Amicus Curiae Brief — Boeing Co. v. United States

No. 01-1209 Ane 4 ae. \

20r

Supreme Court of the Anited States

THE BOEING COMPANY AND CONSOLIDATED SUBSIDIARIES,

Petitioners,

Vv.

UNITED STATES OF AMERICA,

Respondent.

On Writ of Certiorari to the

United States Court of Appeals

for the Ninth Circuit

BRIEF OF TAX EXECUTIVES INSTITUTE, INC.

AS AMICUS CURIAE

IN SUPPORT OF PETITIONERS

FRED F. MURRAY *

MARY L. FAHEY

TAX EXECUTIVES INSTITUTE, INC.

1200 G Street, N.W.

Suite 300

Washington, D.C. 20005-3814

(202) 638-5601

Counsel for Amicus Curiae

* Counsel of Record Tax Executives Institute, Inc.

a EP TE TD

WILSON-EPES PRINTING CO., INC. — (202) 789-0096 — WASHINGTON, D.C. 20001

30 »P

TABLE OF CONTENTS

Page

TREE Ge RAF Cee COD cennsnepensereenenemennnianiante il

INTEREST OF AMICUS CURIAE.............cccccsseeccseeseeees I

SUMMARY OF ARGUMENT .................ccssssssscesessseees

PETA ITOIETS cecnseesemanetinennensnmninmetaenmuannn 8

I. THE NINTH CIRCUIT’S DECISION IS

WRONG AS A MATTER OF LAW. ................ 8

Il. THE DISC PROVISIONS WERE INTENDED

TO PROVIDE A MORE LEVEL PLAYING

PPEEEED werssmnenmacssnevininemensneninmmutennsennimnadianiaaintinis 13

Ill. TREAS. REG. § 1.861-8(e)(3) SHOULD NOT

CONTROL THE CALCULATION OF CTL. ..... 15

A. Consistency with the Principles of Section

861 Does Not Lead to the Mechanical

Application of the Special Allocation Rule

in Treas. Reg. § 1.861-8(€)(3)..........cceeeeeees 16

B. Treas. Reg. § 1.861-8(e)(3) Is a Radical

Departure from the General Rules and

Principles Of Section 861. ........ccccsccseeeeeeees 20

Sd

RSE AEFI IeS covecssscesererscosscevenneenseuesuseusenseneesunsnerensenses 25

(i)

ii

TABLE OF AUTHORITIES

CASES Page

Bowen v. Michigan Academy of Family

Physicians, 476 U.S. 667 (1986) .........cccccceeeeeees 19-20

Commissioner v. Ferro-Enamel Corp., 134 F.2d

ee 6, 17

Cox v. Roth, 348 U.S. 207 (1955)........ccccseesecseeeeees 19

L&F Int'l Sales Corp. v. United States, 912 F.2d

ee 8

Rite Aid Corp. v. United States, 255 F.3d 1357

Te 24-25

Shalala v. Illinois Council on Long Term Care,

aor 20

St. Jude Medical, Inc. v. Commissioner, 34 F.3d

ST IME wnsccssssscosssceussessess 2, 10, 12, 15, 23

United Dominion Industries, Inc. v. United —

LE oe Ly | | re 25

STATUTES

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

ea 8-9

FSC Repeal and_ Extraterritorial Income

Exclusion Act of 2000, Pub. L. No. 106-519,

ae 9

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

eran canincpcmnrrncananscccncnaes 9

EE 17

ee 17

ce 17

| Te 9

Ti tridnsdnensecnnennnnnnesenssensseescses 9

TIT setieecemnteneenpnanensnsenenenescesesess 8

ill

TABLE OF AUTHORITIES—Continued

Page

iii aaa iieiiinaneneaiaiiis 9-10, 15, 20, 23

TU inner ciepipammennieiiiniimabasiideaibanns 9

Revenue Act of 1918, Pub. L. No. 254, 40 Stat.

I I nits ainacinlesintiacaaisiniiieaaaiiin 18

Revenue Act of 1921, Pub. L. No. 98, 42 Stat.

eee 17-18

Revenue Act of 1971, Pub. L. No. 92-178, 85

I II acct cnataaeiantnesiaiaitiniatidataiii 8

_ ¢ ) | coil! ECan 19

REGULATIONS

26 C.F.R.

Fema. Rae, § 1B 8 <h .cccoccssscccssccsssegesssssssscsnseseese passim

Treas. Reg. § 1.861-8(€)(3).........sserseerreereeees passim

Temas. Raw. § 1 BG0 87 ccccreccsccovcscccssscccessscsossesees 21,22

Deeen, Taw, § EGR ccccccesssersssssssssssssrssssssssssssese 15

Temes. Rag, § b.FP6 8 nccccccccescccsssssscsssssessssesssosees passim

MISCELLANEOUS

H.R. Rep. No. 92-533, 92d Cong., Ist Sess.

ee 11, 13, 14, 15, 16, 20-21

LOWELL, CYM H., G. MICHAEL TILTON, ANDREW

W. SHELDRICK & MICHAEL J. DONOHUE, U.S.

INTERNATIONAL TAXATION: AGREEMENTS,

CHECK LISTS & COMMENTARY (2002) ...........00+- 17

Pearce, Esther, History of the Standard Industrial

Classification (Executive Office of the

President, Bureau of the Budget, Office of

Statistical Standards, July 10, 1957), reprinted

at http://www.census.gov/epcd/www/sichist.

ee 22

iV

TABLE OF AUTHORITIES—Continued

Proposed Section 861 Regulations, 38 Fed. Reg.

ae

S. Rep. No. 92-437, 92d Cong., Ist Sess.

(| en 11, 13,

Staff of the Joint Committee on Taxation,

General Explanation of the Tax Reform Act of

1986, 100th Cong., Ist Sess. (1987) .........c00

U.S. Census Bureau, Development of NAICS,

reprinted at _ http://www.census.gov/epcd/

cence

Webster's Ninth New Collegiate Dictionary

(Cea cxennsnmmonsnenensenincesannenemmnaninabinenniuiingienestes

The White House, Explanatory Material on the

President's Economic Program (Aug. 15,

1971), reprinted in BNA SPECIAL REPORT,

i. G Ge, TE, GV Oe cnnnsnnneenctmeinen

Page

21

14, 16

IN THE

Supreme Court of the Anited States

No. 01-1209

THE BOEING COMPANY AND CONSOLIDATED SUBSIDIARIES,

Petitioners,

Vv.

UNITED STATES OF AMERICA,

Respondent.

On Writ of Certiorari to the

United States Court of Appeals

for the Ninth Circuit

BRIEF OF TAX EXECUTIVES INSTITUTE, INC.

AS AMICUS CURIAE

IN SUPPORT OF PETITIONERS

INTEREST OF AMICUS CURIAE

Pursuant to Rule 37 of the Rules of the Supreme Court,

Tax Executives Institute, Inc. respectfully submits this brief

as amicus~ curiae in support of Petitioners, the Boeing

Company and its subsidiaries.' Tax Executives Institute

(“TEI” or “the Institute”) is a voluntary, nonprofit association

' Pursuant to Rule 37.6, amicus TEI states that no counsel for a party

has written this brief in whole or in part and that no person or entity, other

than amicus, its members, its members’ companies, or its counsel, has

made a monetary contribution to the preparation or submission of this

brief. Tax Executives Institute has received the written consents of

Petitioners and Respondent to the filing of this brief; those consents have

been filed with the Clerk of the Court.

2

of corporate and other business executives, managers, and

administrators who are- responsible for the tax affairs of their

employers. The Institute was organized in 1944 and has

approximately 5,300 members who represent more than 2,800

of the leading businesses in the United States, Canada, and

Europe. The members of the Institute represent a cross-

section of the business community in North America. The

Institute is dedicated to promoting the uniform and equitable

enforcement of the tax laws and to reducing the costs and

burdens of administration and compliance to the benefit of

both the government and taxpayers.

Members of the Institute have a vital interest in this case,

which involves the resolution of a sharp conflict concerning

the interpretation of tax statutes affecting the foreign

commerce of the United States. The substantive issue in the

case is whether Treas. Reg. § 1.861-8(e)(3) (relating to the

allocation of research and development expenses) is valid

when its application frustrates the operation of the domestic

international sales corporation (DISC) and foreign sales

corporation (FSC) provisions of the Internal Revenue Code.

Eight years ago, the U.S. Court of Appeals for the Eighth

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

3d 1394 (1994), that the Treasury Regulation is invalid in this

context, noting that the mandated allocation method is

inconsistent with Congress’s intent to allocate costs to

definitely related gross receipts. In the instant case, the U.S.

Court of Appeals for the Ninth Circuit declined to follow

St. Jude Medical and held instead that the regulation is

valid. Amicus TEI submits that the Ninth Circuit’s decision

is wrong because it misapprehends the DISC and FSC

statutory schemes and permits Treas. Reg. § 1.861-8(e)(3)

not only to override the statute but also to undermine

congressional intent.

This case has significant ramifications for taxpayers other

than Boeing. The resolution of the question presented in this

3

case affects the tax liabilities of thousands of other businesses

that are also subject to these provisions. As individuals who

must contend daily with the interpretation and administration

of the nation’s tax laws, the Institute’s members have a vital

interest in the proper disposition of this case.

SUMMARY OF ARGUMENT

1. For more than three decades, the domestic international

sales corporation (DISC) and foreign sales corporation (FSC)

provisions of the Internal Revenue Code have provided

much needed tax relief for U.S. companies competing in

foreign markets. Because of the similarity between the

provisions, amicus TEI will focus primarily on the rules

applicable to DISCs.

This case involves how’ Boeing’s research and

development (R&D) expenses should be allocated to the

revenues generated by its export sales of commercial aircraft

for purposes of determining its allowable benefits under the

DISC and FSC provisions. The issue arises because Treas.

Reg. § 1.861-8(e)(3) requires taxpayers to allocate R&D

expenditures according to the two-digit Standard Industrial

Classification (SIC) Manual produced by the Office of

Management and Budget. The DISC regulations, however,

allow taxpayers greater flexibility, permitting them to group

transactions along product lines.

In determining its combined taxable income (CTI) during

1979 through 1987, Boeing exercised its right to elect product

groupings under the DISC and FSC regulations, grouped its

export sales by airplane program, and determined its costs,

including R&D costs, for each airplane program. Under

the DISC regulations, Boeing’s determination properly

allocated definitely related expenses to its export sales and

was also consistent with the general rule of Treas. Reg.

§ 1.861-8(a)(2), which provides that “allocations and appor-

tionments are made on the basis of the factual relationship of

deductions to gross income.”

4

The government disagreed with Boeing’s approach, not on

the grounds that it had failed to establish a direct link to

support its allocation, but rather on the grounds that Treas.

Reg. § 1.861-8(e)(3) applies certain mechanical rules for

allocating R&D expenses. Although the district court held

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

CTI calculation, the Ninth Circuit concluded that in

computing the company’s net income, the Commissioner

“properly applied Treas. Reg. § 1.861-8(e)(3) to allocate

Boeing’s R&D costs to its export sales.” App. at 2a.” The

court’s conclusion is wrong as a matter of law.

Amicus TEI submits that Treas Reg. § 1.861-8(e)(3)’s

requirement that a taxpayer allocate R&D expenses to sales

revenues within a single two-digit SIC code vitiates the

flexibility taxpayers have under the DISC statute to claim

congressionally provided tax benefits. The section 861

regulations were tailored for the purpose of allocating and

apportioning income and expenses uciween foreign and

domestic sources under the foreign tax credit provisions of

the Code. The mechanical rules of Treas. Reg. § 1.861-

8(e)(3) impermissibly conflict with the more specific DISC

regulations, which accord taxpayers a choice in grouping

sales according to product lines. Because Treas. Reg.

§ 1.861-8(e)(3) cannot be harmonized with the purposes of

the DISC provisions, it is invalid as applied to DISCs.

2. Congress enacted the DISC and FSC provisions to

provide a more level playing field for U.S. companies

competing in foreign markets. The DISC provisions were

enacted at a time when the economy was doing poorly. The

Nixon Administration determined that tax changes were

needed as part of a balanced program of stimulation and

? References to “App.” are to the appendix filed with Boeing's Petition

for a Writ of Certiorari to the United States Court of Appeals for the Ninth

Circuit, No. 01-1209 (Feb. 15, 2002).

5

stability. The changes were designed not only to stimulate

spending but also to provide more jobs in the United States.

Congress agreed, stressing the importance of providing tax

incentives for U.S. firms to increase their international

business not only because of their stimulative effect, but also

to remove a disadvantage to U.S. businesses engaged in

export activities through domestic subsidiaries. The Revenue

Act of 1971 contained the DISC provisions, which were

intended to provide a broad incentive program for taxpayers.

In establishing the DISC regime, Congress created a

statutory scheme that was clearly intended to permit DISCs to

earn profits in excess of those earned under the arm’s-length

pricing rules otherwise used between related parties. Thus,

Congress established a unique regime under which taxpayers

using DISCs were to obtain benefits not ordinarily then

available.

3. There are two primary reasons why Treas. Reg.

§ 1.861-8(e)(3) should not be applied to the calculation of

CTI. First, Congress intended only that the general principles

of section 861 should apply in the DISC context. Second, the

special allocation rule of Treas. Reg. § 1.861-8(e)(3) does not

further those principles in this context.

A. Computing CTI requires allocating costs to gross

receipts and, in the first instance, requires allocating costs to

the gross receipts to which they definitely relate. If costs are

not definitely related to certain receipts, they are apportioned

among income on a ratable basis. Congress provided that

these allocations and apportionments are to be “determined in

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

The DISC regulation—Treas. Reg. § 1.994-1(c)(6)(iii)—

implements this legislative history by providing that CTI

should be determined “generally in accordance with the

principles applicable under section 861.”

6

What is abundantly clear is that the regulation

implementing the DISC provisions and governing the

allocation of costs for CTI purposes, as well as the legislative

history of the DISC provisions, express respect for the section

861 principles, but go no further. The DISC rules

contemplate “consistency.” The legislative history contem-

plates applying generally the “principles” of section 861. In

each case, the goal of the statute is to determine CTI so that

actual circumstances are reflected. The government’s attempt

to rigidly apply rules crafted under section 861 for another

purpose is unsupportable and distortive.

The Code’s sourcing rules “undertake to classify the

sources of income within the United States by the nature and

location of the activities of the taxpayer or his property which

produces income.” Commissioner v. Ferro-Enamel Corp.,

134 F.2d 564, 566 (6th Cir. 1943). The rules have been a part

of the tax law almost since the beginning of the modern

income tax. Treas. Reg. § 1.861-8 provides some general and

some mechanical guidance for allocating and apportioning

deductions. From a general perspective—consistent with the

DISC regulations—there must be a factual relationship

between the deduction and the class of gross income. Treas.

Reg. §§ 1.861-8(a)(2),-8(b)(2). If a deduction cannot be

identified with any specific class of gross income, it will

generally be apportioned among all of the taxpayer's gross

income under Treas. Reg. § 1.861-8(b)(5). Boeing’s alloca-

tions were consistent with these general rules.

That the DISC legislative history and regulations

incorporate consistency with the general section 861

principles into the CTI calculation does not mean that the

statute requires the mechanical application of Treas. Reg.

§ 1.861-8(e)(3) or provides support for its validity in these

circumstances. “Consistent” means “compatible”; it does not

mean “identical.” See Webster's Ninth New Collegiate

Dictionary 280 (1988). Indeed, it would be serendipitous if

7

the rules crafted for determining income source could be

applied, without modification, to implement the DISC regime

with equally important but different policy objectives.

In this case, the cross-references to the principles of section

861 in the DISC regulation and legislative history are not

authority to apply all the mechanical rules of the section 861

regulations for purposes of allocating costs, without regard to

factual relationships, to sales in determining CTI. The

objective of the DISC statute—to allocate costs in accordance

with some factual relationship—may not be foreclosed, as the

government would do in this case.

B. Under the general section 861 rules, a factual

relationship between income and expense is a key element of

allocation and apportionment. These are the “principles

applicable under section 861” to which Congress referred in

1971 and which the DISC statute contemplates will be

applied in determining CTl—a factual connection between

income and expense is clearly required.

In contrast, the special rules for allocating R&D expenses

set forth in Treas. Reg. § 1.861-8(e)(3) are mechanical rules

that apply in lieu of the general section 861 principles in

allocating R&D expenses. Rather than identifying a class of

income to which the R&D expenditures actually relate, Treas.

Reg. § 1.861-8(e)(3) generally assigns the expenditures to

income related to 2 broad product category, which is limited

to a list determined by two-digit SIC codes. The special

allocation of R&D expenses may be appropriate in the

context of the computation of the foreign tax credit, but it

clearly undermines congressional intent in respect of the

computation of CTI. Indeed, the consistency contemplated

by Congress and Treas. Reg. § 1.994-1(c)(6)(iii) comes only

by applying the general rules of the regulations under section

861 to establish definite factual relationships, not by

departing from those relationships by applying mechanical

rules for allocating R&D expenses.

8

It is consistent with the section 861 principles for the

allocation of R&D expenses to yield to the DISC and FSC

rules. By mandating the use of a special allocation rule for

R&D expenses in respect of DISCs, the Treasury Department

does violence to the statutory scheme. Treas. Reg. § 1.8./-

8(e)(3) is invalid as applied by the government to the

computation of CTI.

ARGUMENT

I. THE NINTH CIRCUIT’S DECISION IS WRONG

AS A MATTER OF LAW.

For more than three decades, the domestic international

sales corporation (DISC) and foreign sales corporation (FSC)

provisions of the Internal Revenue Code have provided much

needed tax relief for U.S. companies competing in foreign

markets.’ In 1971, deficits in the United States’ balance of

trade led to the enactment of the DISC provisions.

See Revenue Act of 1971, § 501, Pub. L. No. 92-178, 85 Stat.

497 (1971); L&F Int'l Sales Corp. v. United States, 912 F.2d

377, 377 (9th Cir. 1990).* Following a challenge under the

General Agreement on Tariffs and Trade, Congress replaced

the regime in 1984 with the FSC provisions. — Deficit

Reduction Act of 1984, § 801(a), Pub. L. No. 98-369, 98 Stat.

* Unless otherwise noted, references to the “Code” or “IR.C.” are to

the Internal Revenue Code of 1954 and 1986 (26 U.S.C.), in effect during

the years at issue in this case.

* A corporation qualifying as a DISC is permitted to earn a commission

or profit on export sales that is not subject to immediate taxation. The

DISC’s parent corporation is taxed on a specified portion of the DISC

income as a “deemed” distribution; the remaining income is tax-deferred

until distributed to the parent or the corporation ceases to qualify as a

DISC. The size of commission (or amount of profit) that the DISC may

earn is determined according to one of three pricing methods provided by

statute. I.R.C. §§ 991-97.

9

494 (1984).° Although there are technical differences

between the two statutes, the FSC provisions retain many

features in common with the predecessor DISC statute,

including the features at issue here; the principal objective of

these provisions is to address the inequities that arise when

U.S.-based companies compete in foreign markets because of

fundamental differences between the U.S. system of taxation

and those of many other countries. The legislation provides a

more level playing field for these companies. For more than

30 years, these provisions have served their purpose.

The issue in this case involves how Boeing’s research and

development (R&D) expenses should be allocated to the

revenues generated by its export sales of commercial aircraft

for purposes of determining its income from those sales and

consequently its allowable benefits under the DISC and FSC

provisions of the Internal Revenue Code.°

To determine taxpayers’ maximum DISC benefit, Congress

provided three methods for allocating the income:

In the case of a sale of export property to a DISC by a

[related] person .. . , the taxable income of such DISC

> A FSC is generally not subject to taxation on its “exempt foreign

trade income,” which is treated as foreign source income not effectively

connected with the conduct of a U.S. trade or business. Again, the benefit

is determined according to one of three alternative pricing methods.

ILR.C. §§ 921-27. After the enactment of the FSC provisions, a modified

version of the DISC statute remained in effect. I.R.C. § 995. In 2000,

because of a trade dispute over the validity of the FSC regime, Congress

_ repealed the FSC provisions and enacted the extraterritorial income (ETI)

provisions. FSC Repeal and Extraterritorial Income Exclusion Act of

2000, Pub. L. No. 106-519, 114 Stat. 2423 (2000), codified at IL.R.C.

§§ 114, 941-43.

° Given the reliance of the FSC regulations on their predecessor DISC

rules, this brief follows the lead of the Ninth Circuit in discussing

primarily the DISC provisions of the Cocc. App. at 6a n.3. See also Stip.

§ 28 (“Although there are some differences between the DISC and FSC

rules, none of them relate to th[{e] issue in this case.”’).

10

and such [related] 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) 4 percent of the qualified export receipts on the sale

of such 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 ).

I.R.C.§ 994(a) (emphasis added); see App. at 27a. The

taxpayer may “choose the method resulting in the greatest

amount of profit.” Si. Jude Medical, Inc. v. Commissioner,

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

Pursuant to the latitude provided by Congress, Boeing

elected to use the combined taxable income (CTI) method for

calculating the amount of benefit to which it was entitled

under the DISC provisions. Treas. Reg. § 1.994-1(c)(6)

defines CTI as the excess of the DISC’s gross receipts from

the sale of export property over the total costs of the DISC

and its supplier that relate to those gross receipts. In general,

a higher CTI from a transaction will result in a larger benefit.

In calculating CTI on export sales, revenues from sales must

be determined as well as the costs and expenses properly

allocable to those sales. Treas. Reg. § 1.994-1(c)(6)(iii)

requires that a taxpayer allocate to revenues from export sales

“(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 “determined in a manner consistent with the rules

set forth in [Treas. Reg.] § 1.861-8.” (Emphasis added.) This

regulation implements the statutory directive to compute CTI

on export sales and mirrors the legislative history of the DISC

provisions. That history states that income shall be

determined “generally in accordance with the principles

applicable under section 861.” H.R. Rep. No. 92-533, 92d

Cong., Ist Sess. 74 (1971) (hereinafter cited as the “1971

House Report”)(emphasis added); S. Rep. No. 92-437, 92d

Cong., Ist Sess. 107 (1971) (hereinafter cited as the “1971

Senate Report”) (emphasis added).

The DISC regulations specifically permit taxpayers to

group their transactions. Under Treas. Reg. § 1.994-1(c)(7),

the pricing of goods sold by a taxpayer to its DISC is made

on a transaction-by-transaction basis, but the taxpayer may

annually elect to group the transactions according to product

lines. The only limitation placed on the use of the

administrative pricing methods is that the amount of taxable

income that a supplier may shift to the DISC may not exceed

~ 100 percent of the supplier’s income generated by the

transaction. Treas. Reg. § 1.994-1(e)(1)(i).

The issue in this case arises because Treas. Reg. § 1.861-

8(e)(3)—which was added to the regulations after the

enactment of the DISC provisions—requires taxpayers to

mechanically allocate R&D expenditures according to the

two-digit Standard Industrial Classification (SIC) Manual

produced by the Office of Management and Budget. The

DISC CTI calculation, however, contemplates allocating

revenues from particular sales and, where grouping of

products is elected, to particular products. In determining its

CTI in this case, Boeing exercised its right to elect product

groupings under the DISC regulations, grouped its export

12

sales by airplane program, and determined its costs, including

R&D costs, for each airplane program. The company

calculated its CTI on airplane sales net of the costs

so determined. Under the DISC regulations, Boeing's

determination properly allocated definitely related expenses

to its export sales and was also consistent with the general

rule of Treas. Reg. § 1.861-8(a)(2), which provides that

“allocations and apportionments are made on the basis of the

factual relationship of deductions to gross income.”

The government disagreed with Boeing’s approach, not on

the grounds that it had failed to establish a direct link to

support its allocations, but rather on the grounds that Treas.

Reg. § 1.861-8(e)(3) requires that certain mechanical rules for

allocating R&D expenses be directly applied to DISC.

Application of those rules increased the R&D expenses

allocable to Boeing’s export sales, decreased CTI, and

thereby reduced Boeing’s DISC benefit.

In upholding Boeing’s CTI calculation, the district court

turned to the Eighth Circuit’s decision in St. Jude Medical, 34

F. 3d at 1401, which held that Treas. Reg. § 1.861-8(e)(3)

was invalid as applied to the CTI calculation. Finding the.

Eighth Circuit’s reasoning and analysis “persuasive and

applicable to the current case,” the district court found that

there were serious defects in applying Treas. Reg. § 1.861-

8(e)(3) to the computation of CTI that were “fatal” to the

validity of the regulation. App. at 18a-19a, 23a. On appeal,

the Ninth Circuit reversed, holding that Treas. Reg. § |.861-

8(e)(3) as applied to the CTI calculation is a permissible

interpretation of the statute. App. at 2a.

Amicus TEI submits that the requirement of Treas. Reg.

§ 1.861-8(e)(3) that a taxpayer must allocate R&D expenses

to sales revenues within a single two-digit SIC code vitiates

the flexibility taxpayers have under the DISC statute to

maximize tax benefits. The section 861 regulations were

tailored for the purpose of allocating and apportioning income

13

and expenses between foreign and domestic sources under the

foreign tax credit provisions of the Code. When applied to

CTI calculations, however, Treas. Reg. § 1.861-8(e)(3)

conflicts with another statute of equal importance and fails to

achieve the DISC statutory goal of determining CTI based on

the factual relationships between revenues and costs. In this

context, the mechanical rules of that regulation impermissibly

conflict with the more specific DISC regulations, which allow

taxpayers a choice in grouping sales according to product

lines. Because Treas. Reg. § 1.861-8(e)(3) cannot be

harmonized with the purposes of the DISC provisions, it is

invalid as applied to DISCs.

Il. THE DISC PROVISIONS WERE INTENDED TO

PROVIDE A MORE LEVEL PLAYING FIELD.

Congress enacted the DISC and FSC provisions to provide

a more level playing field for U.S. companies competing in

foreign markets. The DISC provisions were enacted at a time

when the economy was doing poorly. The United States was

experiencing high unemployment, a low gross domestic

product, little or no growth in capital goods expenditures, and

a rising inflation rate. Wage and price controls had been

imposed and there was growing concern about the trade

imbalance between the United States and other countries. 7

1971 House Report at 1, 3-4; 1971 Senate Report at 1-2, 6.

The Nixon Administration determined that tax changes were

needed as part of a balanced program of stimulation and

stability. The changes were designed not only to stimulate

spending but also to provide more jobs in the United States.

See The White House, Explanatory Material on the

President's Economic Program (Aug. 15, 1971), reprinted in

BNA SPECIAL REPORT, App. C at C-2 (Aug. 16, 1971).

It was against this background that Congress enacted the

Revenue Act of 1971.

14

In the Administration’s view, the DISC measure would

“provide a substantial stimulus to United States producers to

increase their export sales with resulting favorable effects

on our balance of payments. This will create additional jobs

by strengthening the position of our companies in

world markets.” /d. at C-4. Congress agreed, stressing the

importance of providing tax incentives for U.S. firms to

increase their exports not only because of their stimulative

effect, but also to remove a disadvantage to U.S. businesses

engaged in export activities through domestic subsidiaries:

United States corporations engaging in export activities

are taxed currently on their foreign earnings at the full

U.S. corporate income tax rate regardless of whether

those earnings are kept abroad or repatriated. In

contrast, U.S. corporations which produce and sell

abroad through foreign subsidiaries generally can

postpone payment of U.S. tax on these foreign earnings

so long as they are kept abroad.

In addition, other major trading nations encourage

foreign trade by domestic producers in one form or

another. Where value added taxes or multistage sales

taxes are used to any appreciable extent, the practice is

to refund taxes paid by the exporter at the time of export

and to impose these taxes on importers. In the case of

income taxes as well, however, most of the major

trading nations have features in their tax laws which tend

to encourage exports. Both to provide an inducement for

increasing exports and as a means of removing

discrimination against those who export through U.S.

corporations, [the House Ways and Means] committee’s

bill provides a deferral of tax where corporations

meeting certain conditions—called § Domestic

International Sales Corporations—are used.

1971 House Report at 58; see also 1971 Senate Report at 90.

15

In enacting the DISC regime, Congress provided taxpayers

with a broad incentive program. In order to maximize the

benefit provided under the statute, Congress suspended

several general rules of taxation that normally apply to

taxpayers. Contrary to the treatment afforded other entities

under the tax law, a DISC may be a corporation whose sole

function is to serve as an accounting device for measuring the

amount of export earnings subject to tax deferral. Treas. Reg.

§ 1.992-1(a). Congress also determined it desirable to avoid

the complexities of the Internal Revenue Code’s transfer

pricing rules—which require a determination of an arm’s-

length price between related persons—and to adopt

administrative rules for determining intercompany pricing.

L.R.C. § 994. See also 1971 House Report at 73. These rules

permitted the DISC to maximize its taxable income regardless

of the sales price actually charged for the property.

LR.C. § 994(a).

The CTI method, used by Boeing in this case, is one of the

two administrative pricing rules adopted by Congress in

1971. To further its intended effects, Congress created a

statutory scheme that was clearly intended to permit DISCs to

earn profits in excess of those earned under the arm’s-length

pricing rules otherwise used between related parties. 1971

House Report at 73-74; see St. Jude Medical, 34 F.3d at 1400.

Thus, Congress established a unique regime under which

taxpayers using DISCs were to obtain benefits not ordinarily

then available.

Ill. TREAS. REG. § 1.861-8(e)(3) SHOULD NOT

CONTROL THE CALCULATION OF CTL.

There are two primary reasons Treas. Reg. § 1.861-8(e)(3)

should not govern the calculation of CTI. First, Congress

intended only that the general principles of section 86]

should apply in the DISC context. Second, the special

allocation rule of Treas. Reg. § 1.861-8(e)(3) does not further

those principles in this context.

16

A. Consistency with the Principles of Section 861

Does Not Lead to the Mechanical Application

of the Special Allocation Rule in Treas. Reg.

§ 1.861-8(e)(3).

Computing CTI requires allocating costs to gross receipts

and, in the first instance, requires allocating costs to the gross

receipts to which they definitely relate. If costs are not

definitely related to any receipts, they are apportioned on a

ratable basis. Under Treas. Reg. § 1.994-1(c)(6)(iii), these

allocations and apportionments are to be “determined in a

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

regulation implements the legislative history providing that

CTI should be determined “generally in accordance with the

principles applicable under section 861.” The legislative

history describes these principles, as follows: “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.” 1971

House Report at 74; Senate Report at 107 (emphasis added).

What is abundantly clear is that neither the regulation

implementing the DISC provisions and governing the

allocation of costs for CTI purposes nor the legislative history

of the DISC provisions contemplates a mechanical

application of rules later adopted under section 861 to the

computation of CTI. These rules express respect for the

principles of section 861, but they stop short of incorporating

section 861 in its entirety into the DISC pricing rules. Treas.

- Reg. § 1.994-1(c)(6)(iii) contemplates “consistency.” The

legislative history contemplates applying generally the

“principles” of section 861. In each case, the goal of the

statute is to determine CTI based on definite relationships.

In defiance of this objective, the government insists that the

mechanical rules of Treas. Reg. § 1.861-8(e)(3) be applied to

allocate R&D expenses in determining CTI. This attempt at

rigid application of rules crafted under section 861 for

17

another purpose is unsupportable and would cause distortion

in the calculation of CTI. To understand this, a brief review

of the background of the mechanical rules at issue may

be helpful.

Section 861 of the Code contains the general sourcing rules

for determining when income should be treated as earned

within the United States. Coupled with sections 862 (source

rules for income without the United States) and 863 (special

rules for determining the source of income), these provisions

“undertake to classify the sources of income within the

United States by the nature and location of the activities of

the taxpayer or his property which produces income.”

Commissioner v. Ferro-Enamel Corp., 134 F.2d 564, 566

(6th Cir. 1943). Both sections 861(b) and 862(b) allow

deductions for expenses, losses, and other deductions

properly allocated and apportioned to the gross income items

listed in sections 861(a) and 862(a), respectively, and allow

deductions for a ratable part of expenses, losses, and other

deductions not definitely allocable to some item of gross

income.’

The sourcing rules have been a part of the tax law almost

since the beginning of the modern income tax. The current

statutory provisions trace their origins to the Revenue Act

’ In general, a taxpayer first determines aggregate gross income in

accordance with section 61 and the relevant principles of the Code and

then identifies its deductions. With respect to each deduction, the

taxpayer must then identify (“allocate”) the deduction with the category of

gross income to which it relates. After deductions are allocated to a class,

they are “apportioned” within that class between the statutory and the

residual grouping of gross income. See generally, CYM H. LOWELL, G.

MICHAEL TILTON, ANDREW W. SHELDRICK & MICHAEL J. DONOHUE, U.S.

INTERNATIONAL TAXATION: AGREEMENTS, CHECKLISTS & COMMENTARY

4 7.03{2] (2002). If a deduction is related to all classes of gross income, it

is generally allocated ratably. Treas. Reg. § 1.861-8(b)(5).

18

of 1921, Pub. L. No. 98, §217, 42 Stat. 227 (1921).*

The sourcing rules are important for a variety of reasons, but

primarily relate to the computation of the foreign tax credit.

A major policy premise underlying these rules is that the

United States has the right to tax fully U.S.-source income but

acknowledges the primary right of foreign countries to tax

foreign-source income. Staff of the Joint Committee on

Taxation, General Explanation of the Tax Reform Act of

1986, 100th Cong., Ist Sess. 916 (1987).

Treas. Reg. § 1.861-8 provides some general and some

specific, mechanical guidance for allocating and apportioning

deductions. From a general perspective, in matching an

expense, loss, or other deduction with an income class, there

must be a factual relationship between that item and the class

of gross income. Treas. Reg. §§ 1.861-8(a)(2), -8(b)(2). In

this regard, the rules state that classes of gross income are not

predetermined. Treas. Reg. § 1.861-8(b)(1). This is entirely

consistent with the DISC rule for determining CTI. If a

deduction cannot be identified with any specific class of gross

income, it will generally be allocable to all of the taxpayer’s

gross income. Treas. Reg. § |.861-8(b)(5). Boeing’s alloca-

tions were consistent with these general rules.

The DISC legislative history and regulations incorporate

consistency with the general section 861 principles into the

CTI calculation. That such consistency is contemplated,

however, does not mean that the statute requires the

mechanical application of Treas. Reg. § 1.861-8(e)(3).

In other words, “consistent” means “compatible”; it does net

mean “identical.” See Webster's Ninth New Collegiate

Dictionary 280 (1988). Indeed, it would be serendipitous if

the rules crafted for determining income source could be

* The first statute requiring the allocation of deductions to income from

specified sources was the Revenue Act of 1918, §§ 214(b), 234(b), Pub.

L. No. 254, 40 Stat. 1057 (1918).

19

applied, without modification, to implemen the DISC regime

with equally important but different policy objectives.”

This Court has cautioned about the ill effects of

mechanically applying the terms of rules structured for one

purpose to the interpretation of another statute with a vastly

different objective. In this regard, Bowen v. Michigan

Academy of Family Physicians, 476 U.S. 667 (1986), is

instructive. There, the Court considered a challenge by

physicians to the validity of a regulation under Part B of

Medicare, which authorized the payment of benefits in

different amounts for similar services. The Medicare statute

cross-referenced provisions of the Social Security Act that

prohibited certain actions against the government.”

The Secretary of Health and Human Services contended that

the cross-reference demonstrated that Congress had forbidden

judicial review of all questions affecting the payment of

benefits under Part B of Medicare. The Court held, however,

that the legislative history of the Medicare program provided

specific evidence of Congress’s intent to foreclose review

only of “amount determinations,” not of substantial statutory

and constitutional challenges to the Secretary’s administration

of Part B. Thus, the incorporation by reference to the Social

Security Act restrictions did not apply on its own terms to

Part B, but rather was incorporated mutatis mutandis, i.e., all

* As this Court has noted, “The policy as well as the letter of the law is

a guide to decision.” Cox v. Roth, 348 U.S. 207, 209 (1955) (citation

omitted). In Cox, the Court refused to permit a literal application of the

Federal Employers’ Liability Act (FELA) to result in the denial of

recovery under the Jones Act against a personal representative of the

owners of a vessel lost at sea. The Court found that the exact words of

FELA should not be “lifted bodily from their context and applied

mechanically to the specific facts of maritime events.” /d.

Section 405(h) of title 42 provided that “no action... to recover any

claim” arising under the Medicare laws shall be “brought under section

1331... of title 28.”

20

necessary changes having been made, into the Medicare

statute. Jd. at 679.'' A similar logic should apply to

this case.

In this case, the reference to the principles of section 861 in

the DISC regulation and legislative history is not license to

apply all the mechanical rules of the section 861 regulations

for purposes of allocating costs, without regard to factual

relationships, to sales in determining CTI. The objective of

the statute—to allocate costs in accordance with some factual

relationship—may not be arbitrarily foreclosed, as the

government would do in this case.

B. Treas. Reg. § 1.861-8(e)(3) Is a Radical

Departure from the General Rules and

Principles of Section 861.

Under the general section 861 rules, a factual relationship

between income and expense is a key element of allocation

and apportionment. See Treas. Reg. §§ 1.861-8(a)-(d). These

are the “principles applicable under section 861” to which

Congress referred in 1971 and which the DISC statute

contemplates will be applied in determining CTI—a factual

connection between income and expense is clearly required.

See I.R.C. § 994(a)(2) (requiring determination of net in-

come “attributable to” the export sale).'* When Treas. Reg.

"* In Shalala v. Illinois Council on Long Term Care, Inc., 529 U.S. 1,

17-18 (2000), the Court clarified that the reasoning of Michigan Academy

applied only when the statute precluded any review of a particular

category of cases.

? The legislative history of the provision confirms that “({t}hese 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.” 1971 House Report at 74 (emphasis

added). CTI is determined by “deducting from the DISC’s gross receipts

the related person's cost of goods sold with respect to the property, the

selling, overhead and administrative expenses of both the DISC and the

related person which are directly related to the production or sale of the

21

§ 1.994-1(c)(6)(iii) was adopted in 1975, the mechanical rules

on which the government relies in this case did not exist.

Indeed, they were not adopted until a couple years later

in 1977."°

In contrast, the special rules for allocating R&D expenses

set forth in Treas. Reg. § 1.861-8(e)(3) are mechanical rules

th * apply in lieu of the general section 861 principles in

alle ating R&D expenses.'* The government recognizes this

in th. **e'ation’s first paragraph by confirming that the

regulati. .1 is a substitute for the factual inquiry. Treas. Reg.

§ 1.861-8(e)(3)(i)(A) begins—

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 unsuccessful research

and development. '°

Rather than identifying a class of income to which the R&D

expenditures actually relate, the regulation generally assigns

export property.” Id. (emphasis added). Thus, expenses related to

property that is not exported are not allocated to export sales of other

property.

'* This regulation was later repromulgated in 1995 as Treas. Reg.

§ 1.861-17.

' The proposed section 861 regulations in place at the time the DISC

regulations were issued retained the factual relationship principle in

respect of R&D expenses and did not require the use of SIC codes. 38

Fed.Reg. 15840, 15843 (June 18, 1973).

'S The regulations also specifically presuppose that the mechanical

rules are not intended to effect an allocation of deductions to all gross

income but rather address allocations to specific classes of gross income.

See Treas. Reg. § 1.861-8(b)(1).

22

the expenditures to income related to a broad product

category, which is limited to a list determined by two-digit

SIC codes."

'° It is difficult to see how a system that classifies economic data by

industrial categories can also serve the purposes of matching gross income

from the sale of specific products with the specific costs that are directly

related to them. The SIC Code system was replaced by the North

American Industry Classification System (NAICS) in 1997 because it was

considered outmoded:

The SIC was established to promote uniformity and comparability

of data collected and published by agencies within the U.S.

government, state agencies, trade associations, and research

organizations. It was developed as an establishment-based industry

classification system that classified each establishment (defined as a

single physical location at which economic activity occurs)

according to its primary activity. The SIC covered the entire field of

economic activities by defining industries in accordance with the

composition and structure of the economy.

U.S. Census Bureau, Development of NAICS, reprinted at http://www.

census.gov/epcd/www/naicsdev.htm. The system was designed to

“classify ‘industry’ in the broad sense of all economic activity; i.e.,

agriculture, forestry, and fisheries; mining; construction; manufacturing;

wholesale and retail trade; finance, insurance, and real estate;

transportation, communication, electric, gas, and sanitary services; and

services.” Esther Pearce, History of the Standard Industrial Classification

(Executive Office of the President, Bureau of the Budget, Office of

Statistical Standards, July 10, 1957), reprinted at http://www.census.

gov/epced/www/sichist.htm.

Requiring the use of even three-digit SIC codes (as currently required

by Treas. Reg. § 1.861-17) can produce absurd results. For example,

R&D expenses directly related to main frame computers would be

allocated to pencil sharpener receipts because both pencil sharpeners and

computers are in the same three-digit SIC Code (357—Computer and

Office Equipment). Examples of other product grouping: include canned

tuna fish and freeze-dried coffee (SIC Code 209), perfumes and floor wax

(SIC Code 284), and batteries and extension cords (SIC Code 369).

23

The special allocation of R&D expenses may be

appropriate in the context of the computation of the foreign

tax credit, but it undermines congressional intent in respect of

the computation of CTI. As the Eighth Circuit determined in

St. Jude Medical, Treas. Reg. § 1.861-8(e)(3)’s requirement

to use SIC categories in allocating R&D expenses “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.” 34 F.3d at 1401 (citations omitted). “Doing

so,” the court stated, “may improperly decrease the profits

allocated to a DISC, thus thwarting Congress’s intent when it

promulgated the DISC intercompany pricing rules.” /d. at

1402-03. In effect, the government’s proposed application of

the mechanical rules of section 861 to the allocation of R&D

expenses for DISC purposes would preclude any allocation to

transactions or products based on actual factual relationships.

Although the government approach is consistent with the

mechanical rules of Treas. Reg. § 1.861-8(e)(3), it is

inconsistent with (i) section 994(a)(2)’s requirement for

determining net income “attributable to” the export sale; (ii)

the general rules of the section 861 regulations as they exist

today, (iii) all aspects of those regulations as they existed at

the time that Treas. Reg. § 1.994-l(c)(6)(ili) was

promulgated, (iv) the mandate of Treas. Reg. § !.994-

I(c)(6)(iii) that requires allocations of deductions based on

definite factual relationships, and (v) the flexibility afforded

taxpayers to permit DISC benefits to be calculated by

reference to CTI determined on a product-by-product basis

after allocating costs based on factual relationships. Indeed,

the consistency contemplated by the statute and Treas. Reg.

§ 1.994-1(c)(6)(iii) comes only by applying the general rules

of the regulations under section 861 to establish definite

factual relationships, not by departing from _ those

relationships by applying the mechanical rules for allocating

R&D expenses. This is particularly true where taxpayers,

because of the structure of their sales and manufacturing

24

production and the detailed records kept, can clearly establish

the necessary factual relationships. In contrast to Treas. Reg.

§ 1.861-8(e)(3), the section 994 regulations are consistent

with congressional intent because they permit taxpayers to

allocate R&D costs to products and product groupings based

on factual relationships.

It is enlightening that neither the Ninth Circuit nor the

government seeks to justify the application of the mechanical

R&D rule to allocations under section 994 on the ground that

it achieved allocations based on factual relationships. Indeed,

the Ninth Circuit seeks to justify the application of a rule that

ignores factual relationships on the grounds that the

deductions at issue might be considered unrelated to specific

income items. See App. at 12a. But this analysis does not

support the application of the rule at issue since that rule is

not one that purports to allocate deductions ratably.'”

It is consistent with “the principles applicable under the

section 861” for the allocation of R&D expenses to yield to

the DISC and FSC rules. Cf. Rite Aid Corp. v. United States,

'’ That Boeing’s R&D expenditures may have exceeded its income in a

given product category in any year is irrelevant. The section 861

regulations clearly contemplate situations in which the costs directly

related to a particular product line will exceed the gross income generated

by that product line in a particular year. Treas. Reg. § 1.861-8(d)(1)

specifically states that “[eJach 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 [dealing with 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). The specific regulation relied upon by the government

for the allocation of R&D expenses also provides that “[a]mounts

apportioned under this paragraph (e)(3) may exceed the amount of

gross income related to the product category within the statutory

grouping.” Treas. Reg. § 1.861-8(e)(3)(iiB). This is consistent with the

current deductibility of R&D expenses and the result of the annual

accounting for taxes.

25

255 F.3d 1357, 1359-60 (Fed. Cir. 2001) (holding that a

consolidated return regulation cannot be used to subvert the

intent of another statute); see also United Dominion

Industries, Inc. v. United States, 532 U.S. 822, 839 (2001)

(Thomas, J. concurring) (when construing a complex

statutory and regulatory scheme that lends itself to several

interpretations, “we should be inclined to rely on the

traditional canon that construes revenue-raising laws against

their drafter.”). By mandating the use of a special allocation

rule for R&D expenses in respect of DISCs and FSCs, the

government woes violence to those statutory schemes. The

Eighth Circuit in St. Jude Medical is correct: Treas. Reg.

§ 1.861-8(e)(3) is invalid as applied to the computation

of CTI.

CONCLUSION

For the foregoing reasons, the Court should reverse the

decision of the U.S. Court of Appeals for the Ninth Circuit.

Respectfully submitted,

FRED F. MURRAY *

MARY L. FAHEY

TAX EXECUTIVES INSTITUTE, INC.

1200 G Street, N.W.

Suite 300

Washington, D.C. 20005-3814

(202) 638-5601

Counsel for Amicus Curiae

* Counsel of Record Tax Executives Institute, Inc.

August 9, 2002