the U.S. and

exempting or deferring some income of U.S. taxpayers earned

abroad) that was designed to tax export sales more favorably

than comparable domestic transactions.'? These provisions,

intended to level the playing field for U.S. exporters and to

increase the volume of exports from the U.S., gave taxpayers

considerable flexibility to maximize their tax benefits. It was no

accident that the statutory scheme permitted taxpayers to

. See General Explanation of Tax Legislation Enacted in the 106th

Congress, April 19, 2001, Joint Committee Print, 107th Cong., Ist

Session. See also Hearings on Trade Relations with Europe and the

New Transatlantic Economic Partnership Before the Subcomm. on

Trade of the House Comm. on Ways and Means, 105th Cong., at 117

(1998) (statement of Jeremy O. Preiss, Chief International Trade

Counsel, United Technologies Corporation) (“Congress enacted both

the DISC and the FSC in part to begin leveling the playing field

between the U.S. income tax system * * * and more export friendly

territorial systems. The FSC is not a provision designed to confer a

tax benefit on U.S. exporters that is not enjoyed by their competitors

abroad; to the contrary, the FSC is designed to ameliorate — in quite

smal] measure - a significant tax advantage that is enjoyed by

allocate their expenses, including R&D expenses, to product

groups.

Congress has steadfastly adhered to this important policy in

the face of repeated protests from other countries that these

features of U.S. law provide illegal export subsidies. Thus, as

noted above (see pages 2-3, supra), after the DISC regime was

determined to violate international law, Congress enacted the

FSC legislation. In that legislation, Congress pointedly codified

the principles of the DISC regulations that permit taxpayers to

maximize their tax incentive through the allocation of expenses

to product groups. The ETI legislation, which was enacted in

November 2000 after the FSC regime also was declared

inconsistent with international obligations, includes an identical

provision.'* The FSC regulations remain in effect under the ETI

regime to fill the gap before new regulations are promulgated. '°

“ The statutory product grouping provisions for FSC (IRC

§ 927(d(2)\(B)) and ETI (IRC § 943(b)(1)(B)) both state as follows:

Grouping of transactions. To the extent provided in

regulations, any provision of this subpart [the overall FSC or

ETI regime] which, but for this subparagraph, would be

applied on a transaction-by-transaction basis may be applied

by the taxpayer on the basis of groups of transactions based

on product lines or recognized industry or trade usage. Such

purposes.

'S General Explanation of Tax Legislation Enacted in the 106th

Congress, April 19, 2001, Joint Committee Print, 107th Cong., Ist

Session. The importance of the issue presented here is not diminished

by the recent decision of the World Trade Organization’s Appellate

Body that the current ETI regime is inconsistent with WTO rules,

which authorizes the European Union to impose retaliatory tariffs

against the United States. See WTO Report of the Appellate Body on

Complaint of the European Communities Concerning United States

Tax Treatment for “Foreign Sales Corporations,” Daily Rep. for

Executives, No. 10, at L-1 (Jan. 15, 2002). That decision does not

displace U.S. law and the ETI system thus remains in effect. The

At bottom, the decision below ignores Congress’

continuous support for the grouping rule and undermines a

longstanding statutory policy designed to provide tax incentives

for exports. Prior to the Ninth Circuit’s decision, taxpayers

could rely on statutory and regulatory language, the intent of

Congress, and the Eighth Circuit’s validation of that

understanding in St. Jude Medical to compute export income in

accordance with the DISC/FSC/ETI regulations, including the

grouping rule. After the Ninth Circuit’s decision, however, that

benefit is available with certainty only to taxpayers in the

Eighth Circuit. Thousands of taxpayers in other circuits will not

be able to predict the magnitude of the export incentives

promised to them by ETI (or its successor regime). Nor will

those taxpayers be able to take advantage of those incentives as

Congress intended without significant risk of an IRS challenge.

Moreover, taxpayers outside the Eighth Circuit are now

vulnerable to IRS claims for back taxes that would retroactively

reduce the incentives upon which those taxpayers already have

relied. The Court should resolve this dispute so that a single

rule applies to export decision-making and tax liability

throughout the United States.

WTO decision may be accessed at <www.wto.org/english/tratop_e/

dispu_e/distabase_wto_members4 3.htm>.

CONCLUSION

The petition for a writ of certiorari should be granted.

Respectfully submitted.

JOEL V. WILLIAMSON KENNETH S. GELLER*

WAYNE S. KAPLAN CHARLES ROTHFELD

ROGER J. JONES BRITTON B. GUERRINA

MARJORIE M. MARGOLIES Mayer, Brown, Rowe & Maw

Mayer, Brown, Rowe & Maw 1909 K Street, N.W.

190 South LaSalle Street Washington, D.C. 20006

Chicago, Illinois 60603 (202) 263-3000

(312) 701-7229

* Counsel of Record

Counsel for Petitioners

FEBRUARY 2002

APPENDIX

APPENDIX A

Nos. 99-35818 and 99-35857

UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

THE BOEING COMPANY, and

Consolidated Subsidiaries; BOEING SALES

CORPORATION,

Plaintiffs-Appellees,

Vv.

UNITED STATES OF AMERICA,

Defendant-Appellant.

THE BOEING COMPANY, and

Consolidated Subsidiaries, Plaintiff, and

BOEING SALES CORPORATION,

Plaintiff-Appellant,

Vv.

UNITED STATES OF AMERICA,

Defendant-Appellee.

Apmil 4, 2001, Argued and Submitted,

Seattle, Washington

August 2, 2001, Filed

Before DAVID R. THOMPSON, TROTT, and PAEZ, Circuit

Judges.

DAVID R. THOMPSON, Circuit Judge:

The United States appeals the district court’s summary

judgment determining that the Boeing Company and its

consolidated subsidianes (“Boeing”) are entitled to an income

tax refund of approximately $419 million for the years 1979

through 1987. The issue is how research and development costs

(“R&D”) should be accountec fc. |. omputing Boeing’s net

income from export sales of commercial airplanes under the

Internal Revenue Code’s export incentive provisions for a

Domestic International Sales Corporation (“DISC”) and a

Foreign Sales Corporation (“FSC”).

We have jurisdiction under 28 U.S.C. § 1291 (1994). We

conclude that, in computing Boeing's net income, the

Commissioner of Internal Revenue properly applied Treas.

Reg. § 1.861-8(e)(3) to allocate Boeing’s R&D costs to its

export sales. Accordingly, we reverse the district court s

summary judgment granting Boeing’s tax refund claim.

FACTS

From 1972 to 1984, Boeing exported commercial airplanes

through its subsidiary, Boeing International Sales Corporation,

which qualified as a DISC under Internal Revenue Code

(“LR.C.”) § 992. After 1984, Boeing exported commercial

airplanes through its subsidiary, Boeing Sales Corporation,

which qualified as a FSC under LR.C. § 922.

During the relevant period, Boeing maintained separate

“programs” for each of its major commercial airplane product

lines.’ Each of Boeing’s programs constitutes a separate

product or product line under industry practice and trade usage

in the commercial airplane business.

ed its R&D

In developing these programs, Boeing segregat

costs into two broad categories. The first category, Blue-Sky

R&D, was for R&D costs incurred prior to Boeing s Board of

In view of our reversal of the summary judgment for

approximately $419 mullion in favor of Boeing, we poten: ym

district court’s partial summary judgment for approximately $

million in favor of the United States, pursuant to Boeing's conditional

cross-appeal which the government does not oppose.

, Dunng the tax years at issue, Boeing established or maintained a

separate program for the following airplane models — 707, 727, 737,

737-300, 747, 757 and 767.

Directors giving approval for a new airplane model, which

approval was referred to as “Program Go Ahead.” Blue Sky

R&D included basic research relating to commercial airplanes

that might be the precursor to a specific program. The second

category, Company Sponsored Product Development, was for

costs incurred for a specific program after Program Go Ahead

had been given for a particular airplane model and included the

R&D cost of designing, developing, testing and qualifying that

airplane. Approximately 77 percent of the R&D costs in the tax

years at issue in this case fall within the Company Sponsored

Product Development category.

For accounting purposes, Boeing apportioned Blue Sky

R&D to all of its airplane programs, but allocated Company

Sponsored Product Development R&D directly to the particular

program for which those costs were incurred. Boeing deducted

all R&D costs in the period in which they were incurred,

regardless of whether there were any corresponding sales

during that period. This meant that significant R&D costs for

any new program could be allocated to that program in years

prior to any sales of airplanes within that program.

Boeing used the combined taxable income method (“CTT”)

to calculate the intercompany price and profits from its export

sales. See LR.C. §§ 994(a)(2) & 925(a)\(2). Pursuant to Treas.

Reg. § 1.994-1(c\(7), Boeing grouped its export sales by

program and apportioned costs, including R&D costs, to the

particular airplane program for which those costs were

incurred. If those R&D costs exceeded the amount of sales for

the airplane program to which those costs were allocated. the

excess of costs over sales, according to the IRS, simply

“disappeared,” in that those costs were not accounted for by

Boeing in computing its CTI.

During an audit, the IRS determined that Boeing’s method

of allocating its R&D costs *a its DISC and FSC sales violated

Treas. Reg. § 1.861-8(e)(3), which requires all R&D costs to be

allocated to and apportioned among all sales within the broad

product categories set forth in the Office of Management and

Budget’s Standard Industrial Classification (“SIC”). Because

all of Boeing’s commercial airplane sales fell within SIC code

37 (Transportation Equipment), the IRS allocated all of

Boeing’s R&D costs in a given period to all of Boeing’s

commercial airplane sales in that period. By this method of

allocation, none of the R&D expenses “disappeared” (the

government's characterization); instead, all of such expenses

were charged to sales in the relevant penod.

This methed of allocation by the iRS caused a substantial

decrease in Boeing’s net income from its DISC and FSC sales.

Because net income from such sales is accorded favorable tax

treatment, Boeing’s overall income tax liability, according to

the IRS, was substantially understated.

Boeing paid the amount of additional tax required by the

IRS, and timely filed claims for refund. When those claims

were denied or not acted upon, Boeing filed this suit seeking a

refund of corporate income taxes and interest in the total

amount of $458,609,373. Both sides moved for summary

judgment. The district court, relying on St. Jude Medical, Inc.

v. Ce missioner, 34 F.3d 1394 (8th Cir. 1994), accepted

Boeing’s method of allocating R&D, and granted judgment in

favor of Boeing for $419,110,539. This appeal followed.

ANALYSIS

We review de novo a district court’s interpretation of the

LR.C. and corresponding treasury regulations. See United

States v. Hagberg, 207 F.3d 569, 571 (9th Cir. 2000).

Generally, a court must defer to the Commissioner’s

interpretation of the I.R.C. by the regulations he issues, so long

as those regulations “implement the congressional mandate in

some reasonable manner.” See Redlark v. Commissioner, 141

F.3d 936, 939 (9th Cir. 1998) (quoting Rowan Cos. v. United

States, 452 U.S. 247, 252, 68 L. Ed. 2d 814, 101 S. Ct. 2288

(1981)). A court has authority to reject the Commissioner’s

reasoned interpretation and invalidate a regulation only when

the LR.C. section to which the regulation applies has a meaning

that is clear, unambiguous, and in conflict with the regulation.

See id. (citing Chevron U.S.A., Inc. v. Natural Res. Def

Council, 467 U.S. 837, 841-44, 81 L. Ed. 2d 694, 104 S. Ct.

2778 (1984)).

When Congress, by explicitly leaving a gap for an agency

to fill, delegates authonty to the agency to elucidate a specific

provision of a statute by regulation, that delegation is “express”

and the agency’s regulations issued pursuant to the legislation

are “legislative regulations.” Such regulations are given

controlling weight unless they are arbitrary, capricious, or

manifestly contrary to the statute. See 141 F.3d at 939-40

(citing Chevron U.S.A., Inc., 467 U.S. at 843-44). if delegation

to the agency is implicit, however, a court owes deference only

to the agency's reasonable interpretation of the statutory

provisions and related regulations. See McLean v. Crabtree,

173 F.3d 1176, 1181 (9th Cir. 1999), cert. denied, 528 U.S.

1086, 145 L. Ed. 2d 685, 120 S. Ct. 814 (2000).

| Both Treas. Reg. §§ 1.861-8(e)(3) and 1.994-1(c) are

legislative regulations because they were promulgated pursuant

to LR.C. §§ 863(a) and 994(b), which contain explicit grants of

authonty from Congress. See Black & Decker Corp. v.

Commissioner, 986 F.2d 60, 63 (4th Cir. 1993) (explaining that

section 863(a) providesexpress Congressional authorization for

Treas. Reg. § 1.861-8, which describes the allocation of costs,

losses, and deductions derived from domestic and foreign

sources), see also 1.R.C. § 994(b)(2) (granting the Secretary the

authonty to prescribe regulations “for the allocation of

expenditures in computing combined taxable income. . . in

those cases where a DISC is seeking to establish or maintain a

market for export property”).

In St. Jude Medical, however, the Eighth Circuit concluded

that § 1.861-8(a)(3) was promulgated pursuant to the

Commissioner’s general grant of authority in .R. C. § 7805(a),

not pursuant to any express legislative delegation, and as a

result the court owed deference only to the IRS’s reasonable

interpretation of the applicable statutes and regulations. See Sr.

Jude Medical, 34 F.3d at 1400 n. 11.

In the present case, we need not decide which standard of

review applies, because whether we review the Commissioner's

interpretation under an “arbitrary or capricious” standard, or

under the arguably less deferential “reasonableness” standard,

we uphold that interpretation. We agree with the Commissioner

that Boeing’s method of allocating R&D costs and calculating

CTI on its DISC and FSC sales of commercial airplanes

violates Treas. Reg. § 1.861-8(e)(3)’s requirement for the

allocation of “total costs” and that Treas. Reg. § 1.861-8(e)(3)

is a permissible interpretation of the I.R.C.

The DISC and FSC provisions permit a taxpayer to defer

or exempt from tax a significant portion of income from export

sales. See ILR.C. §§ 991-997; §§ 921-927.° These tax incentives

are intended to encourage and increase exports by domestic

corporations.

Qualified DISCs, which are subsidiaries incorporated

under “the laws of any State,” are not taxed directly.* LR.C.

§ 992(a)(1). Instead, the parent corporation is taxed on a

> The DISC provisions were enacted in 1971. The FSC provisions

were enacted in 1984 to cure some problems with the DISC

provisions. See Deficit Reduction Act of 1984, Pub. L. No. 98-369,

98 Stat. 494. Because the differences between these statutory

schemes are not relevant to this appeal, we generally discuss only the

DISC provisions.

‘ Prior to the enactment of the DISC legislation, domestic

corporations which directly marketed their products in a foreign

market were taxed on their foreign earnings “at the full U.S.

corporate income tax rate regardless of whether (the) earnings [were]

kept abroad or repatriated.” H.R. Rep. No. 92-533, reprinted in 1971

U.S.C.C.A.N. 1825, 1872.

specified portion of its subsidiary DISC’s profits. See I.R.C.

§ 995. The DISC’s remaining profits are tax deferred until

either they are distributed to the parent corporation or the DISC

Us to meet statutory requirements. See I.R.C. § 995(a) &

The amount of a DISC’s profit depends on the transfer

price at which its parent is deemed to have sold to it the product

it resells. There are three methods for calculating this transfer

price, and thus the amount of taxable income made on export

sales. See I.R.C. § 994(a). These “intercompany pricing rules”

are intended to “avoid the complexities of the [arm’s-length]

pricing rules . . . and also to provide encouragement for the

operation of DISC’s.” H.R. Rep. No. 92-533, reprinted in 1971

U.S.C.C.A.N. 1825, 1887. Although the intercompany pricing

rules permit a DISC to earn profits in excess of the arm’s length

pricing rules, they also serve to limit the amount of income

which can be deferred from taxation. See id; /ntel Corp. v.

Commissioner, 76 F.3d 976, 981 (9th Cir. 1995).

A taxpayer is permitted to choose the pricing method that

maximizes its DISC’s profit. See LR. C. § 994. There is an

incentive to maximize DISC profit because “[t] he greater the

DISC profit, the larger the amount of tax-deferred income and

the larger the deemed dividend.” St. Jude Medical, 34 F.3d at

1397. Deemed dividends are taxed as foreign source income,

which qualifies the parent corporation for a corresponding

foreign tax credit. See ILR.C. §§ 862(a)(2), 901 & 904.

In computing its DISC profits, Boeing chose the combined

taxable income (CTI) method described in I.R.C. § 994(a)(2),

which permits such profits to be computed on the basis of fifty

percent of the “combined taxable income . . . attributable to the

qualified export receipts .. . .” The statute does not define

’ In contrast. a portion of a FSC’s profits are permanently exempt

from taxation. See .R.C. § 923(a).

“combined taxable income.” Instead, “combined taxable

income” is defined in Treas. Reg. § 1.994-1(c)(6), which states:

[T]he combined taxable income of a DISC and its related

supplier from a sale of export property is the excess of the

gross receipts (as defined in section 993(f)) of the DISC

from such sale over the total costs of the DISC and related

supplier which relate to such gross receipts.

26 C.F.R. § 1.994-1(c)(6) (emphasis added). Gross receipts are

“the total receipts from the sale ... of property held primarily for

sale ... in the ordinary course of trade or busir-ess, and gross

income from all other sources,” but do not include interest with

respect to the sales. 26 US.C. § 993(f); 26 C.FR.

§ 1.994-1(c)(6).

Generally, the pricing of goods sold by a supplier (the

taxpayer) to its DISC should be made on a transaction-by-

transaction basis. Jd. § 1.994-1(c)(7). However, the taxpayer

may elect to determine the price “on the basis of groups

consisting of products or product lines.” Jd. The taxpayer's

choice as to the grouping of transactions “shall be controlling,”

and “costs deductible in a taxable year shall be allocated and

apportioned to the items or classes of gross income of such

taxable year resulting from such grouping.” /d.

§ 1.994-1(c)(6)iv). The district director must accept this

determination if it conforms to a recognized industry or trade

usage, or the major groups recognized by the SIC. /d

§ 1.994-1(c)(7)ii).

Before calculating DISC CTI, the taxpayer must allocate

its costs between export sales and domestic sales. The costs of

goods sold are determined according to 26 C.F. R. § 1.61-3. /d.

§ 1.994-1(c)(6)ii). Other costs “which shall be treated as

relating to the gross receipts from sales of export property are

(a) the expenses, losses, and other deductions definitely related,

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

ratable part of any other expenses, losses or other deductions

which are not definitely related to a class of gross income,

determined in a matter consistent with the rules set forth in

1.861-8.” Jd. § 1.994-1(c)(6)(iii) (emphasis added).° Neither

the § 1.994 regulations nor the .R.C. define “definitely related”

other than by reference to § 1.861-8.

Section 1.861-8(b)(2) states “[a] deduction shall be

considered definitely related to a class of gross income and

therefore allocable to such class if it is incurred as a result of,

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

which such class of gross income is derived.” /d.

§ 1.861-8(b)(2). Recognizing that “research and development

is an inherently speculative activity, that findings may

contribute unexpected benefits, and that the gross income

derived from successful research and development must bear

the cost of umsuccessful research and development,”

§ 1.861-8(e)(3)’ provides:

Expenditures for research and development which a

taxpayer deducts under section 174 shall ordinarily be

considered deductions which are definitely related to all

income reasonably connected with the relevant broad

product category (or categories) of the taxpayer and

therefore allocable to all items of gross income as a class

(including income from sales, royalties, and dividends)

related to such product category (or categories) .. . . The

individual products included within each category are

enumerated in the . . . Standard Industrial Classification

Manual.

* The regulations offer the following as examples of deductions that

are generally considered “not definitely related” to any class of gross

imome — personal interest expense, real estate and sales taxes,

medical expenses, charitable contributions, and alimony payments.

See 26 C.F.R. § 1.861-8(e)(9\i) +v).

” In 1996, the provisions of § 1.861-8(e)(3) were renumbered and,

with amendments not relevant to this appeal, were republished as

Treas. Reg. § 1.861-17.

10a

The district court, relying on St. Jude Medical, determined that

Treas. Reg. § 1.861-8(e)(3) was invalid as applied to DISC CTI

computations. In St. Jude Medical, the Eighth Circuit identified

three reasons why § 1.861-8(e)(3) did not control the

computation of DISC combined taxable income. See St. Jude

Medical, 34 F.3d at 1401-02. First, the court determined that

§ 1.861-8(e)(3)’s requirement that the taxpayer group its sales

under a broad SIC code conflicted with Congress’s intent to

permit taxpayers to allocate costs by product or product lines

under § 1.994-1(c)(6)(iv) & (c)(7). Jd. at 1401. Second, the

court found section § 1.861-8(¢)(3)(i)’s “deemed” relationship

between R&D costs and export sales conflicted with Congress's

intent to allocate to each item of gross income only the

expenses directly related thereto. Jd. Third, the court

determined that § 1.861-8(e)(3)’s dictate that “gross income

derived from successful research and development bear the cost

of unsuccessful research and development” was inconsistent

with Congress’s intent that CTI computations include only

those costs that are directly related to the production or sale of

export property. Jd. Applying a reasonableness standard of

review,® the Eighth Circuit concluded that Treas. Reg.

§ 1.861-8(e)(3) was unreasonable and invalid as applied to

Boeing’s DISC CTI computations under § 1.994-1(c)(6) & (7).

Id. at 1402.

We decline to follow the reasoning of St. Jude Medical.

Instead, we agree with the Commissioner that Treas. Reg.

* The Eighth Circuit considered “whether the regulation harmonizes

with the plain language of the statute, its origin, and its purpose.” /d.

at 1400 (quoting Nat'l Muffler Dealers Ass'n v. United States, 440

U.S. 472, 477, 59 L. Ed. 2d 519, 99 S. Ct. 1304 (1979)). The court

also considered “the span of time between the enactment of the

statute and promulgation of the regulation, the length of time the

regulation has been in effect, the evolution of the regulation, the

reliance placed on the regulation, the consistency of the

Commissioner's interpretation, and the degree of congressional

scrutiny.” /d.

lla

§ 1.861 8(e)(3) is consistent with the guidance provided by the

relevant I.R.C. provisions. Under I.R.C. § 994(a)(2), CT] is to

be calculated based on revenue and costs “attributable to” sales

in the applicable year. This statutory text does not confine the

relevant costs to those “definitely related” to sales of a

particular product.

The legislative history supports this position. The

applicable House Report states:

[T]he combined taxable income from the sale of the export

property is to be determined generally in accordance with

the principles applicable under section 861 for determining

the source (within or without the United Siates) of the

income . . . .These rules generally allocate to each item of

gross income all expenses directly related thereto, and

then apportion other expenses among all items of gross

income on a ratable basis. Thus the combined taxable

income . . . would be determined by deducting from the

DISC’s gross receipts the . . . cost of goods sold with

respect to the property [and the expenses] of both the DISC

and the related person which are directly related to the

production or sale of the export property and a portion of

the related person’s and the DISC’s expenses not allocable

to any specific item of income, such portion to be

determined based on the basis of the ratio of the combined

gross income from the export property to the total gross

income of the related person and the DISC.

H.R. Rep. No. 92-533, at 74, reprinted in 1971 U.S.C.C.A.N.

1825, 1887-1888 (emphasis added).

This House Report reflects that Congress recognized some

of the costs incurred in a given tax year would not be “directly

related” to specific income items. The Report further reflects

Congress’s intention that those costs not “directly related”

would be allocated to export-related sales on a pro rata basis.

The Commissioner’s application of Treas. Reg. § 1.861-8(e)(3)

effectuates this Congressional intent.

12a

There is no conflict between Treas. Reg. § 1.861-8(e)(3)

and Treas. Reg. § 1.994-1(c)(6). The latter simply substitutes

the term “definitely related” for “directly related.” Like House

Report 92-533, Treas. Reg. § 1.994-1(c)(6) contemplates that

costs which are not “definitely related” to specific items of

income in a given year will be allocated to the combined

taxable income of the taxpayer’s export-related business.

Treas. Reg. § 1.994-1(c)(6) is clear in explaining that “total

costs . .. which relate to” the receipts from export sales will be

allocated to the combined taxable income from such sales and

that those “total costs” include both “definitely” and

“indefinitely” related costs.

To the extent there is any tension between Treas. Reg.

§ 1.861-8(e)(3) and Treas. Reg. § 1.994-1(c)(7), the regulations

can be harmonized by recognizing that the more narrowly a

taxpayer chooses to define income items, the more costs

become “indirectly” or “indefinitely” related to specific items

of income. The taxpayer is required, nonetheless, to apportion

these costs to broader categories of income and allocate them

between the taxpayer’s export and domestic sales by the

proportional method set forth in Treas. Reg. § 1.861-8(e)(3).”

Interpreted in this way, the regulations may be read to give

effect to both. See, e. g., United States v. Borden Co., 308 U.S.

188, 198, 84 L. Ed. 181, 60 S. Ct. 182 (1939) (“It is a cardinal

principle of construction that . . . [w]hen there are two acts

upon the same subject, the rule is to give effect to both if

possible.”’); see also Black & Decker Corp. v. Commissioner,

986 F.2d 60, 65 (4th Cir. 1993) (explaining that the tenets of

statutory construction apply with equal force to the

interpretation of regulations).

We are unpersuaded that Congressional inaction weighs in

favor of either of the parties. Since 1977, when the IRS first

* If the regulations were truly in conflict, Treas. Reg. § 1.861-8(e3)

would hkely control as the later and more specific regulation. See

United States v. Carper, 24 F.3d 1157, 1159 (9th Cir. 1994).

13a

promulgated Treas. Reg. § 1.861-8(e)(3), Congress has both

amended the DISC statutory scheme and enacted temporary

legislation governing the allocation of R&D costs in other

contexts. The government argues that Congress’s failure to

legislatively override Treas. Reg. § 1.861-8(e)(3) as to the

computation of DISC CTI signals Congress’s approval of that

regulation’s method for computing such income.'® The tax

court in St. Jude Medical relied in part on this argument. See Sr.

Jude Med., Inc. v. Commissioner, 97 T.C. 457, 485 (1991)

(“Congress has repeatedly considered the regulations at issue

and ...has neither modified the allocation and apportionment

regulations as applied to the computation of combined taxable

income nor expressed its disapproval of the regulations.”’), aff'd

in part and rev'd in part by, 34 F.3d 1394 (8th Cir. 1994). On

the other hand, the Eighth Circuit discounted this argument in

St. Jude Medical, 34 F.3d at 1402 n. 15, and Boeing argues

Congress has failed to act in the seven years since the Eighth

Circuit in St. Jude Medical determined that Treas. Reg.

§ 1.861-8(e)(3) was invalid as applied to DISC income

determinations. /d. at 1402.

The most that can be said from these competing arguments

is that Congressional inaction provides no reliable indication of

how this case should be resolved. Treas. Reg. § 1.861-8(e)(3),

however, is areasonable interpretation of the applicable statutes

and regulations. As such, it provides the proper method for

allocating Boeing’s R&D costs attributable to its export sales

of commercial airplanes. Accordingly, we reverse the district

Pub. L. No. 97-34, 95 Stat. 172, 249, Congress placed a two-year

moratorium on Treas. Reg. § 1.861-8(e)3) to the extent it was being

used to determine whether particular income was foreign source or

United States source income. This moratoruum was extended an

additional two years by the Deficit Reduction Act of 1984 § 126,

Pub. L. No. 98-369, 98 Stat. 494, 648 and an additional year by the

Consolidated Omnibus Budget Recorciliation Act of 1985 § 13211,

Pub. L. No. 99-272, 100 Stat. 82, 324.

14a

court’s summary judgment for $419,110,539 in favor of

Boeing. We also reverse the district court’s partial summary

judgment for approximately $1 million in favor of the

government, and remand to the district court for further

procéedings consistent with this opinion.

REVERSED and REMANDED.

lSa

APPENDIX B

No. C96-1990C

UNITED STATES DISTRICT COURT

for the Western District of Washington

THE BOEING COMPANY (and consolidated subsidianes)

and BOEING SALES CORPORATION.

Plaintiffs.

UNITED STATES OF AMERICA,

Defendant

September 10, 1998, Decided

ORDER

COUGHENOUR, Chief Judge.

In this taxpayer refund case, the parties cross-move for

summary judgment. Having considered all of the files and

pleadings herein, and having heard oral argument, the Court

GRANTS summary judgment in favor of plaintiffs.

INTRODUCTION

Plaintiffs (“Boeing’’) sue for the refund of over $446 million

in federal income tax and assessed interest paid for the taxable

periods 1979 through 1987. The case arses in the context of a

special set of incentive provisions in the Internal Revenue Code

(“IRC”) allowing a U.S. taxpayer to defer or exempt from tax

a portion of its net income on export sales if the property 1s sold

through a subsidiary established as a domestic international

sales corporation (“DISC”) or a foreign sales corporation

(“FSC”). Boeing thus has a substantial incentive under those

provisions to increase net income from export sales by reducing

the amount of deductions on its export sales. In the instant case,

Boeing challenges the manner in which the IRS allocated and

16a

apportioned over $1 billion in research and development

(“R&D”) costs in determining the net income of Boeing’s

DISC/FSC. Specifically, Boeing argues that Treasury Reg.

§ 1.861-8(e)(3) is illegal when applied to DISC/FSC combined

taxable income (“CTT”) computations.

FACTUAL BACKGROUND

The parties have stipulated to the facts relevant to the instant

motions. During the years at issue, Boeing was the world’s

leading manufacturer of commercial airplanes and one of the

country’s largest exporters. On average, approximately 70% of

Boeing’s commercial airplane sales by dollar volume consisted

of qualified export sales. From 1972 until 1984, Boeing

exported commercial airplanes and related goods and services

through its subsidiary, Boeing International Sales Corporation

(“BISC”), a qualified DISC under LR.C. § 992. After 1984,

Boeing exported commercial airplanes and related goods and

services through its subsidiary, Boeing Sales Corporation, a

qualified FSC, under I.R.C. § 922.

For the time period in question, Boeing contends that it

established or maintained separate Programs of each of its

major commercial airplane product lines — the 707, the 727,

the 737, the 747, the 767, the 757 and the 737-300. Within each

Program, Boeing developed several different models (or

“denvatives”), such as a passenger and cargo version of the

747. Each of Boeing’s Programs is a separate product or

product line in conformance with industry practice and trade

usage in the commercial airplane business. The initial airplane

in each of the Programs at issue, with the exception of the

737-300, was required to obtain a new type certification from

the Federal Aviation Administration (“FAA”). The certificate

sets forth the applicable regulatory requirements that the

airplane has met.

Boeing classifies its R&D ¢ »sts into two broad categones —

“Blue-Sky R&D,” incurred before the Program Go Ahead

(“PGA”) for a new airplane Program or major model derivative,

17a

and Program R&D, also referred to as Company Sponsored

Product Development (“CSPD”), incurred after PGA. CSPD

expenditures represent approximately 77% of the R&D

amounts at issue in this case. PGA is the point at which Boeing

makes the firm business decision and commitment to produce

a particular airplane model and the decision is made by the

Board of Directors. Blue Sky R&D goes to basic research

relating to commercial airplanes, such as research in the field

of aerodynamics or avionics and to concept research aimed at

identifying new commercial airplanes, that might adapt new

technology to achieve a new market niche. Blue Sky R&D may

be a precursor to a specifically identified Program, although the

majonty of Blue Sky projects never become Programs. CSPD

1s Program-specific and includes the cost of designing,

developing, testing, and qualifying a particular new airplane

model for commercial service with an FAA type certification.

The majority of those costs are nonrecurring.

Under Boeing’s cost accounting system, Blue-Sky R&D was

allocated to all Programs and apportioned among them. CSPD

R&D, on the other hand, was charged directly to the Programs

in which they were incurred, and deducted on a current year

bases regardless of whether there were any sales in the

corresponding Program that year. During the years at issue, for

financial accounting purposes, the Blue-Sky and CSPD R&D

costs were expensed in the penod in which they were incurred.

And, for overall federal income tax purposes, all the R&D costs

were deducted in the period they were incurred.

For purposes of calculating the intercompany price and

profits from its export sales, Boeing chose the combined

taxable income (“CTI”) method under § 994(a)(2) and

§ 925(aX{2) of the Code. To calculate CTI, Boeing chose to

“group” its export sales by airplane Program under Treas. Reg.

§ 1.994-1(c)(7). Boeing relied on its cost accounting system

and the resulting identification of costs and expenses, including

R&D, chargeable to the specific Program. Boeing’s method

charged the R&D to the specific program even if there were no

18a

sales in the Program in the same year in which the CSPD R&D

on that Program was incurred, and it would not be charged

again against Program sales in later years.

Upon an audit, the IRS rejected Boeing’s method of

calculating CTI, claiming that Boeing’s method made R&D

effectively “disappear” for CTI purposes. The IRS instead

applied Treas. Reg. § 1.861-8(e)(3), which provides that R&D

expenses should be deemed related to all sales within the broad

product categories set forth in the Standard Industnal

Classification (“SIC”) published by the Office of Management

and Budget. All of Boeing’s sales of commercial airplanes falls

into SIC code 37, Transportation Equipment. Accordingly, for

a given year, the IRS allocated all of Boeing’s R&D expenses

(Blue-Sky and CSPD) to all of Boeing’s income from sales of

commercial airplanes and then apportioned those R&D

expenses among Boeing’s airplane Programs on the basis of

sales. All of the R&D is thus deducted against the revenue from

Boeing’s commercial airplanes sales for that year, whether or

not the R&D is factually related to those sales.

ANALYSIS

Given the stipulated facts submitted by the parties, these

summary judgment motions present a pure legal question:

whether Treas. Reg. § 1.861-8(e)(3) may be applied to Boeing’s

DISC/FSC CTI computations. This is not a question of first

impression. The Eight Circuit dealt with precisely this question

in St. Jude Medical, Inc. v. C.LR., 34 F.3d 1394, 1396 (8th Cir.

1994). After examining the legislative intent behind the DISC

and the applicable regulations, the Eight Circuit squarely held

that “§ 1.861-8(e)(3) is invalid as applied to DISC CTI

computations.” The Court found that § 1.861-8(e)(3) was

unreasonable as applied to the DISC statute as it did not

“harmonize{] with the plain language of the statute, its origin,

and its purpose.” /d. at 1402. This Court finds the reasoning and

19a “

analysis in St. Jude to be persuasive and applicable to the

current case.’

I. Statutory Framework

The St. Jude court set out in detail the statutory framework

governing the calculation of CTI for a DISC/FSC, which this

Court will summarize briefly. In 1971, Congress enacted the

DISC provisions, I.R.C. §§ 991-997, as a tax incentive to

encourage and increase exports of products by US.

manufacturers. St. Jude, 34 F.3d at 1396. In 1984, the FSC

provisions were enacted to replace and cure some shortcomings

in the DISC provisions. Deficit Reduction Act of 1984, Pub. L.

98-369, § 801(a), 98 Stat. 494, 990; S. Rep. No. 98-169, at 636

(1984). Qualified DISC/FSC corporations are not subject to tax.

Instead, the parent corporation is taxed on a specified portion

of the DISC profits as a deemed distribution. I.R.C. § 995;

L&F Intl. Sales Corp. v. United States, 912 F.2d 377, 378 (9th

Cir. 1990). The remaining DISC profits are tax deferred until

distributed to the parent or until the DISC ceases to qualify as

a DISC. § 995(a) and (b). The FSC provisions permanently

exempt a portion of FSC profits from tax. § 923(a).

} Under the DISC statute, Congress also created intercompany

pricing rules which provide for the price at which the parent

corporation is deemed tc have sold its products to the DISC

corporation. The intercornpany pricing rules were intended to

“avoid the complexities of the [arms length] pricing rules in the

| The St. Jude court said that a tax regulation must be a reasonable

interpretation of the congressional mandate in order to be upheld. 34

F.3d at 1400. The government argues that the appropriate standard of

review should be governed by the standard set forth in Chevron USA

v. Natural Resources Defense Council, 467 U.S. 837, 81 L. Ed. 2d

694, 104 S. Ct. 2778 (1984). Even if that is the case, however, the

‘Chevron standard still requires a reasonable interpretation of a statute.

See Redlark v. C.1.R., 141 F.3d 936, 939 (9th Cir. 1998) (courts “will

not overnde the agency’s reasonable construction” of statute). St

Jude found § 1.861-8(e)(3) to be an unreasonable construction.

20a

case of sales by a domestic corporation . . . to a DISC and also

to provide encouragement for the operation of DISC’s.” 34

F.3d at 1397 (quoting H.R. Rep. No. 533 at 73, reprinted in

1971 U.S.C.C.A.N. at 1887). The rules allowed a DISC

corporation profit in excess of arm's length rules and regardless

of the sales price actually charged. /d. The rules also served to

“limit[] the amount of income of which the parent can defer

realization,” Jntel Corp. v. Commissioner, 76 F.3d 976, 981

(9th Cir. 1995), by fixing a transfer price so that the entire

amount of export sales would not be deferred, but only the

amount computed under the statute.

Under the DISC intercompany pricing rules, taxpayers may

choose between three pricing methods to achieve the largest

amount of income allocation to DISC. See LR.C. § 994.

Boeing chose the combined taxable income, “CTI,” method for

its DISC/FSC. LR.C. § 994(a)(2) states that the DISC is

entitled to fifty percent of the “combined taxable income . . .

attributable to the qualified export receipts” for the property.’

The statute does not further define CTI. That definition is found

in Treas. Reg. § 1.994-1(c)(6), which defines CTI as “the

excess of gross receipts . . . from such a sale over the total costs

of the DISC and related supplier which relate to such gross

receipts.”

Treas. Reg. § 1.994-1(c)(6)(ii1) provides that the costs fall

into three categories: (1) costs of goods sold, (2) costs that are

“definitely related” to export property, and (3) costs that “are

not definitely related to a class of gross income.” Taxpayers

must allocate their costs between export sales and domestic

sales to compute CTI. Rather than creating a new method of

cost allocation within the DISC provisions, Congress intended

that CTI costs computations “be determined generally in

> Although there are some differences between the DISC and

FSC provisions, the parties agree that the calculation of the CTI

on export sales is essentially the same for both. See Genera/

Dynamics, 108 T.C. 107 at 116.

2la

accordance with the principles applicable under [I.R.C.] section

861." St. Jude, at 1401. Treas. Reg. § 1.861-8(e)(3) provides

the general rules for allocating and apportioning R&D under

I.R.C. § 861 and deems a definite relationship between an R&D

expenditure and a broad SIC product category. 34 F.3d at

1399.

At the same time, Treas. Reg. § 1.994-1(c)(6)(iv) provides

that the taxpayer's grouping choice under § 1 .994-1(c)(7) “shall

be controlling and costs deductible in a taxable year shall be

allocated and apportioned to the items or classes of gross

income of such taxable year resulting from such grouping.” In

this case, Boeing chose to group according to a recognized

industry/trade usage, i.e. product line, and not the SIC code

category, a choice that is not only allowed, but controlling.

Il. The Application of § 1.861-8(e)(3) to DISC/FSC CTI

Computations

The conflict between Treas. Reg. § 1.861-8(e)(3) and Treas.

Reg. § 1.994-1(c)(6)(iv) as applied to CTI computations was

resolved in Boeing’s favor in St. Jude. St. Jude was a U.S.

corporation that incurred R&D related to three different

products: an insulin pump, a cardiac pacemaker, and an

artificial heart valve. St. Jude exported heart valves through its

DISC, but never sold the insulin pump or cardiac pacemaker.

St. Jude used the CTI method to calculate DISC transfer prices

and grouped each of its three products separately under Treas.

Reg. § 1.994-1(c)(6)iv) and (c)(7), so that no portion of the

R&D expenses for the insulin pump and pacemaker were

allocated to export receipts from heart valves. The IRS applied

§ 1.861-8(e)(3) to all three products and grouped them under

SIC Code 38, so that all R&D expenses effectively were

charged against export sales of heart valves in computing CTI.

The St. Jude court found three primary defects with such an

application of § 1.861-8(e)(3). The first defect is that the

§ 1.861-8(e)(3) requires grouping according to a two-digit SIC

Code, which conflicts with Congress's intent to allow costs to

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be allocated on a product-by-product basis or on the basis of

product lines. See St. Jude, 34 F.3d at 1401. The second defect

is that the “deemed” relationship mandated by § 1.861-8(e)(3)

is inconsistent with Congress’s intent to “generally allocate to

each item of gross income all expenses directly related

thereto.” St. Jude, 34 F.3d at 1401 (emphasis in orginal). The

third defect is that the SIC categories requiring “gross income

derived from successful research and development [to] bear the

cost of unsuccessful research and development” is inconsistent

with Congress’s intent to deduct only those costs “directly

related to the production or sale of the export property.” /d.

The government provides little resistance to the first two

defects identified by St. Jude. It argues that there is no conflict

between the mandated SIC grouping in § 1 .861-8(e)(3) and the

taxpayer elected grouping of § 1.994-1(c)(6){iv) and (c)(7)

because the grouping choice in § 1.861-8(e)(3) is somehow an

exception to § 1.994-1(c)(6)iv) when computing CTI. The

government's only citation for that proposition, however, is the

tax court decision in St. Jude which was reversed by the Eighth

Circuit.

The government also argues that § 1.994-1(c)(6)iv) and

(c)(7) were merely for “administrative convenience” and using

the grouping provisions to increase tax savings would be

inconsistent with the purpose of CTI, which the government

suggests is to limit the amount of tax savings available to

taxpayers under the DISC/FSC provisions. The government

reads too much into /ntel Corp. in search of support for its

proposition that CTI was meant to limit tax savings regardless

of § 1.994-1(c)(6)(iv) and (c)(7). Intel Corp.’s description of

the intercompany pricing rules merely recognizes that in the

context of an incentive provision designed to allow “domestic

exporters to enjoy a deferral of tax on their export earnings

somewhat similar to that available to exporters who utilized

foreign subsidiaries,” [76 F.3d at 981, the exporters should

enjoy a partial but not complete deferral.

23a

The government seems to use the third defect as the basis

for their argument that Sz. Jude’s holding should be limited to

R&D on unsuccessful products. However, while the difference

between successful and unsuccessful R&D was an important

factor in St. Jude, its holding and analysis did not turn on that

distinction. Indeed, it is the very nature of R&D that it cannot

be known in advance whether or not the R&D effort will be

successful and if successful, when it will be successful. If the

development of a new product takes several years, it makes no

sense for the taxpayer to apply Treas. Reg. § 1.861-8(e)(3) for

the irst years when the R&D has not resulted in sales, and then

follow St. Jude in a subsequent year when there have been

sale . Thus, although one of the defects of § 1.861-8(e)(3) is not

appli:able here, the other two are; and those defects are fatal.

The government also attempts to distinguish Sr. Jude by

arguing that it did not address the issue of “total costs,” referred

to in § 1.994-1(c)(6), that is presented here. In fact, however,

the St. Jude court rejected the government's argument that

“total costs” should be calculated by deducting R&D from all

export sales for the year, not just for a Program to which the

R&D is related. St. Jude considered § 1.994-1(c)(6) and

concluded that Congress intended an actual relationship, rather

than a deemed relationship, between the export gross receipts

and the expense in question, and that § 1.861-8(e)(3’s

“deeming” of a relationship violated Congress's intent. Thus,

under Sr. Jude, “total costs” is calculated by deducting the R&D

from the income to which the R&D is actually related, not from

the total income of a DISC/FSC for any given year.

General Dynamics Corp. & Subsidiaries v. Commissioner,

108 T.C. 107 (1997), does not support the government’s

position either. Preliminarily, General Dynamics dealt with the

definition of “total costs” on a very different set of facts.

General Dynamics used the completed contract method of

accounting for long-term contracts for federal income tax

purposes. Normally, under the completed contract method,

income and expenses connected with long-term contracts are

24a

not reported or claimed until the completion of the contract, so

General Dynamics did not recognize income from its long-term

contracts until the year that the contract was completed.

General Dynamics elected, however, to deduct certain peniod

costs, including marketing and selling expenses, distribution

expenses, pension and profit-sharing contributions, but not

R&D, in the year incurred. The Tax Court found that those

costs were not definitely related to income other than export

sales, so they had to be accounted for in determining CTI when

income was received from the completed contracts. 108 T.C.

at 124-25.

More importantly, however, applying General Dynamics

here would arrive at a result inconsistent with § 1.861-8(e)(3).

The government’s method of computing CTI reduces the CTI

for a current Program within a given year (i.e., sales of 747’s in

1980) by the R&D incurred for a different Program that same

year (i.e., 757 R&D incurred in 1980). Under the approach in

Gene~>| Dynamics, however, because it is premised on the

completed contract accounting method, current R&D (i.e., 757

R&D incurred in 1980) would be currently deducted whether

or not there was a sale in the Program, and not charged against

the export sales in the Program until a sale was made (i.e., 757

sales in 1981).

CONCLUSION

Accordingly, summary judgment is GRANTED in favor of

plaintiffs.

25a

APPENDIX C

No. 99-35818, 99-35857

UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

THE BOEING COMPANY, and

Consolidated Subsidiaries; BOEING SALES

CORPORATION,

Plaintiffs-Appellees,

Vv.

UNITED STATES OF AMERICA,

Defendant-Appellant.

THE BOEING COMPANY, and

Consolidated Subsidiaries, Plaintiff, and

BOEING SALES CORPORATION,

Plaintiff-Appellant,

Vv.

UNITED STATES OF AMERICA,

Defendant-Appellee.

November 19, 2001

Before: THOMPSON, TROTT, and PAEZ, Circuit Judges

The panel, as constituted above, has unanimously voted to

deny appellee Boeing’s petition for rehearing. Judges Trott and

Paez have also voted to deny its petition for rehearing by the

court en banc, and Judge Thompson has recommended that

petition be denied.

The full court has been advised of the petition for court

rehearing en banc, and no judge of the court has requested en

banc rehearing. See Fed. R. App. P. 35(b).

The petition for panel rehearing and for rehearing by the

court en banc are DENIED.

26a

APPENDIX D

26 U.S.C. § 861 (1979)

§ 861. Income from sources within the United States.

(a) GROSS INCOME FROM SOURCES WITHIN UNITED STATES.

~ The following items of gross income shall be treated as

income from sources within the United States:

(b) TAXABLE INCOME FROM SOURCES WITHIN UNITED

STATES. - From the items of gross income specified in

subsection (a) as being income from sources within the United

States there shall be deducted the expenses, losses, and other

deductions properly apportioned or allocated thereto and a

ratable par of any expenses, losses, or other deductions which

cannot definitely be allocated to some item or class of gross

income. The remainder, if any, shall be included in full as

taxable income from sources within the United States. In the

case of an individual who does not itemize deductions, an

amount equal to the zero bracket amount shall be considered a

deduction which cannot definitely be allocated to some item or

class of gross income.

27a

APPENDIX E

26 U.S.C. § 994 (1979)

§ 994. Inter-company pricing rules.

(a) In general. In the case of a sale of export property to a

DISC by a person described in section 482, the taxable income

of such DISC and such person shall be based upon a transfer

price which would allow such DISC to derive taxable income

attributable to such sale (regardless of the sales price actually

charged) in an amount which does not exceed the greatest of—

(1) 4percent of the qualified export receipts on the sale

of suclr property by the DISC plus 10 percent of the export

promotion expenses of such DISC attributable to such receipts,

(2) 50 percent of the combined taxable income of such

DISC and such person which is attributable to the qualified

export receipts on such property derived as the result of a sale

by the DISC plus 10 percent of the export promotion expenses

of such DISC attributable to such receipts, or

(3) taxable income based upon the sale price actually

charged (but subject to the rules provided in section 482).

(b) Rules for commissions, rentals, and marginal costing.

The Secretary shall prescribe regulations setting forth—

(1) rules which are consistent with the rules set forth

in subsection (a) for the applicat ~n of this section in the case

of commissions, rentals, and other income, and

(2) rules for the allocation of expenditures in

computing combined taxable income under subsection (a)(2) in

those cases where a DISC is seeking to establish or maintain a

market for export property.

section, the term “export promotion expenses” means those

expenses incurred to advance the distribution or sale of export

property for use, consumption, or distribution outside of the

28a

United States, but does not include income taxes. Such

expenses shall also include freight expenses to the extent of 50

percent of the cost of shipping export property aboard airplanes

owned and operated by United States persons or ships

documented under the laws of the United States in those cases

where law or regulations does not require that such property be

shipped aboard such airplanes or ships.

29a

APPENDIX F

26 C.F.R. 1.994-1 (1979)

§ 1.994-1 Inter-company pncing rules for DISC’s

(a) In general -- (1) Scope. In the case of a transaction

descnbed in paragraph (b) of this section, section 994 permits

a person related to a DISC to determine the allowable transfer

price charged the DISC (or commission paid the MISC) by its

choice of three methods descnbed in paragraph (c} 2), (3), and

(4) of this section: The “4 percent” gross receipts method, the

“50-50” combined taxable income method, and the section 482

method. Under the first two methods, the DISC is entitled to 10

percent of its export promotion expenses as additional taxable

income. When the gross receipts method or combined taxable

income method ts applied to a transaction, the Commissioner

may not make distnbutions, apportionments, or allocations as

provided by section 482 and the regulations thereunder. For

rules as to certain “incomplete transactions” and for computing

combined taxable income, see paragraph (c) (5) and (6) of this

section. Grouping of transactions for purposes of applying the

method chosen is provided by paragraph (c)(7) of this section

The rules in paragraph (c) of this section are directly applicable

only in the case of sales or exchanges of export property to a

DISC for resale, and are applicable by analogy to leases,

commissions, and services as provided in paragraph (d) of this

section. For rules limiting the application of the gross receipts

method and combined taxable income method so that the

supplier related to the DISC wili not incur a loss on

transactions, see paragraph (e)(1) of this section. Paragraph

(e)(2) of this section provides for the applicability of section

482 to resales by the DISC to related persons. Paragraph (e)(3)

of this section provides for the time by which a reasonable

estimate of the transfer price (including commissions and other

payments) should be paid. The subsequent determination and

further adjustments to transfer prices are set forth in paragraph

(e)(4) of this section. Export promotion expenses are defined in

30a

paragraph (f) of this section. Paragraph (g) of this section has

several examples illustrating the provisions of this secuon

Section 1.994-2 prescribes the marginal costing fules

authonzed by section 994(b)(2)

general. Under this paragraph, rules are prescnbed for

computing the allowable price for a transfer from a related

supplier to a DISC in the case of a sale of export property

descnbed in paragraph (b)(1) of this section.

(2) The “4-percent” gross receipts method. Under the

gross receipts method of pricing, the transfer price for a sale by

the related supplier to the DISC is the price as a result of which

the taxable income denved by the DISC from the sale will not

exceed the sum of (1) 4 percent of the qualified export receipts

of the DISC derived from the sale of the export property (as

defined in section 993 (c)) and (ii) 10 percent of the export

promotion expenses (as defined in paragraph (f) of this section)

of the DISC attnbutable to such qualified export receipts.

(3) The “50-50” combined taxable income method.

Under the combined taxable income method of pricing, the

transfer price for a sale by the related supplier to the DISC is

the price as a result of which the taxable income denved by the

DISC from the sale will not exceed the sum of (i) 50 percent of

the combined taxable income (as defined in subparagraph (6)

of this paragraph) of the DISC and its related supplier

attributable to the qualified export receipts from such sale and

(ii) 10 percent of the export promotion expenses (as defined in

paragraph (f) of this section) of the DISC attnbutable to such

qualified export receipts.

(4) Section 482 method. If the rules of subparagraphs

(2) and (3) of this paragraph are inapplicable to a sale or a

taxpayer does not choose to use them, the transfer price for a

sale by the related supplier to the DISC is to be determined on

3la

the basis of the sale price actually charged but subject to the

rules provided by section 482 and the regulations thereunder.

(5) Incomplete transactions. (i) For purposes of the

gross receipts and combined taxable income methods, where

property (encompassed within a transaction or group chosen

under subparagraph (7) of this paragraph) is transferred by a

related supplier to a DISC during a taxable year of either the

DISC or related supplier, but some or all of such property is not

sold by the DISC during such year —

(a) The transfer price of such property sold by the DISC

during such year shall be computed separately from the transfer

price of the property not sold by the DISC during such year,

(b) With respect to such property not sold by the DISC

during such year, the transfer price paid by the DISC for such

year shall be the related supplier's cost of goods sold (see

subparagraph (6)(11) of this paragraph) with respect to the

property, except that, with respect to such taxable years ending

on or before August 15, 1975, the transfer price paid by the

DISC shall be at least (but need not exceed) the related

supplier's cost of goods sold with respect to the property.

property is resold by the DISC, an additional amount shall be

paid by the DISC (to be treated as income for such year by the

related supplier) equal to the excess of the amount which would

have been the transfer price under this section had the transfer

to the DISC by the related supplier and the resale by the DISC

taken place during the taxable year of the DISC during which

it resold the property over the amount already paid under (b) of

this subdivision.

(d) The time and manner of payment of transfer prices

required by (b) and (c) of this subdivision shall be determined

under paragraph (e) (3), (4), and (5) of this section.

(11) For purposes of this paragraph, a DISC may determine

the year in which it receives property from a related supplier

32a

and the year in which it sells property in accordance with the

method of identifying goods in its inventory properly used

under section 471 or 472 (relating respectively to general rule

for inventories and to LIFO inventories). Transportation

expense of the related supplier in connection with a transaction

to which this subparagraph applies shall be treated as an item

of cost of goods sold with respect to the property if the related

supplier includes the cost of intracompany transportation

between its branches, divisions, plants, or other units in its cost

of goods sold (see subparagraph (6)(1i) of this paragraph).

(6) Combined taxable income. For purposes of this

section, the combined taxable income of a DISC and its related

supplier from a sale of export property is the excess of the gross

receipts (as defined in section 993(f)) of the DISC from such

sale over the total costs of the DISC and related supplier which

relate to such gross receipts. Gross receipts from a sale do not

include interest with respect to the sale. Combined taxable

income under this paragraph shall be determined after taking

into account under paragraph (e)(2) of this section all

adjustments required by section 482 with respect to transactions

to which section is applicable. In determining the gross receipts

of the DISC and the total costs of the DISC and related supplier

which relate to such gross receipts, the following rules shall be

applied:

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

subparagraph, the taxpayer’s method of accounting used in

computing taxable income will be accepted for purposes of

determining amounts and the taxable year for which items of

income and expense (including depreciation) are taken into-

account. See § 1.991-1(b)(2) with respect to the method of

accounting which may be used by 4 DISC.

(ii) Cost of goods sold shall be determined in accordance

with the provisions of § 1.61-3. See sections 471 and 472 and

the regulations thereunder with respect to inventories. With

respect to property to which an election under section 631

33a

applies (relating to cutting of timber considered as a sale or

exchange), cost of goods sold shall be determined by applying

§ 1.631-1 (d)(3) and (e) (relating to fair market value as of the

beginning of the taxable year of the standing timber cut during

the year considered as its cost).

(111) Costs (other than cost of goods sold) which shall be

treated as relating to gross receipts from sales of export

property are (a) the expenses, losses, and other deductions

definitely related, and therefore allocated and apportioned,

thereto, and (b) a ratable part of any other expenses, losses, or

other deductions which are not definitely related to a class of

gross income, determined in a manner consistent with the rules

set forth in § 1.861-8.

(iv) The taxpayer’s choice in accordance with subparagraph

(7) of this paragraph as to the grouping of transactions shall be

controlling, and costs deductible in a taxable year shall be

allocated and apportioned to the items or classes of gross

income of such taxable year resulting from such grouping.

(v) If an account receivable arising with respect tc a sale of

export property is transferred by the related supplier to a DISC

which is a member of the same controlled group within the

meaning of § 1.993-1(k) for an amount reflecting a discount

from the selling price taken into account in computing (without

regard to this subdivision) combined taxable income of the

DISC and its related supplier, then the combined taxable

income from such sale shall be reduced by the amount of the

discount.

(7) Grouping transactions. (i) Generally, the

determinations under this section are to be made on a

transaction-by-transaction basis. However, at the annual choice

of the taxpayer some or all of these determinations may be

made on the basis of groups consisting of products or product

lines.

34a

(11) A determination by a taxpayer as to a product ora

product line will be accepted by a district director if such

determination conforms to any one of the following standards:

(a) A recognized industry or trade usage, or (b) the 2-digit

major groups (or any inferior classifications or combinations

thereof, within a major group) of the Standard Industrial

Classification as prepared by the Statistical Policy Division of

the Office of Management and Budget, Executive Office of the

President.

(iii) A choice by the taxpayer to group transactions for a

taxable year on a product or product line basis shall apply to all

transactions with respect to that product or product line

consummated during the taxable year. However, the choice of

a product or product line grouping applies only to transactions

covered by the grouping and, as to transactions not

encompassed by the grouping, the determinations are made on

a transaction-by-transaction basis. For example, the taxpayer

may choose a product grouping with respect to one product and

use the transaction-by-transaction method for another product

within the same taxable year.

(iv) For rules as to grouping certain related and subsidiary

services, see paragraph (d)(3)(ii) of this section.

***

35a

APPENDIX G

26 C.F.R. § 1.861-8 (1979)

§ 1.861-8 Computation of taxable income from sources within

the United States and from other sources and activities

(a) Jn general — (1) Scope. Sections 861(b) and 863(a)

state in general terms how to determine taxable income of a

taxpayer from sources within the United States after gross

income from sources within the United States has been

determined. Sections 862(b) and 863(a) state in general terms

how to determine taxable income of a taxpayer from sources

without the United States after gross income from sources

without the United States has been determined. This section

provides specific guidance for applying the cited Code sections

by prescribing rules for the allocation and apportionment of

expenses, losses, and other deductions (referred to collectively

in this section as “deductions”) of the taxpayer. The rules

contained in this section apply in determining taxable income

of the taxpayer from specific sources and activities under other

sections of the Code, referred to in this section as operative

sections. See paragraph (f)(1) of this section for a list and

description of operative sections. The operative sections

include, among others, sections 8761(b) and 882 (relating to

taxable income of a nonresident alien individual or a foreign

corporation which is effectively connected with the conduct of

a trade or business in the United States), section 904(a)(1) (as

in effect before enactment of the Tax Reform Act of 1976,

relating to taxable income from sources within specific foreign

countnes), and section 904(a)(2) (as in effect before enactment

of the Tax Reform Act of 1976, or section 904(a) after such

enactment, relating to taxable income from all sources without

the United States).

(2) Allocation and apportionment of deductions in general.

A taxpayer to which this section applies is required to allocate

deductions to a class of gross income and then, if necessary to

make the determination required by the operative section of the

36a

Code, to apportion deductions within the class of gross income

between the statutory grouping of gross income (or among the

statutory groupings) and the residual grouping of gross income.

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

to gross income (see paragraphs (c\(2) and (e)(9) of this

section) and which, therefore, are ratably apportioned to all

gross income, all deductions of the taxpayer (except the

deductions for personal exemptions enumerated in paragraph

(e)(11) of this section) must be so allocated and apportioned.

As further detailed below, allocations and apportionments are

made on the basis of the factual relationship of deductions to

gross income. If an affiliated group of corporations joins in

filing a consolidated return under section 1501, the provisions

of this section are to be applied separately to each member in

that affiliated group for purposes of determining such

member’s taxable income.

***

(b) Allocation — (1) In general. For purposes of this

section, the gross income to which a specific deduction is

definitely related is referred to as a “class of gross income” and

may consist of one or more items of gross income. The rules

emphasize the factual relationship between the deduction and

a class of gross income. See paragraph (d)(1) of this section

which provides that in a taxable year there may be no item of

gross income in a class or less gross income than deductions

allocated to the class, and paragraph (d)(2) of this section which

provides that a class of gross income may include excluded

income. Allocation is accomplished by determining, with

respect to each deduction, the class of gross income to which

the deduction is definitely related and then allocating the

deduction to such class of gross income (without regard to the

tax-payable year in which such gross income is received or

accrued or is expected to be received or accrued). The classes

of gross income are not predetermined but must be determined

on the basis of the deductions to be allocated. Although most

deductions will be definitely related to some class of a

37a

taxpayer's total gross income, some deductions are related to

all gross income. In addition, some deductions are treated as not

definitely related to any gross income and are ratably

apportioned to all gross income. (See paragraph (e)(9) of this

section.) In allocating deductions it is not necessary to

differentiate between deductions related to one item of gross

income and deductions related to another item of gross income

where both items of gross income are exclusively within the

same statutory grouping or exclusively within the residual

grouping.

(2) Relationship to activity or properiy. A deduction shall

be considered definitely related to a class of gross income and

therefore allocable to such class if it is incurred as a result of,

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

which such class of gross income is derived. Where a

deduction is incurred as a result of, or incident to, an activity or

in connection with property, which activity or property

generates, has generated, or could reasonably have been

expected to generate gross income, such deduction shall be

considered definitely related to such gross income as a class

whether or not there is any item of gross income in such class

which is received or accrued during the taxable year and

whether or not the amount of deductions exceeds the amount of

the gross income in such class. See paragraph (d)(1) of this

section and example (17) of paragraph (g) of this section with

respect to cases in which there is an excess of deductions. In

some cases, it will be found that this subparagraph can most

readily be applied by determining, with respect to a deduction,

the categories of gross income to which it is not related and

concluding that it is definitely related to a class consisting of all

other gross income.

(3) Supportive functions. Deductions which are supportive

in nature (such as overhead, general and administrative, and

supervisory expenses) may relate to other deductions which can

more readily be allocated to gross income. In such instance,

such supportive deductions may be allocated and apportioned

38a

along with the deductions to which they relate. On the other

hand, it would be equally acceptable to attribute supportive

deductions on some reasonable basis directly to activities or

property which generate, have generated, or could reasonably

have been expected to generated gross ‘ncome. This would

ordinarily be accomplished by allocating the supportive

expenses to all gross income or to another broad class of gross

income and apportioning the expenses in accordance with

paragraph (c)(1) of this section. For this purpose, reasonable

departmental overhead rates may be utilized. For examples of

the application of the principles of this paragraph (b)(3) other

than to expenses attributable to stewardship activities, see

examples (19) through (21) of paragraph (g) of this section.

See paragraph (e)(4) of this section for the allocation and

apportionment of deductions attributable to stewardship

activities.

(4) Deductions related to a class of gross income. See

paragraph (e) of this section for rules relating to the allocation

and apportionment of certain specific deductions definitely

related to a class of gross income. See paragraph (c)(1) of this

section for rules relating to the apportionment of deductions.

(5) Deductions related to all gross income. If a deduction

does not bear a definite relationship to a class of gross income

constituting less than all of the gross income, it shall ordinanly

be treated as definitely related and allocable to all of the

taxpayer’s gross income except where provided to the contrary

under paragraph (e) of this section. Paragraph (e)(9) of this

section lists various deductions which generally are not

definitely related to any gross income and are ratably

apportioned to all gross income.

related to a class of gross income. Where a deduction has been

allocated in accordance with paragraph (b) of this section to a

class of gross income which is included in one statutory

grouping and the residual grouping, the deduction must be

39a

apportioned between the statutory grouping and the residual

grouping. Where a deduction has been allocated to a class of

gross income which is included in more than one statutory

grouping, such deduction must be apportioned among the

Statutory groupings and, where necessary, the residual!

grouping. If the class of gross income to which a deduction has

been allocated is included in its entirety in either a single

statutory grouping or the residual grouping, there is no need to

apportion that deduction. If a deduction is not definitely related

to any gross income, it must be apportioned ratably as provided

in paragraph (c)(2) of this section. A deduction is apportioned

by attributing the deduction to gross income (within the class

to which the deduction has been allocated) which is in the

statutory grouping or in each of the statutory groupings and to

gross income (within the class) which is in the residual

grouping. Such attribution must be accomplished in a manner

which reflects to a reasonably close extent the factual

relationship between the deduction and the grouping of gross

income. In apportioning deductions, it may be that for the

taxable year there is no gross income in the statutory grouping

or that deductions will exceed the amount of gross income in

the statutory grouping. See paragraph (d)(1) of this section

with respect to cases in which there is an excess of deductions.

In determining the method of apportionment for a specific

deduction, examples of bases and factors which should be

considered include, but are not limited to—

(i) Comparison of units sold attributable to the statutory

grouping and attributable to the residual grouping;

(ii) Comparison of the amount of gross sales or receipts;

(iii) Comparison of costs of goods sold;

(iv) Comparison of profit contribution;

(v) Comparison of expenses incurred, assets used, salaries

paid, space utilized, and time spent which are attributable to the

40a

activities or properties giving nse to the class of gross income;

and

(vi) Comparison of the amount of gross income in the

statutory grouping with the amount in the residual grouping.

Paragraphs (e)(2) through (e)(8) of this section provide the

applicable rules for allocation and apportionment of deductions

for interest, research, and development expenses, and certain

other deductions. The effects on tax liability of the apportion-

ment of deductions and the burden of maintaining records not

otherwise maintained and making computations not otherwise

made shal! be taken into consideration in determining whether

a method of apportionment and its application are sufficiently

precise. A method of apportionment described in this

paragraph (c)(1) of this section may not be used when it does

not reflect, to a reasonably close extent, the factual relationship

between the deduction and the groupings of income. The

principles set forth above are applicable in apportioning both

deductions definitely related to a class which constitutes less

than all of the taxpayer’s gross income and to deductions

related to all of the taxpayer’s gross income. If a deduction is

not definitely related to any class of gross income, it must be

apportioned ratably as provided in paragraph (c)(2) of this

section.

(2) Deductions not definitely related to any gross income.

If a deduction is not definitely related to any gross income (see

paragraph (e)(9) of this section), the deduction must be

apportioned ratably between the statutory grouping (or among

the statutory groupings) of gross income and the residual

grouping. Thus, the amount apportioned to each statutory

grouping shall be equal to the same proportion of the deduction

which the amount of gross income in the statutory grouping

bears to the total amount of gross income. The amount

apportioned to the residual grouping shall be equal to the same

proportion of the deduction which the amount of the gross

4la

income in the residual grouping bears to the total amount of

gross income.

(d) Excess of deductions and excluded and eliminated

income —(1) Excess of deductions. Each deduction which bears

a definite relationship to a class of gross income shall be

allocated to that class in accordance with paragraph (b)(1) of

this section even though, for the taxable year, no gross income

in such class is received or accrued or the amount of the

deduction exceeds the amount of such class of gross incom:

In apportioning deductions, it may be that, for the taxable year,

there is no gross income in the statutory grouping (or residual

grouping), or that deductions exceed the amount of gross

income in the statutory grouping (or residual grouping). If

there is no gross income in a statutory grouping or the amount

of deductions allocated and apportioned to a statutory grouping

exceeds the amount of gross income in the statutory grouping,

the effects are determined under the operative section. If the

taxpayer is a member of a group filing a consolidated return,

such excess of deductions allocated or apportioned to a

statutory grouping of income of such member is taken into

account in determining the consolidated taxable income from

such statutory grouping, and such excess of deductions

allocated or apportioned to the residual grouping of income is

taken into account in determining the consolidated taxable

income from the residual grouping. See § 1.1502-4(d)(1) and

the last sentence of § 1.1502-12. For an illustration of the

principles of this paragraph (d)(1), see example (17) of

paragraph (g) of this section.

(2) Allocation and apportionment to exempt, excluded or

eliminated income. In allocating or apportioning deductions to

classes or statutory groupings of gross income, including

apportionment pursuant to paragraph (c)(2) of this section

(deductions not definitely related to any class of gross income),

gross income shall include amounts which are otherwise

exempt or excluded (such as the income of a nonresident alien

individual or foreign corporation which is not effectively

42a

connected income) or which are otherwise eliminated in the

computation of consolidated taxable income reported for the

taxable year on a consolidated retum (but deferred

intercompany transactions, as defined in § 1.1502-13, shall not

be included until the year they are included in taxable income).

Hence, a deduction may be allocated and apportioned to

exempt, excluded, or eliminated income. See example (24) of

paragraph (g) of this section. No deduction shall be allowed,

under this section, for any amount, or part thereof, allocable

and apportionable to a class of exempt, excluded, or eliminated

income, if such amount is not allowed as a deduction under

another section of the Code. See section 265 and the

regulations thereunder.

(e) Allocation and apportionment of certain deductions —

(1) Jn general Subparagraphs (2) and (3) of this paragraph

contain rules with respect to the allocation and apportionment

of interest expense and research and development expenditures,

respectively. Subparagraphs (4) through (8) of this paragraph

contain rules with respect to the allocation of certain other

deductions. Subparagraphs (9) of this paragraph lists those

deductions which are ordinarily considered as not being

definitely related to any class of gross income. Subparagraph

(10) of this paragraph lists special deductions of corporations

which must be allocated and apportioned. Subparagraph (11)

of this paragraph lists personal exemptions which are neither

allocated nor apportioned. Examples of allocation and

apportionment are contained in paragraph (g) of this section.

** *

(3) Research and experimental expenditures —- (i)

Allocation — (A) In general. The methods of allocation and

apportionment of research and development set forth in this

paragraph (e)(3) recognize that research and development is an

inherently speculative activity, that findings may contribute

unexpected benefits, and that the gross income derived from

successful research and development must bear the cost of

43a

unsuccessful research an development. Expenditures for

research and development which a taxpayer deducts under

section 174 shall ordinarily be considere’ deductions which are

definitely related to all income reasonably connected with the

relevant broad product category (or categories) of the taxpayer

and therefore allocable to all items of gross income as a class

(including income from sales, royalties, and dividends) related

to such product category (or categories). For purposes of this

allocation, the product category (or categories) which a

taxpayer may be considered to have shall be limited to the

following list. Ordinarily a taxpayer’s research and

development expenditures may be divided between the relevant

product categories. Where research and development is

conducted with respect to more than one product category, the

taxpayer may aggregate the categories for purposes of

allocation and apportionment; however, the taxpayer may not

subdivide the categories in this list. Where research and

development is not clearly identified with any product category

(or categories), it will be considered conducted with respect to

all the taxpayer’s product categories. The individual products

included within each category are enumerated in Executive

Office of the President, Office of Management and budget,

Standard Industrial Classification Manual, 1972 (or later

edition, as available).

SIC Major Groups Nonmanufactured categories

(01, 02 ,07, 08, 09)...........cece00 Agriculture, forestry and fisheries.

4, Hard mineral mining.

IT oncintnetsennabiepetainestesnattaianeiniie Crude petroleum, and natural gas.

CED cnscsenbemnnnenmmmienmenenen Nonmetallic minerals.

5, en Construction services.

(40, 41, 42, 43, 44, 45, Transportation services.

46, 47)

SUED ccisnesesentecunniosevietnsssesnesen Communication.

SIC Major Groups

(52, 53, 54, 55, 56, 57,

58, 59)

(60, 61, 62, 63, 64, 65,

66, 67)

(70, 72, 73, 75, 76, 78,

79, 80, 81, 82, 83,

84, 86, 88, 89)

44a

Nonmanufactured categories

Electric, gas and sanitary services.

Wholesale trade (not applicable

with respect to sales by the

taxpayer of goods and services

from any other of the taxpayer’s

product categories and not

applicable with respect to a

domestic international sales

corporation for which the

taxpayer is a related supplier of

goods and services from any

other of the taxpayer’s product

categories).

Retail trade (not applicable with

respect to sales by the taxpayer

of goods and services from any

other of the taxpayer’s product

categories, except Wholesale

trade, and not applicable with

respect to a domestic

international sales corporation

for which the taxpayer is a

related supplier of goods and

services from any other of the

taxpayer's product categories,

except Wholesale trade).

Finance, insurance, and real estate.

Other services.

Food and kindred products.

Tobacco manufacturers.

Textile mill products.

SIC Major Groups

Tee eee eC

POUR ECC EC EIST)

Te PETE CeCe Cee ee eer)

Poe PEC COC ETC Cee eee

TePeETICEECCC Cee eee

PUTT TOC T ECCT eee eee

Tee TUTE ECCT eee eee

eee eee eee ee eee

Tee EU ESTO eee)

CORRE EE EEE EEE EEE TEES

POC UUCP OSC C ICT eee

45a

Nonmanufactured categories

Apparel and other finished

products made from fabrics

and similar materials.

Lumber and wood products,

except furniture.

Furniture and fixtures.

Paper and allied products.

Printing, publishing, and

allied industries.

Chemicals and allied products.

Petroleum refining and related

industries.

Rubber and miscellaneous

plastics products.

Leather and leather products.

Stone, clay, glass and concrete

products.

Primary metal industries.

Fabricated metal products,

except machinery and

transportation equipment.

Machinery, except electrical.

Electrical and electronic

machinery, equipment

and supplies.

Transportation equipment.

46a

SIC Major Groups Nonmanufactured categories

ED ccenteenestinnsntsenininiense Measuring, analyzing, and

controlling instruments;

photographic, medical and

optical goods, watches and

checks.

SE iiicccelsatechddaceildmibaaainninate Miscellaneous manufacturing

industries.

(B) Exception. Where research and development is

undertaken solely to meet legal requirements imposed by a

political entity with respect to improvement or marketing of

specific products or processes, and the results cannot

reasonably be expected to generage amounts of gross income

(beyond de minimis amounts) outside a single geographic

source, the deduction for such research and development shall

be considered definitely related anu therefore allocable only to

the grouping (or groupings) of gross income within that

geographic source as a class (and apportioned, if necessary,

between such groupings as set forth in subdivisions (ii)(B) and

(iii) of this paragraph (e)(3)). For example, where a taxpayer

performs tests on a product in response to a requirement

imposed by the U.S. Food and Drug Administration, and the

test results cannot reasonably be expected to generate amounts

of gross income (beyond de minimis amounts) outside the

United States, the costs of testing shall be allocated solely to

gross income from sources within the United States.

(ii) Apportionment of resec ch and development — sales

method — (A) Exclusive apportionment. Where an apportion-

ment based upon geographic sources of income of a deduction

for research and development is necessary (after applying the

exception in subdivision (i)(B) of this paragraph (d)(3), an

amount equal to -

(1) Fifty percent (50%), in the case of a taxable years

beginning during 1977.

47a

(2) Forty percent (40%), in the case of a taxable year

beginning during 1978.

(3) Thirty percent (30%), in the case of a taxable year

beginning during 1979, and thereafter,

of such deduction for research and development shall be

apportioned exclusively to the statutory grouping of gross

income, or the residual grouping of gross income, as the case

may be, arising from the geographic source where the research

and development activities which account for more than fifty

percent (50%) of the amount of such deduction were

performed. If the fifty percent test of the preceding sentence is

not met, then no part of the deduction shall be apportioned

under this subdivision (ii)A). This exclusive apportionment

reflects the view that research and development is often most

valuable in the country where it is performed, for two reasons.

First, research and development often benefits a broad product

category, consisting of many individual products, all of which

may be sold in the nearest market but only some of which may

be sold in foreign markets. Second, research and development

often is utilized in the nearest market before it is used in other

markets, and in such cases, has a lower value per unit of sales

when used in foreign markets. The taxpayer may establish to

the satisfaction of the Commissioner that, in its case, one or

both of the conditions mentioned in the preceding sentences

warrant a significantly greater percen. then the relevant percent

specified in (/), (2) or (3) of this subdivision (11)(A) because the

research and development is reasonably expected to have very

limited or long delayed application outside the geographic

source where it was performed. For purposes of establishing

that only some products within the product category (or

categories) are soid in foreign markets, the taxpayer shall

compare the commercial production of individual products in

domestic and foreign markets made by itself, by uncontrolled

parties (as defined under (C) of this subdivision (ii)) of

products involving intangible property which was licensed or

sold by the taxpayer, and by those controlled corporations (as

48a

defined under (D) of this subdivision (ii)) which cas reasonably

be expected to benefit directly or indirectly from any of the

taxpayer’s research expense connected with the product

category (or categories). The individual products compared for

this purpose shall be limited, for non-manufactured categories,

solely to those enumerated in Executive Office of the President,

Office of Management and Budget Standarc IJndustrial

Classification Manual, 1972 or later edition, as available), and,

for manufactured categories, solely to those enumerated at a 7-

digit level on pages 5 through 200 of U.S. Bureau of the

Census, Census of Manufactures: 1972, Numerical List of

Manufactured Products (New (1972) SIC Basis), 1973, (or later

edition, as available). Examples (9), (10), amd (13) in

paragraph (g) of this section illustrate the application of this

rule. For purposes of establishing the delayed application of

research findings abroad, the taxpayer shall compare the

commercial introduction of its own particular products and

processes (not limited by those listed in the Standard Industrial

Classification Manual or the Numerical List of Manufactured

Products) in the United States and foreign markets, made by

itself, by uncontrolled parties (as defined under (C) of this

subdivision (ii)) of products involving intangible property

which was licensed or sold by the taxpayer, and by those

controlled corporations (as defined under (D) of this

subdivision (ii)) which can reasonably be expected to benefit,

directly or indirectly, from the taxpayer’s research expense.

For purposes of evaluating the delay in the application of

research findings in foreign markets, the taxpayer shall use a

safe haven discount rate of 10 percent per year of delay unless

he is able to establish, by reference to the cost of money and the

number of years during which economic benefit can be directly

attributable to the results of taxpayer’s research, that another

discount rate is more appropriate (see examples (9) through

(12) in paragraph (g) of this section).

(B) Remaining apportionment. The amount equal to the

remaining portion of such deduction for research and

49a

development, not apportioned under (A) of this subdivision (11),

shall be apportioned between the statutory grouping (or among

the statutory groupings) within the class of gross income and

the residual grouping within such class in the same proportions

that the amount of sales from the product category (or

categories) which resulted in such gross income within the

statutory grouping (or statutory groupings) and in the residual

grouping bear, respectively, to the total amount of sales from

the product category (or categories). For the purposes of this

paragraph (e)(3), amounts received from the lease of equipment

during a taxable year shall be regarded as sales receipts for such

taxable year. Amounts apportioned under this paragraph (e)(3)

may exceed the amount of gross income related to the product

category within the statutory grouping. In such case, the excess

shall be applied against other gross income within the statutory

grouping. See paragraph (d)(1) of this section for instances

where the apportionment leads to an excess of deductions over

gross income within the statutory grouping.

apportionment under (B) of this subdivision (ii), the sales from

the product category (or categories) by each party uncontrolled

by the taxpayer, of particular products involving intangible

property which was licensed or sold by the taxpayer to such

uncontrolled party shall be taken fully into account both for

determining the taxpayer’s apportionment and for determining

the apportionment of any other member of a controlled group

of corporations to which the taxpayer belongs if the

uncontrolled party can reasonably be expected to benefit

directly or indirectly (through any member of the controlled

group of corporations to which the taxpayer belongs) from the

research expense connected with the product category (or

categories) of such other member. In the case of licensed

products, if the amount of sales of such products is unknown

(for example, where the licensed product is a component of a

large machine), a reasonable estimate should be made. In the

case of sales of intangible property, and in cases where a

50a

reasonable estimate of sales of licensed products cannot be

made, the sales taken into account shall be an amount which is

ten times the amount received or secured for the intangible

during the taxpayer’s taxable year. For purposes of this

subdivision (ii)(C), the term “uncontrolled party” means a party

which is not a person with a relationship to the taxpayer

(specified in section 267(b)), or is not a member of a controlled

group of corporations to which the taxpayer belongs (within the

meaning of section 993 (a)(3). An uncontrolled party can

reasonably be expected to benefit from the research expense of

a member of a controlled group of corporations to which the

taxpayer belongs if such member can reasonably be expected

to license, sell, or transfer intangible property to that

uncontrolled party, or transfer secret processes to that

uncontrolled party, directly or indirectly through a member of

the controlled group of corporations to which the taxpayer

belongs.

(D) Sales of controlled parties. For purposes of the

apportionment under purposes of the apportionment under (B)

of this subdivision (ii), the sales from the product category (or

categories) of the taxpayer shall be taken fully into account and

the sales from the product category (of categories) of a

corporation controlled by the taxpayer shall be taken into

account to the extent provided in (/) or (2) of this subdivision

(11D) for determining the taxpayer’s apportionment, fi such

corporation can reasonably be expected to benefit directly or

indirectly (through another member of the controlled group of

corporations to which the taxpayer belongs) from the taxpayer’s

research expense connected with the product category or

categories). However, sales from the product category (or

categories) between or among such controlled corporations or

the taxpayer shall not be taken into account more than once; in

such a situation, the amount sold by the selling corporation to

the buying corporation shall be subtracted from the sales of the

buying corporation. For purposes of this subdivision (ii)(D),

the term “a corporation controlled by the taxpayer” means any

Sla

corporation other than an “uncontrolled party” as defined in (C)

of this subdivision (ii). A corporation controlled by the

taxpayer can reasonably be expected to benefit from the

taxpayer's research expense if the taxpayer can be exptected to

license, sell, or transfer intangible property to that corporation,

or transfer secret processes to that corporation, either directly

or indirectly through a member of the controlled group of

corporations to which the taxpayer belongs. Past experience

with research and development shall be considered in

determining reasonable expectations. However, if the

corporation controlled by the taxpayer has entered into a

bonafide cost-sharing arrangement, in accordance with the

provisions of § 1.482-2(d)(4), with the taxpayer for the purpose

of developing intangible property, then that corporation shall

not reasonably be expected to benefit from the taxpayer’s share

of the research expense. The sales from the product category

(or categories) of a corporation controlled by the taxpayer taken

into account shall be the greater of-

(1) The amount of sales that would have been taken into

account under paragraph (e)(3)(ii(C) of this section if the

controlled corporation were an uncontrolled party and if any

intangible property contributed by the taxpayer to the controlled

corporation were treated as a license of that intangible property;

(2) The amount of sales that bear the same proportion to

total sales of the controlled corporation as the taxpayer’s direct

or indirect ownership, as defined in section 1563, of the total

combined voting power of all classes of stock entitled to vote

of such corporation bears to the total outstanding combined

voting power of all such classes of stock of such corporation.

(iii) Apportionment of research and development — optional

gross income methods. If the conditions of either (A) or (B) of

this subdivision (iii) are met, in lieu of apportioning the

deduction for research and development expense under

S2a

subdivision (ii) of this paragraph (e)(3), a taxpayer may, at his

option, for any taxable year apportion such deduction, as

prescribed in (A) or (B) of this subdivision (iii), between the

statutory grouping (or among the statutory groupings) of gross

income and the residual grouping of gross income. These

optional methods must be applied to the taxpayer’s entire

deduction for research and development expense remaining

after applying the exception in subdivision (i)(B) of this

paragraph (e)(3), and may not be applied on a product category

basis. However, if any member of an affiliated group which

files a consolidated return apportions its research and

development expense for a taxable year under this subdivision

(iii), then all members joining that return must use this

subdivision (iii) for such taxable year.

(A) Option One. If, when apportioned ratably on the basis

of gross income between the statutory grouping (or among the

statutory groupings) of gross income and the residual grouping

of gross income in the same proportions that the amount of

gross income in the statutory grouping (or groupings) and the

amount of gross income in the residual grouping bear,

respectively, to the total amount of gross income.

(1) The amount of research and development expense

ratably apportioned to the statutory grouping (or groupings in

the aggregate) is not less than fifty percent (50%) of the amount

which would have been so apportioned if the taxpayer had used

the method described in subdivision (ii) of this paragraph

(e)(3), and

(2) The amount of research and development expense

ratably apportioned to the residual grouping is not less than

fifty percent (50%) of the amount which would have been so

apportioned if the taxpayer had used the method described in

subdivision (ii) of this paragraph (e)(3).

then the taxpayer may apportion his research and development

expense ratably on the basis of gross income.

53a

(B) Option T.-o. If, when the amount of research and

development expense is apportioned ratably on the basis of

gross income, either condition (1) or (2) of (A) of this

subdivision (iii) is not met, the taxpayer may either:

(1) Where condition (1) of (A) of this subdivision (111) is

not met, apportion fifty percent (50%) of the amount of

research and development expense which would have been

apportioned to the statutory grouping (or groupings in we

aggregate) under subdivision (ii) of this paragraph (e)(3) to

such statutory grouping (or to such statutory groupings in the

aggregate and then among such groupings on the basis of gross

income within each grouping), and apportion the balance of the

amount of research and development expenses to the residual

grouping; or

(2) Where condition (2) of (A) of this subdivision (iii) is

not met, apportion fifty percent (50%) of the amount of

research and development expense which would have been

apportioned to the residual grouping under subdivision (ii) of

this paragraph (e)(3) to such residual grouping, and apportion

the balance of the amount of research and development

expenses to the statutory grouping (or to the statutory groupings

in the aggregate and then among such groupings ratably on the

basis of gross income within each grouping).

(iv) Examples. Examples (3) through (16) and example (23)

of paragraph (g) of this section illustrate the allocation and

apportionment of research and development deductions.

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.