Opposition Brief — Boeing Co. v. United States

P

No. 01-1209 Pp

In the Supreme Court of the United States

THE BOEING COMPANY AND CONSOLIDATED

SUBSIDIARIES, PETITIONERS

v.

UNITED STATES OF AMERICA

ON PETITION FOR A WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

BRIEF FOR THE UNITED STATES IN OPPOSITION

THEODORE B. OLSON

Solicitor General

Counsel of Record

EILEEN J. O’CONNOR

Assistant Attorney General

DAVID ENGLISH CARMACK

FRANK P. CIHLAR

Attorneys

Department of Justice

Washington, D.C. 20530-0001

(202) 514-221 7

QUESTIONS PRESENTED

1. Whether, in computing their combined taxable

income from the export sales of aircraft during the

period from 1979-1984 under the provisions of the

Internal Revenue Code pertaining to “domestic

international sales corporations” (26 U.S.C. 991-997

(1976 & Supp. III 1979)), petitioners must take into

account expenses incurred for aircraft research and

development in the manner required by the then-

applicable Treasury regulations.

2. Whether, in computing their combined taxable

income from the export sales of aircraft during the

period from 1985-1987 under the provisions of the

Internal Revenue Code pertaining to “foreign sales

corporations” (26 U.S.C. 921-927 (1988)), petitioners

must take into account expenses incurred for aircraft

research and development in the manner required by

the then-applicable Treasury regulations.

(I)

TABLE OF CONTENTS

Page

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Statutes and regulations involved ..........cccccecccescecsesseesneeseeeeees

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TABLE OF AUTHORITIES

Cases:

Intel Corp. v. Commissioner, 76 F.3d 976 (9th Cir.

I 20

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

aff'd in part & rev'd in part, 34 F.3d 1394 (8th Cir.

GENO) ccussensssnsnssenenensnsscenensessnsensesenenensenessensnesanses 14, 15, 18, 19, 20

United States v. Correll, 389 U.S. 299 (1967) cocccccccccoccccoe. 19

Statutes and regulations:

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

§ 805(b), 98 Stat. 1000-1001 .o......cccccccccsceceseceseseeseserseeeesnenees 3

Economic Recovery Tax Act of 1981, § 223, Pub.

I 20

FSC Repeal and Extraterritorial Income Exclusion

Act of 2000, Pub. L. No. 106-519, § 5, 114 Stat.

RD cepeerreenereennnsnnsecnsenereeencenderneneecenstenemnenensnsnsntescenenenscssnseneens 4

Internal Revenue Code (26 U.S.C.):

ee 4

§ 861 (1976 & Supp. ITI 1979) .......... 1, 7, 9, 18, 19, 20, 21, 22

ee 8

EU cerientititcererseretceemrntmeenrienintgteeaiatantataattinnitasea aaa 8

EE 19

Sera cose eninensnestesenteneenmesneneeennnenseemnenstcantnneseeersteteaaraaataiias 20

SETI ctetrrenteeusecnnsensnenesesesmnansensenertntanstseaneneniemamtaseammsstaasamsaa 6

$§ 921-927 (1976 & Supp. [I] 1979) ........ccccccccccccesceceeseceeseees 2.3

(IIT)

IV

Statutes and regulations—Continued: Page

§ 923 6

§ 925 (1988) 2

§ 925(a) 5

§ 925(a) (1988) 6

§ 925(a)(1) 6

§ 925(aX(2) 7

§§ 991-997 (1976 & Supp. ITI 1979) 2

§ 993(f) 8

§ 994 (1976 & Supp. ITI 1979) 1

§ 994(a) 5,6

§ 994(a)(1) 6

§ 994(a)(2) 7,15

§ 995(b)\1)(E) (1988) 3

§ 995(f) (1988) 3

26 C.F.R.:

Section 1.861-8 (1979) 1

Section 1.861-8(a)(2) (1979) .. 20

Section 1.861-8(b)(1) a)

Section 1.861-8(b)(5) 9

Section 1.861-8(c)(1) 9

Section 1.861-8(c)(2) 9

Section 1.861-8(e3) 14, 15, 16

Section 1.861-8(e)(3) (1979) 10, 13,

14, 18, 20, 21

Section 1.861-8(e(3)(i A) (1979) 9-10, 9a

Section 1.861-8(e(3)ii) (1979) 15

Section 1.861-8(f)(1)(iii) 9

Section 1.861-17 2,10

Section 1.861-17(a\(2)(ii) 10, 22

Section 1.994-1 (1979) 1

Section 1.994-1(a)(1) 6

Section 1.994-1(c)(6) 8, 16, 23

Section 1.994-1(c)(6)iii) 8

Section 1.994-1(c\6Xiv) 14, 18, 21

Section 1.994-1(¢(7) 10, 16

Section 1.994-1(c)(7) (1979) 21

V

Regulations—Continued: Page

Section 1.994-1(¢)(7\i) 6

Section 1.994-1(¢)(7)(ii) 18

Section 1.925(a)-1T (1989) 2,3, 3a

Section 1.925(a)-1T(aX(1) 6

Section 1.925(a)-1T(e)\6) (1989) 21,23

Section 1.925(a)-1T(e8) 6

Section 1.925(a)-1T(e8\ii) 10

Section 1.925(a)-1T(e8)ii) (1989) 21

Miscellaneous:

Appellate Body, World Trade Organization, United

States—Tax Treatment for “Foreign Sales Corpora-

tions,” AB-1999-9 (Feb. 24, 2000) 4

Appellate Body, World Trade Organization, United

States—Tax Treatment for “Foreign Sales Corpora-

tions,” Recourse to Article 21.5 of the DSU by the

European Communities, AB-2001-8 (Jan. 14,

2002) 4,5

B. Bittker & J. Eustice, Federal Income Taxation

of Corporations and Shareholders:

4th ed. 1979 4

5th ed. 1987 4,8

B. Bittker & L. Lokken, Federal Taxation of Income,

Estates and Gifts (Supp. 1999) )

R. Doernberg, /nternational Taxation (4th ed. 1999) ....... 2,3

D. Keller et al., Management Accountants’, Handbook

(4th ed. 1992) 20

H.R. Conf. Rep. No. 861, 98th Cong., 2d Sess. (1984) ........ 20

H.R. Conf. Rep. No. 1004, 106th Cong., 2d Sess. (2000) .... 17

H.R. Rep. No. 533, 92d Cong., Ist Sess. (1971) ........ 7, 8, 15, 20

S. Rep. No. 437, 92d Cong., Ist Sess. (1971) ever 2,7, 8, 20

1 Staff of the Sen. Comm. on Finance, 98th Cong., 2d

Sess., Deficit Reduction Act of 1984 (Comm. Print

1984) 20

T.D. 8646, 1996-1 C.B. 145 10

In the Supreme Court of the Gnited States

No. 01-1209

THE BOEING COMPANY AND CONSOLIDATED

SUBSIDIARIES, PETITIONERS

v.

UNITED STATES OF AMERICA

ON PETITION FOR A WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

BRIEF FOR THE UNITED STATES IN OPPOSITION

OPINIONS BELOW

The opinion of the court of appeals (Pet. App. 1a-14a)

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

court (Pet. App. 15a-24a) is unreported.

JURISDICTION

The judgment of the court of appeals was entered on

August 2, 2001. A petition for rehearing was denied on

November 19, 2001 (Pet App. 25a). The petition for a

writ of certiorari was filed on February 15, 2002. The

jurisdiction of this Court is invoked under 28 U.S.C.

1254(1).

STATUTES AND REGULATIONS INVOLVED

The relevant portions of Sections 861 and 994 of the

Internal Revenue Code, 26 U.S.C. 861 and 994 (1976 &

Supp. III 1979), and of 26 C.F.R. 1.861-8 and 1.994-1

(1979), as they were in effect in the years relevant to

(1)

2

this case, are set forth at Pet. App. 26a-53a. In addition

to those provisions, the relevant portions of Section 925

of the Internal Revenue Code, 26 U.S.C. 925 (1988), of

26 C.F.R. 1.925(a)-1T (1989), and of 26 C.F.R. 1.861-17

are set forth at App., infra, la-11a.

STATEMENT

1. This case concerns the proper allocation of re-

search and development expenses in the calculation of

income from foreign sales of goods during the years

from 1979 to 1987. This question arose under two sepa-

rate sets of statutory and regulatory provisions, all of

which have since been modified or repealed.

a. In 1971, Congress enacted provisions that estab-

lished a separate tax status for “domestic international

sales corporations” (DISCs). 26 U.S.C. 991-997 (1976 &

Supp. III 197.;. The DISC provisions sought to “pro-

vide substantial stimulus to exports and at the same

time to avoid granting undue tax advantages.” S. Rep.

No. 437, 92d Cong., Ist Sess. 13 (1971). Under these

provisions, a domestic manufacturer could form a DISC

in the United States “the income of which is not taxed

at the DISC level. Instead, the corporate shareholder

was taxed directly on a portion of the DISC’s income

deemed distributed. The portion of the income not

deemed distributed was not subject to any U.S. taxa-

tion until actually distributed.” R. Doernberg, /nterna-

tional Taxation 395-396 (4th ed. 1999).

Soon after their enactment, the DISC provisions

were challenged by other Nations as impermissible ex-

port subsidies under the General Agreement on Tariffs

and Trade. See R. Doernberg, supra, at 396. Asa

consequence of that international challenge, Congress

replaced the DISC provisions in 1984 with the “foreign

sales corporation” (FSC) provisions of the Code. 26

3

U.S.C. 921-927 (1988 & Supp. V 1993). See Deficit

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

Stat. 1001-1002. When the FSC provisions were en-

acted in 1984, the DISC provisions were left in effect

only “for small corporations” (with export receipts less

than $10 million) and were revised to require the

payment of interest on any deferred tax liability. 26

U.S.C. 995(b)(1)(E), 995(f) (1988). By thus imposing an

interest charge on any deferred taxes under the post-

1984 DISC provisions, the asserted export subsidy was

removed (see R. Doernberg, supra, at 412), as was the

economic incentive even for small corporations to

employ the post-1984 DISC regime. As a consequence,

taxpayers engaged in export operations after 1984

routinely did so under the F'SC provisions.

b. The FSC provisions contemplate that a U.S.

parent will establish a foreign corporation with a genu-

ine foreign presence to conduct export sales. “If a

corporation qualifies as a FSC, a portion of its foreign

trade income is exempt from the U.S. corporate income

tax [and] (t]hat portion can be distributed as a dividend

tax-free to the U.S. parent corporation * * *.” R.

Doernberg, supra, at 397. Because the FSC may be

subject to taxes abroad for its foreign sales income,

“many U.S. corporations organize FSCs in foreign

countries imposing relatively low, or no, corporate and

dividend withholding taxes on that income.” bid.

Separate regulations were adopted to implement the

new requirements of the FSC regime. See, e.g, 26

C.F.R. 1.925(a)-1T (1989).

c. In February 2000, the World Trade Organization

determined that the FSC provisions that had super-

seded the DISC provisions provided a prohibited ex-

port subsidy in violation of the WTO Agreement on

Subsidies and Countervailing Measures and the Agree-

4

ment on Agriculture. Appellate Body, World Trade

Organizations, United States—Tax Treatment for

“Foreign Sales Corporations,” AB-1999-9 (Feb. 24,

2000).' Following that decision, Congress repealed the

FSC provisions as of September 30, 2000. With the ex-

ception of a narrow, transitional rule for certain trans-

actions commenced under the FSC regime, Congress

repealed and replaced the "SC provisions with the new

“extraterritorial income exclusion” (ETI) of Section 114

of the Internal Revenue Code. 26 U.S.C. 114. See FSC

Repeal and Extraterritorial Income Exclusion Act of

2000, Pub. L. No. 106-519, § 5, 114 Stat. 2433. These

new ETI provisions contain a degree of complexity that

even the DISC and FSC provisions cannot rival.’ The

ETI provisions were again challenged in proceedings

before the WTO, which led to the opinion of the WTO

Appellate Body issued in January of 2002. Appellate

Body, World Trade Organization, United States—Tax

Treatment for “Foreign Sales Corporations,” Recourse _

to Article 21.5 of the DSU by the European

Communities, AB-2001-8, at 9-12 (Jan. 14, 2002).° In

that opinion, the WTO Appellate Body concluded that

the ETI provisions—like the FSC and DISC provisions

1 <http://www.wto.org/english/tratop_e/dispu_e/distabase_e.

htm>

2 Professors Bittker and Eustice noted that the original DISC

provisions “quickly reach, and rarely leave, a plateau of statutory

intricacy seldom rivaled in other sections of the Code.” B. Bittker

& J. Eustice, Federal Income Taxation of Corporations and

Shareholders 4 17.14, at 17-43 (4th ed. 1979). When the FSC pro-

visions were enacted to replace the DISC provisions in 1984, these

same commentators remarked that the new provisions replaced

the old with an “equally complex” statutory scheme that “deflies)

concise explanation.” Jd. { 17.14, at 17-55 (Sth ed. 1987).

3 See note 1, supra.

5

that preceded them—constitute prohibited export

subsidies under the WTO agreements. Id. at 91-93.

The WTO Appellate Body further concluded that the

narrow transitional rules that had left the FSC provi-

sions temporarily in place for certain transactions were

also in violation of the WTO agreements. Jd. at 84.

2. a. The substantive question presented by the p >ti-

tion addresses one element of the complex require-

ments for computing what is known as the “combined

taxable income” (CTI) of the parent and its sales sub-

sidiary under the separate DISC (26 U.S.C. 994(a)) and

FSC (26 U.S.C. 925(a)) tax regimes. The taxes imposed

under these separate regimes vary depending on the

amount of CTI that results from the covered export

transactions. In general, under these tax provisions,

the parent has an incentive to maximize the portion of

its profits that are encompassed within its export-

related CTI rather than within the parent’s non-export

related income, for this tends to reduce its overall tax

burden. The taxpayer therefore seeks to minimize the

portion of its overall costs that are allocated to its

covered export transactions; which has the consequence

of maximizing the portion of its overall profits that are

allocated to the export-related CTI, and thereby

reducing its overall tax burden.

b. While there are numerous differences between a

DISC and a FSC, the principal one for the purposes of

this case is that income tax on a portion of the export

income attributed to a DISC is deferred, while a portion

of the export income attributed to a FSC is exempt

from income tax. Under both regimes, the combined

taxable income of the parent and the sales subsidiary is

an ingredient in the determination of the portion of that

income that is allocated to the subsidiary and thus

available for tax deferral or exemption. In the DISC

6

regime, the combined taxable income resulting from the

sale is allocated based on an assumed transfer price for

the exported good that would allow the DISC to derive

income that does not exceed the greatest of (i) 4% of the

export receipts, (ii) 50% of the combined taxable income

of the parent and the DISC, or (iii) the income resulting

from an arm’s length sale price. 26 U.S.C. 994(a). The

FSC regime has a similar, but different, allocation

procedure that also, in some circumstances, requires or

permits consideration of the combined taxable income

of the parent and the sales subsidiary. 26 U.S.C. 925(a)

(1988).*

Although these pricing rules are generally to be

applied on a transaction-by-transaction basis, a tax-

payer may choose instead to apply them to groups of

exported goods consisting of products or product lines

selected to determine the allowable transfer price. Dif-

ferent grouping regulations were adopted for this

purpose under the DISC and FSC regimes. Compare

26 C.F.R. 1.994-1(a)(1), (e(7)i) (DISC), with 26 C.F.R.

1.925(a)-1T(a)(1), (c)(8) (FSC). The grouping rules

make it unnecessary for the taxpayer to file a separate

schedule for each and every sale, and they provide a

limited flexibility in the choice of the pricing rule to

apply. For example, the grouping rules would gener-

ally permit a taxpayer to elect the “4 percent of the

qualified export receipts” pricing rule of Section

994(a)(1) for DISCs or the “1.83 percent of the foreign

trading gross receipts” pricing rule of Section 925(a)(1)

for FSCs to determine the allowable transfer price for

4 Unlike the DISC, the FSC is a foreign corporation, and a

portion of its foreign trade income is subject to United States tax.

26 U.S.C. 921, 923. For this reason, Boeing Sales Corporation

(petitioner’s FSC) is a party to this case. See note 9, infra.

7

one group of products, while employing the “50 percent

of the combined taxable income” rule of Section

994(a)(2) for DISCs and the “23 percent of the combined

taxable income” rule of Section 925(a)(2) for FSCs on

another group of products.

c. Petitioner chose to use the “50 percent of the com-

bined taxable income” price rule set forth in Section

994(a)(2) and the “23 percent of the combined taxable

income” price rule set forth in Section 925(a)(2) for all of

its groups of DISC and FSC export sales.’ Although

Congress never defined the term “combined taxable

income” in either the DISC or the FSC statutes, Con-

gress contemplated that “the combined taxable income

from the sale of the export property is to be determined

generally in accordance with the principles applicable

under section 861 for determining the source (within or

without the United States) of the income of a single

entity with operations in more than one country.” H.R.

Rep. No. 533, 92d Cong., Ist Sess. 74 (1971). The rules

established under Section 861 of the Internal Revenue

Code, 26 U.S.C. 861, “generally allocate to each item of

gross income all expenses directly related thereto, and

then apportion other expenses among all items of gross

® As used hereafter in this brief, the singular “petitioner”

refers to the parent corporation, The Boeing Company. Under the

method used by petitioner, the transfer price is the price that

would allow the DISC to derive taxable income attributable to the

sale of the property in an amount that does not exceed “50 percent

of the combined taxable income of such DISC and [the parent re-

lated supplier) which is attributable to the qualified export re-

ceipts on such property derived as a result of the sale by the

DISC.” 26 U.S.C. 994(a)(2). See H.R. Rep. No. 533, 92¢ Cong., Ist

Sess. 74 (1971); S. Rep. No. 437, supra, at 107. The cognate rule for

a FSC is found in Section 925(a)(2), which sets the limit at 23

percent of CTI.

8

income on a ratable basis.” H.R. Rep. No. 533, supra, at

74; S. Rep. No. 437, supra, at 107-108.

Section 861, to which the DISC committee reports

refer, serves to distinguish between domestic and for-

eign source income for income tax purposes. The deter-

mination of the domestic or foreign source of the income

has importance for many purposes. See generally B.

Bittker & J. Eustice, Federal Income Taxation of

Corperations and Shareholders { 17.02, at 17-4 to 17-27

(5th ed. 1987). Section 861(a) specifies a number of

broad categories of gross income (such as interest from

United States payers) that are treated as United States

sources income. Section 861(b) provides, in turn, that

expenses “properly apportioned or allocated” to the

items of gross income specified in Section 861(a), along

with a ratable portion of any expense that “cannot

definitely be allocated” to an item of gross income, shall

be deducted to arrive at taxable income. 26 U.S.C.

861(b). The key determination made under Section

861(b) is thus whether an expense is “properly appor-

tioned or allocated” to an item of gross income. Con-

gress did not define the statutory phrase that provides

for expenses “properly apportioned or allocated”

against various types of income, and taxpayers there-

fore look to Treasury regulations for guidance.

d. The Treasury regulations adopted to implement

the DISC provisions tracked the congressional commit-

tee reports. 26 C.F.R. 1.994-1(c)(6) provides that CTI

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 receipts.” Section

1.994-1(c)(6)(iii), in turn, defines the costs that are

treated as relating to those gross receipts as (emphasis

added):

9

(a) the expenses, losses, and other deductions defi-

nitely related, and therefore allocated and appor-

tioned, 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, deter-

mined in a manner consistent with the rules set

forth in § 1.861-8.

The DISC regulations thus specifically incorporate

the regulations issued under Section 861. Those regu-

lations were promulgated in 1977 “principally to ensure

that foreign operations of domestic corporations are

charged with a proper share of deductions.” B. Bittker

& L. Lokken, Federal Taxation of Income, Estates and

Gifts { 70.10.1, at S70-26 (Supp. 1999). Expenses, losses

and other deductions are to be allocated to the class of

gross income to which they are definitely related (26

C.F .R. 1.861-8(b)(1)) and then apportioned, if necessary,

between so-called “statutory groupings” and “residual

groupings” (26 C.F.R. 1.861-8(c)(1)).° The deductions

that are related to all of a taxpayer’s gross income or

that are not definitely related to any class of gross

income are ratably apportioned to all gross income. 26

C.F.R. 1.861-8(b)(5) and (c)(2).

The regulations under Section 861 recognized “that

research and development is an inherently speculative

activity, that findings may contribute unexpected bene-

fits, and that the gross income derived from successful

research and development must bear the cost of

unsuccessful research and development.” 26 C.F.R.

® The computation of DISC taxable income was treated

as a “statutory grouping” for these purposes. 26 C.F.R. 1.861-

&(f)(1)(Gii). The same is true of FSC taxable income. [bid.

10

1.861-8(e)(3)(i)(A) (1979).’ Consequently, research and

development expenses were “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).” Ibid. These regulations

originally used the two-digit categories found in the

Standard Industrial Classification Manual published by

the Office of Management and Budget as the relevant

product categories. bid. When these regulations were

revised in 1995, however, the narrower three-digit

standard industrial classification codes were adopted as

the relevant product categories for this purpose. 26

. C.F.R. 1.861-17(a)(2)(ii). See T.D. 8646, 1996-1 C.B. 145.

3. a. Petitioner, along with its DISC (Boeing Inter-

national Sales Corporation) and its FSC (Boeing Sales

Corporation), chose to group its export sales according

to petitioner’s internally designated “Airplane Pro-

grams” and to use the combined taxable income method

for each grouping. Invoking 26 C.F.R. 1.994-1(c)(7)

(DISC) and 26 C.F.R. 1.925(a)-1T(ce)(8)(ii) (FSC), peti-

tioner treated each of its programs as a product line and

computed the CTI for each program. Pet. App. 2a-3a.

In doing so, however, petitioner declined to follow the

requirement of the regulations that research and

development expenses be allocated on the basis of the

(then) two-digit industrial classification codes required

by 26 C.F.R. 1.861-8(e)(3)()(A) (1979). Instead, peti-

tioner sought to allocate most of its research and devel-

7 In December 1995, the research and development provisions

previously published as 26 C.F.R. 1.861-8(e)(3) (1979) were

amended and renumbered as 26 C.F .R. 1.861-17.

11

opment expenses along narrower, airplane-by-airplane

product lines. Pet. App. 3a. The result of the narrower

allocation method followed by petitioner would be to

reduce the research and development expenses allo-

cated to its export sales and thereby increase the “com-

bined taxable income” from those sales and decrease

the resulting United States taxes owed by petitioner

during the relevant years. /d. at 3a-4a.

b. Petitioner organized its operations in defined

operating divisions that dealt with specific products or

services and operated largely autonomously. Peti-

tioner’s largest division was its Commercial Airplane

Division, which produced different models of commer-

cial airplanes and related products and provided related

services. The Commercial Airplane Division was, in

turn, divided for purposes of organization and account-

ing into programs dealing with a specific airplane model

or with spares, sundry or other activities. Petitioner’s

financial statements generally did not break down

revenues or profits by programs. Instead, they were

reported in total for the Commercial Airplane Division.

Pet. App. 2a.

Petitioner divided its R&D expenditures into two

categories: “Blue Sky R&D” and “Company Sponsored

Product Development.” Of the approximately $4.6 bil-

lion in R&D expenditures incurred by petitioner during

the relevant years, approximately $1.0 billion was clas-

sified as Blue Sky R&D and $3.6 billion was classified as

Company Sponsored Product Development. Pet. App.

2a-3a; C.A. E.R. 4-5.

Blue Sky R&D involved basic airplane technology, as

well as the development of new airplanes prior to the

initiation of specific airplane programs. A large amount

of petitioner’s Blue Sky R&D expenses were incurred

in “informal programs” or “projects” that were the pre-

12

cursors to specific formally identified programs. For

example, petitioner incurred significant Blue Sky R&D

expenditures related to what petitioner referred to as

the 7X7 “Program” or “Project” and which eventually

became the 767 Program when petiticner’s Board of

Directors authorized the “program go-ahead.” Pet.

App. 3a, 17a; C.A. E.R. 62-63, 102.°

Company Sponsored Product Development repre-

sented research an? development expenditures that

petitioner identified ~, _varticular airplane programs.

The difference between Blue Sky R&D and Company

Sponsored Product Developinent was a function of the

way petitioner divided its commercial airplane business

for cost accounting and management purposes. Under

petitioner’s system, an “airplane program” designated

the organizational component that developed and

manufactured a specific airplane model after that model

had achieved “program go-ahead” status. See note 8,

supra. During the tax years at issue in this case, peti-

tioner established or maintained a separate program for

each of the following airplane models: 707, 727, 737,

737-300, 747, 757 and 767. Pet. App. 16a; C.A. E.R. 4.

c. In computing CTI, petitioner annually allocated

its Blue Sky R&D costs among all of its airplane pro-

grams primarily on the basis of the number of direct

labor hours incurred in each program. Pet. App. 3a;

C.A. E.R. 157. Petitioner allocated Company Spon-

sored Product Development research to the particular

program for which it was incurred. Each year peti-

8 Program go-ahead was the point at which petitioner's Board

of Directors made a firm commitment to produce a particular air-

plane model. That decision was contingent, in part, on the exis-

tence of a significant number of firm customer orders for that air-

plane model. Pet. App. 3a, 17a; C.A. E.R. 105-106, 115-116.

13

tioner made these allocations to a particular airplane

program even though there might be no sales in that

program for that year. As a result, under petitioner's

method of allocating R&D expenses, approximately $1.9

billion dollars of R&D expenditures during the years in

question—expenditures that were deducted from the

income earned by petitioner's Commercial Airplane

Division in determining its taxable income generally—

were not deducted in computing the CTI for sales

through Boeing International Sales Corporation and

Boeing Sales Corporation for purposes of the DISC and

FSC provisions. Pet. App. 3a; C.A. E.R. 152-153. The

result was to increase the amount of tax exempt or tax

deferred income treated favorably under the DISC and

FSC provisions.

d. On audit, the Internal Revenue Service rejected

petitioner’s methods of allocating R&D expenses in

computing the CTI from DISC and FSC sales of its

commercial airplanes and related products and services

and recomputed the CTI from those sales by

the R&D expenses in accordance with 26 C.F.R. 1.861-

8(e)(3) (1979). The Service thus allocated petitioner’s

R&D expenses (both Blue Sky R&D and Company

Sponsored Product Development R&D) to all of peti-

tioner’s income from sales of commercial airplanes and

related products and services in a single category under

the two-digit Standard Industrial Classification Code 37

(Transportation Equipment) and apportioned those

R&D expenses among petitioner's programs on the

basis of sales in each program. This reallocation of

R&D expenses resulted in more expenses being allo-

cated to petitioner’s qualified export sales, thereby

decreasing the CTI for those sales under the DISC and

FSC provisions, and thereby yielding a greater tax

14

liability for each of the years in question. Pet. App. 3a-

4a, 18a.

4. Petitioners paid the additional tax and filed timely

claims for refund. After those claims were not granted,

petitioners filed this suit for refund in the United

States District Court for the Western District of Wash-

ington. Pet. App. 4a. Petitioners contended that the

application of 26 C.F.R. 1.861-8(e)(3) (1979) to CTI cal-

culations was “arbitrary, capricious, and invalid under

the Code sections and regulations governing DISC and

FSC export transactions.” C.A. E.R. 8.

The district court upheld petitioner’s contention.

Pet. App. 24a. The court concluded that there is a con-

flict between the two-digit Standard Industrial Clas-

sification Code product categories mandated by 26

C.F.R. 1.861-8(e)(3) (1979) and the statement in the

DISC regulation that a taxpayer’s grouping of trans-

actions is “controlling” (26 C.F.R. 1.994-1(c)(6){iv)) in

the allocation of deductions against the gross income

resulting from such grouping. Pet. App. 2la. In so

ruling, the court followed the decision of the Eighth

Circuit in St. Jude Medical, Inc. v. Commissioner, 34

F.3d 1394 (1994), which had concluded that 26 C.F.R.

1.861-8(e)(3) is invalid as applied to DISC computations.

The district court stated that the court in St. Jude had

identified three “defects” in the application of 26 C.F.R.

1.861-8(e)(3) to DISC transactions, two of which were

present here. Pet. App. 2la. First, the court stated

that the two-digit Standard Industrial Classification

Code grouping of 26 C.F.R. 1.861-8(e)(3) departs from

the legislative intent to allow costs “to be allocated on a

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

lines” when computing CTI. Pet. App. 2la-22a.

Second, the court stated that the two-digit industrial

code grouping required by 26 C.F.R. 1.861-8(e)(3) is

15

inconsistent with a legislative intent to allocate to each

product group “all expenses directly related” to the

exported goods. Pet. App. 22a (quoting St. Jude, 34

F.3d at 1401). The district court therefore concluded

that the regulatory requirements of 26 C.F.R. 1.861-

8(e)(3)(ii) (1979) are inapplicable to the calculation of

CTI and entered judgment in favor of petitioners and

against the government for $419,110,539 in tax and

assessed interest. Pet. App. 4a.’

5. The court of appeals reversed. Pet. App. la-14a.

Declining to follow the reasoning or hoiding of St. Jude,

the court of appeals agreed with the government that

26 C.F.R. 1.861-8(e)(3) provides the appropriate method

for allocating R&D expenses in calculating CTI under

the DISC and FSC provisions. Pet. App. 10a-lla. The

court noted that, under the plain text of Section

994(a)(2), “CTI is to be calculated based on revenue and

costs ‘attributable to’ sales in the applicable year * * *

{and the statute] does not confine the relevant costs to

those ‘definitely related’ to sales of a particular pro-

duct.” Id. at 1la. The court concluded that the leg-

islative history of the statute requires the same conclu-

sion (ibid. (quoting H.R. Rep. No. 533, supra, at 74)):

_® Because the decision of the district court resulted in a correla-

tive increase in the taxable income of petitioner’s FSC, the court

also awarded the government a judgment of $481,149 against Boe-

ing Sales Corporation. See United States v. Boeing Sales Corp.,

No. 01-1382 (Mar. 20, 2000), Cond. Cross Pet. at 3. Boeing Sales

Corporation therefore filed a conditional cross-appeal. Because

both sides agreed that the judgment against Boeing Sales

Corporation was a computational function of the judgment in favor

of petitioner and should be reversed if the principal judgment were

reversed, the conditional cross-appeal was not separately briefed.

Appeliee’s Br. 17 n.8; Appellant’s Reply Br. 1 n.1.

16

This House Report reflects that Congress recog-

nized 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 in-

tention that those costs not “directly related” would

be allocated to export-related sales on a pro rata

basis. The Commissioner’s interpretation of [26

C.F.R.] 1.861-8(e)(3) effectuates this Congressional

intent.

The court of appeals disagreed with the district court

on whether there was a conflict between the require-

ments of 26 C.F.R. 1.861-8(e)(3) and 26 C.F.R. 1.994-

1(c)(6). The court of appeals emphasized that the DISC

statute and its legislative history contemplate that the

“total costs” allocable to export sales were to include

to apportion these costs to broader categories of income

and allocate them between the taxpayer's export and

domestic sales by che proportional method set forth in

(26 C.F.R.] 1.861-8(e)(3).” Pet. App. 12a. The court

concluded that petitioner’s alternative method of

allocating R&D costs for purposes of the DISC and

FSC provisions was invalid because it fails to allocate

the “total costs” of export sales in computing CTI. Id.

at 6a.

—eoVr

17

ARGUMENT

1. As a consequence of the various revisions and

repeals of the pertinent statutory provisions, the

specific issues presented in this case under the separate

tive importance. For the reasons set forth in detail at

pages 2-3, supra, the interpretation of the DISC statute

and regulations has no prospective importance

(i) because that statute is not available for large export-

ers (such as petitioner) and (ii) because the features of

the DISC that were determined to represent a prohib-

ited export subsidy under the GATT were removed by

Congress in 1984 and the statute thus no longer pro-

vides significant tax relief even for small exporters.

Similarly, the proper construction of the separate F'SC

statute and regulations lacks prospective importance

because it has relevance only for the few taxpayers

who, following enactment of the ETI, claim reliance on

the narrow transitional FSC rules. See pages 3-5,

supra. And, regulations under the ETI have not yet

been formalized and issued for public comment.” The

questions presented in the petition therefore lack

recurring importance and do not warrant review by this

Court.

9 a. For the reasons carefully detailed in the deci-

sion below (Pet. App. 10a-13a), the court of appeals

10 In the legislative history of the ETI, Congress emphasized its

intention that, for the common case involving foreign trade

address, and remove, the asserted “conflict” in the regulations that

was the premise for the decision of the court of appeals in the St.

Jude case. See page 14, infra.

18

correctly concluded that, in determining “combined tax-

able income” for DISC and FSC transactions during the

years relevant to this case, R&D expenses were to be

grouped under the two-digit SIC codes required by 26

C.F.R. 1.861-8(e)(3) (1979). See also note 11, infra

Although the decision of the Eighth Circuit in St. Jude

Medical, Inc. v. Commissioner, 34 F.3d 1394, 1396-

1402 (1994), conflicts with that determination as applied

to DISC transactions only, there is no recurring

impertance to that conflict because the pertinent pro-

visions of the DISC statute have been modified or

repealed. See pages 2-3, supra.

b. There is no conflict among the circuits concerning

the further determination of the court of appeals in this

case that the agency’s regulations provide a proper allo-

cation of R&D expenses to FSC transactions. Indeed,

this is the first appellate decision even to address that

issue. The FSC statute and regulations present this

expense-allocation question in a distinctly different

context than was before the court in St. Jude, which

addressed only the materially different DISC provi-

sions. See 34 F.3d at 1396-1402.

The DISC regulations involved in St. Jude specified

“that the taxpayer’s choice regarding the grouping of

transactions shall control as long as it conforms to a

recognized industry/trade usage or a SIC group.” 34

F.3d at 1402 (emphasis added) (citing 26 C.F.R. 1.994-

1(c)(6)(iv), (7)(ii)). The court in St. Jude concluded that

this regulation required the Treasury to respect the

grouping chosen by the taxpayer in allocating R&D

expenses in making CTI calculations under the DISC

regime, rather than the two-digit SIC classification

code grouping specified in the Section 861 regulations.

The court emphasized that the Section 861 regulations

were not adopted with DISCs specifically in mind and

19

that, “at the time the DISC legislation was enacted,

[the Section 861 regulations] did not contain the SIC

categories * * * .” 34 F.3d at 1402. The court

concluded in St. Jude that, because the two-digit SIC

classification code allocation procedures of the Section

861 regulations were adopted after the DISC legislation

was enacted, they should not be “applied to DISC CTI

computations.” Ibid.”

ll For reasons similar to those adopted by the court of appeals

in this case (see Pet. App. 10a-13a), the Tax Court in St. Jude also

rejected the assertion that there is a conflict between the DISC

regulations and the Section 861 regulations. St. Jude Medical, Inc.

v. Commissioner, 97 T.C. 457, 479-481 (1991), aff’d in part and

rev'd in part, 34 F.3d 1394 (8th Cir. 1994). The Tax Court

emphasized that the cost allocation methods established in the

Section 861 regulations are entitled to substantial judicial defer-

ence. 97 T.C. at 483. Section 863 of the Code expressly authorizes

the Secretary of the Treasury to prescribe regulations under Sec-

tion 861 to specify how items of income, expense, and losses and

deductions are to be allocated or apportioned to sources within or

without the United States (26 U.S.C. 863(a)), and the regulations

adopted under this statute are to be upheld when, as here, they

provide a reasonable choice among alternative methods of imple-

menting the statute. 97 T.C. at 483. As this Court held in United

States v. Correll, 389 U.S. 299, 307 (1967):

In this area of limitless factual variations, “it is the province of

Congress and the Commissioner, not the courts, to make the

appropriate adjustments.” Commissioner v. Stidger, 386 US.

287, 296. The role of the judiciary in cases of this sort begins

and ends with assuring that the Commissioner’s regulations

fall within his authority to implement the congressional man-

date in some reasonable manner.

The Tax Court also noted the Section 861 a

nize[] with the origin and purposes of” the DISC provisions.

T.C. at 483. The DISC committee reports state that “the combined

taxable income from the sale of the export property is to be

determined generally in accordance with the principles applicable

20

The reasoning of the court of appeals in St. Jude,

however, has no application to CTI calculations under

the separate FSC statute and regulations. In the first

place, by the time Congress enacted the FSC provisions

in 1984, the Section 861 regulations for R&D expense

allocations in CTI calculations had long been in place.

26 C.F.R. 1.861-8(e)(3) (1979). And, when the FSC was

enacted, Congress specifically endorsed application of

the then-existing Section 861 regulations to the new

FSC regime. 1 Staff of the Sen. Comm. on Finance,

98th Cong., 2d Sess, Deficit Reduction Act of 1984, at

636 (Comm. Print 1984). See also H.R. Conf. Rep. No.

861, 98th Cong., 2d Sess. 968-977 (1984).”

under section 861 * * * [which] generally allocate to each item of

gross income all expenses directly related thereto, and then appor-

tion other expenses among all items of gross income on a ratable

basis.” H.R. No. 533, supra, at 74; S. Rep. No. 437, supra, at 107-

108. Contrary to petitioners’ assertion (Pet. 17-19), nothing in the

Section 861 regulations conflicts with this legislative description of

those regulations. The Section 861 regulations apportion items of

expense partially on a direct and partially on a ratable basis. See

26 C.F.R. 1.861-8(a)(2) (1979) (“allocations and apportionments are

made on the basis of the factual relationship of deductions to gross

income”). The regulations thus recognize a fundamental tenet of

cost accounting, which is that “the unit of costing determines

whether a cost is direct or indirect: as the unit of costing changes,

some indirect costs may be converted to direct costs.” D. Keller et

u., Management Accountants’ Handbook 4 7.2(b), at 7-8 (4th ed.

.992).

Beginning with the Economic Recovery Tax Act of 1981,

§ 223, Pub. L. No. 97-34, 95 Stat. 249, Congress enacted a series of

moratoriums on 26 C.F.R. 1.861-8(e)(3) (1979) for geographic

source purposes under Section 904 of the Code. Those moratori-

ums, however, did not apply to CTI calculations under either the

DISC or FSC provisions. See Intel Corp. v. Commissioner, 76

F.3d 976, 983 (9th Cir. 1996); St. Jude Medical, Inc. v. Commis-

sioner, 34 F.3d at 1403-1405. Congress thus specifically contem-

21

Secondly, when the FSC regulations were adopted,

they did not employ the language from the DISC

regulations on which the court relied in the St. Jude

case. While the DISC regulations had stated that the

grouping election of the DISC and its parent would be

“controlling” (26 C.F.R. 1.994-1(c)(7) (1979)) and that

the “costs deductible in a taxable year [were to] be allo-

cated and apportioned to the items or classes of gross

income * * * resulting from such grouping” (26 C.F.R.

1.994-1(c)(6)(iv)), the regulations adopted to implement

the FSC regime contained no parallel provision. See 26

C.F.R. 1.925-1T(c)(6) (1989). The regulatory language

on which the court of appeals relied in St. Jude in con-

cluding that a conflict existed between the grouping

directives of the DISC regulations and the Section 861

regulations thus did not exist under the FSC regime.

Instead, under the FSC regime, both the Section 861

regulations and the FSC regulations direct the tax-

payer to recognized trade usages and the “two-digit

major groups * * * of the Standard Industrial

Classification” codes in allocating expenses among

groups of products. 26 C.F.R. 1.925(a)-1T(c)(8)(ii)

(1989); see 26 C.F.R. 1.861-8(e)(3) (1979). Since the Sz.

Jude case concerned DISC transactions only, that court

did not have the FSC provisions before it. And, since

the reasoning of the St. Jude court concerning the

DISC provisions is inapplicable to the different statu-

tory and regulatory provisions governing the taxation

of FSC transactions, there is no conflict between that

decision and the holding in this case that the two-digit

plated that the Section 861 regulations (including the two-digit

SIC classification code grouping requirement) were to apply to

22

SIC codes properly apply in allocating expenses among

FSC product lines.

Moreover, in the course of generally revising the

Section 861 regulations in 1995, the Treasury adopted a

more specific product grouping provision that now

directs the allocation of R&D expenditures on the basis

of “the three digit classification of the Standard Indus-

trial Classification Manual (SIC code).” 26 C.F.R.

1.861-17(a)(2)(ii). That more recent regulatory defini-

tion of product groups makes the controversy raised by

petitioner in this case even more remote for the future.

In any event, the FSC provisions were repealed in

2000 and replaced by the ETI. See pages 3-5, supra.

Because there is no relevant, current conflict among the

circuits concerning the present application of either the

FSC or the ETI, and since the DISC has no genuine

present application for export transactions, there is no

probable future importance to the issues addressed in

this case. Further review of the extremely narrow,

technical questions presented by the petition is there-

fore not warranted.

3. Petitioner errs in contending that the straight-

forward application of the longstanding Treasury regu-

lations adopted by the court of appeals in this case

achieves a “perverse result” (Pet. 16). The difference

between the R&D expense allocation requirements of

the Section 861 regulations and the model-by-model

allocation proposal of petitioner is not just one of

timing. Although petitioner suggests that “[t]here 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” (Pet. 22),

this obscures the fact that, under petitioner’s interpre-

tation, such excess costs would never be deducted from

gross income generated in a later year. Petitioner’s

23

contention is that, in calculating its CTI, it should be

allowed to ignore nearly $2 billion in aircraft R&D

expenses because the income from some of the applica-

tions of that research was not realized in the tax years

that the expenses were incurred. Petitioner’s interpre-

tation would improperly overstate its “combined tax-

able income” from export sales of aircraft (and thereby

reduce its United States taxes) by violating the

requirement that “the total costs of the DISC and

related supplier which relate to such gross receipts” be

deducted in computing CTI. 26 C.F.R. 1.994-1(c)(6)

a added). See also 26 C.F.R. 1.925(a)-1T(c)(6)

CONCLUSION

The petition for a writ of certiorari should be denied.

Respectfully submitted.

THEODORE B. OLSON

Solicitor General

EILEEN J. O’CONNOR

Assistant Attorney General

DAVID ENGLISH CARMACK

FRANK P. CIHLAR

Attorneys

APRIL 2002

APPENDIX

STATUTES AND REGULATIONS INVOLVED

In addition to the statutes and regulations set forth

in the appendix to the petition, the following statutes

and regulations are involved in this case.

1. During the years relevant to this case, 26 U.S.C.

925 (1985) (added by Pub. L. No. 98-369, Div. A, tit.

VIII, § 801(a), 98 Stat. 990), provided, in relevant part:

(a) In general.—In the case of a sale of export

property to a FSC by a person described in section

482, the taxable income of such FSC and such per-

son shall be based upon a transfer price which would

allow such FSC to derive taxable income attribut-

able to such sale (regardless of the sales price

actually charged) in an amount which does not

exceed the greatest of—

(1) 1.83 percent of the foreign trading gross

receipts derived from the sale of such property

by such FSC,

(2) 23 percent of the combined taxable income

of such FSC and such person which is

attributable to the foreign trading gross

receipts derived from the sale of such property

by such FSC, or

(3) taxable income based upon the sale price

actually charged (but subject to the rules

provided in section 482).

Paragraphs (1) and (2) shall apply only if the FSC meets

the requirements of subsection (c) with respect to the

sale.

(la)

2a

(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 application 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 sub-

section (a)(2) in those cases where a FSC is

seeking to establish or maintain a market for

export property.

(c) Requirements for use of administrative pric-

ing rules.—A sale by a FSC meets the requirements

of this subsection if—

(1) all of the activities described in section

924(e) attributable to such sale, and

(2) all of the activities relating to the solicita-

tion (other than advertising), negotiation, and

making of the contract for such sale,

have been performed by such FSC (or by another

person acting under a contract with such FSC).

(d) Limitation on gross receipts pricing rule.

—The amount determined under subsection (a)(1)

with respect to any transaction shall not exceed 2

times the amount which would be determined under

subsection (a)(2) with respect to such transaction.

3a

(e) Taxable income.—For purposes of this sec-

tion, the taxable income of a FSC shall be

determined without regard to section 921.

(f) Special rule for cooperatives.—In any case in

which a qualified cooperative sells export property

to a FSC, in computing the combined taxable income

of such FSC and such organization for purposes of

subsection (a)(2), there shall not be taken into

account any deduction allowable under subsection

(b) or (c) of section 1382 (relating to patronage divi-

dends, per-unit retain allocations, and nonpatronage

distributions).

2. 26 C.F.R. § 1.925(a)-1T (1989) provided, in rele-

vant part:

Temporary regulations; transfer pricing rules for

s.

* * * * *

(c)(6) Full costing combined taxable income—i)

In gen eral. For purposes of section 925 and this

section, if a FSC is the principal on the sale of

export property, the full costing combined taxable

income of the FSC and its related supplier from

the sale is the excess of the foreign trading

gross receipts of the FSC from the sale over the

total costs of the FSC and related supplier including

the related supplier’s cost of goods sold and its

and the FSC’s noninventoriable costs (see § 1.471-

11(c)(2)Gii)) which relate to the foreign trading gross

receipts. Interest or carrying charges with respect

to the sale are not foreign trading gross receipts.

4a

(ii) Section 482 applicability. 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 the section is

applicable. If a related supplier performs services

under contract with a FSC, the FSC shall compen-

sate the related supplier an arm’s length amount

under the provisions of § 1.482-2(b) (1) throug* ‘6).

Section 1.482-2(b)(7), which provides that an arm’s

length charge shall not be deemed equal to costs or

deductions with respect to services which are an

integral part of the business activity of either the

member rendering the services (i.e., the related

supplier) or the member receiving the benefit of the

services (i.e., the FSC), shall not apply if the

administrative pricing methods of section 925(a) (1)

and (2) are used to compute the FSC’s profit and if

the related supplier is the person rendering the

services. Section 1.482-2(b)(7) shall apply, however,

if a related person other than the related supplier is

the person rendering the services or if the section

482 method of section 925(a)(3) is used to compute

the FSC’s profit. See § 1.925(a)-1T(a)(3)(ii). For a

special rule for computation of combined taxable in-

come where the related supplier is a qualified

cooperative shareholder of the FSC, see paragraph

(c)(7) of this section.

(iii) Rules for determination of gross receipts and

total costs. In determining the gross receipts of the

FSC and the total costs of the FSC and related

supplier which relate to such gross receipts, the

rules set forth in subdivisions (iii) (A) through (E) of

this paragraph shall apply.

5a

(A) Subject to the provisions of subdivisions (iii)

(B) through (E) of this paragraph, the methods of

accounting used by the FSC and related supplier

to compute their taxable incomes will be accepted

for purposes of determining the amounts of items

of income and expense (including depreciation) and

the taxable year for which those items are taken

into account.

(B) A FSC may, generally, choose any method of

accounting permissible under section 446(c) and

the regulations under that section. However, if a

FSC is a member of a controlled group (as defined

in section 927(d)(4) and § 1.924(a)-1T(h)), the FSC

may not choose a method of accounting which,

when applied to transactions between the FSC

and other members of the controlled group, will

result in a material distortion of the income of the

FSC or of any other member of the controlled

group. Changes in the method of accounting of a

FSC are subject to the requirements of section

446(e) and the regulations under that section.

(C) Cost of goods sold shall be determined in

accordance with the provisions of § 1.61-3. See

sections 471 and 472 and the regulations there-

under with respect to inventories. With respect to

property to which an election under section 631

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).

6a

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

shall be treated as relating to gross receipts from

sales of export property are the expenses, losses,

and deductions definitely related, and therefore

allocated and apportioned thereto, and a ratable

part of any other expenses, losses, or deductions

which are not definitely related to any class of

income, determined in a manner consistent

with the rules set forth in § 1.861-8. The deduction

for depletion allowed by section 611 relates to

gross receipts from sales of export property and

shall be taken into account in computing the com-

bined taxable income of the FSC and its related

supplier.

(7) Cooperatives and combined taxable income

method. If a qualified cooperative, as defined in section

1381(a), sells export property to a FSC of which it is a

shareholder, the combined taxable income of the FSC

and the cooperative shall be computed without taking

into account deductions allowed under section 1382(b)

and (c) for patronage dividends, per-unit retain alloca-

tions and nonpatronage distributions. The FSC and

cooperative must take into account, however, when

computing combined taxable income, the cooperative s

cost of goods sold, or cost of purchases.

(8) Grouping transactions. (i) [Reserved]. For

further guidance, see § 1.925(a)-1(c)(8)(i).

(ii) A determination by the related supplier as to a

product or a product line will be accepted by a

district director if such determination conforms to

either of the following standards: Recognized trade

or industry usage, or the two-digit major groups (or

any inferior classifications or combinations thereof,

Ta

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. A product shall

be included in only one product line for purposes of

this section if a product otherwise falls within more

than one product line classification.

(iii) A choice by the related supplier to group trans-

actions 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 to be made on a transaction-by-transaction

basis. For example, the related supplier 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. Sale

transactions may. not be grouped, however, with

lease transactions.

(iv) For purposes of this section, transactions in-

volving military property, as defined in section

923(a)(5) and § 1.923-1T(b)(3)(ii), may be grouped

only with other military property included within

the same product or product line grouping deter-

mined under the standards of subdivision (8)(ii) of

this paragraph. Non-military property included

within a product or product line grouping which

includes military property may be grouped, at the

election of the related supplier, under the general

8a

grouping rules of subdivisions (i) through (iii) of this

paragraph.

(v) A special grouping rule applies to agricultural

and horticultural products sold to the FSC by a

qualified cooperative if the FSC satisfies the re-

quirements of section 923(a)(4). Section 923(a)(4)

increases the amount of the FSC’s exempt foreign

trade income with regard to sales of these products,

see § 1.923-1T(b)(2). This special grouping rule pro-

vides that if the related supplier elects to group

those products that no other export property may

be included within that group. Export property

which would have been grouped under the general

grouping rules of subdivisions (i) through (iii) of this

paragraph with the export property covered by this

special grouping rule may be grouped, however, at

the election of the related supplier, under the

general grouping rules.

(vi) For rules as to grouping certain related and

subsidiary services, see paragraph (d)(3)(ii) of this

section.

(vii) If there is more than one FSC (or more than

one small FSC) within a controlled group of corpora-

tions, the same grouping of transactions, if any,

must be used by all FSCs (or small FSCs) within the

controlled group. If the same grouping of trans-

actions is required by this subdivision, and if group-

ing is elected, the same transfer pricing method

must be used to determine each FSC’s (or small

FSC’s) taxable income with respect to that group-

ing.

9a

(viii) The product or product line groups that are

established for purposes of determining combined

taxable income may be different from the groups

that are established with regard to economic pro-

cesses (see § 1.924(d)-1(e)).

* * * * *

(g) Effective date. The provisions of this section and

§ 1.925 (b)-1T apply with respect to taxable year ending

after December 31, 1984, except that a corporation may

not be a FSC for any taxable year beginning before

January 1, 1985.

3. Since December 22, 1995, 26 C.F.R. § 1.861-17 has

provided (T.D. 8646, 60 FR 66503 (Dec. 22, 1995)):

§ 1.861-17 Allocation and apportionment of research

and experimental expenditures.

(a) Allocation—{1) In general. The methods of

allocation and apportionment of research and

experimental expenditures set forth in this section

recognize that research and experimentation is an

inherently speculative activity, that findings may

contribute unexpected benefits, and that the gross

income derived from successful research and experi-

mentation must bear the cost of unsuccessful re-

search and experimentation. Expenditures for re-

search and experimentation that a taxpayer deducts

under section 174 ordinarily shall be considered

deductions that 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

10a

categories). For purposes of this allocation, the

product category (or categories) that a taxpayer

may be considered to have shall be determined in

accordance with the provisions of paragraph (a)(2) of

this section.

(2) Product categories—{i) Allocation based on |

product categories. Ordinarily, a taxpayer’s

research and experimental expenditures may be

divided between the relevant product categories.

Where research and experimentation is conducted

with respect to more than one product category, the

taxpayer may aggregate the categories for purposes

of allocation and apportionment; however, the tax-

payer may not subdivide the categories. Where

research and experimentation is not clearly identi-

fied with any product category (or categories), it

will be considered conducted with respect to all the

taxpayer’s product categories.

(ii) Use of three digit standard industrial classifi-

cation codes. A taxpayer shall determine the rele-

vant product categories by reference to the three

digit classification of the Standard Industrial Classi-

fication Manual (SIC code). A copy may be pur-

chased from the Superintendent of Documents,

United States Government Printing Office, Wash-

ington, DC 20402. The individual products included

within each category are enumerated in Executive

Office of the President, Office of Management and

Budget, Standard Industrial Classification Manual,

1987 (or later edition, as available).

(iii) Consistency. Once a taxpayer selects a

product category for the first taxable year for which

this section is effective with respect to the taxpayer,

lla

it must continue to use that product category in

following years, unless the taxpayer establishes to

the satisfaction of the Commissioner that, due to

changes in the relevant facts, a change in the

product category is appropriate. For this purpose, a

change in the taxpayer’s selection of a product

category shall include a change from a three digit

SIC code category to a two digit SIC code category,

a change from a two digit SIC code category to a

three digit SIC code category, or any other aggrega-

tion, disaggregation or change of a previously

selected SIC code category.

* * * * *

renee