Opposition Brief — Boeing Co. v. United States

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Nos. 01-1209 and 01-1382

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In the Supreme Court of the Anited States

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THE BOEING COMPANY AND

CONSOLIDATED SUBSIDIARIES, PETITIONERS

Vv.

UNITED STATES OF AMERICA

UNITED STATES OF AMERICA, CROSS-PETITIONER

Vv.

BOEING SALES CORPORATION, ET AL.

ON PETITIONS FOR WRITS OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

BRIEF FOR THE UNITED STATES

THEODORE B. OLSON

Solicitor General

Counsel of Record

EILEEN J. O’CONNOR

Assistant Attorney General

LAWRENCE G. WALLACE

Deputy Solicitor General

KENT L. JONES

Assistant to the Solicitor

General

DAVID ENGLISH CARMACK

FRANK P. CIHLAR

Attorneys

Department of Justice

Washington, D.C. 20530-0001

(202) 514-2217

QUESTIONS PRESENTED

No. 01-1209

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 in-

ternational sales corporations” (26 U.S.C. 991-997 (1976

& Supp. III 1979)), petitioners must take into account

expenses incurred for aircraft research and develop-

ment 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.

No. 01-1382

3. Whether, if the judgment in No. 01-1209 is re-

versed, the judgment in favor of cross-respondent in

No. 01-1382 should then also be reversed.

(I)

TABLE OF CONTENTS

Opinions below

Jurisdiction

Statutes and regulations involved

Statement

Summary of argument

Argument:

I. In computing the “combined taxable income” from

export sales for the purpose of the DISC and FSC

provisions of the Internal Revenue Code, peti-

tioners must take research and development

expenses into account in the manner required by

28 C.F.R. 1.861-8(e)(3)

A. Congress directed the Secretary of the Treasury

to issue regulations to determine the manner in

which expenses are to be taken into account in

computing the “combined taxable income”

from export sales under the DISC and FSC

provisions of the Internal Revenue Code ...............

B. The challenged regulations establish a permis-

sible implementation of the governing statutes

and should therefore be sustained

1. The basic framework for cost allocation

under 26 C.F .R. 1.861-8 directly implements

the general provisions of the statute .................

2. Within this basic framework, the Secretary

quired to er»ure that research expenses are

tioned in calculati

“combined taxable income”

(IIT)

Table of Contents—continued: Page

a. Research costs that are deducted cur-

rently under Section 174 of the Internal

Revenue Code are not “definitely related”

to specific items of income

b. Research costs inherently benefit a broad

class of products for any manufactur’: ......

3. The Secretary’s choice among alternative

methods of apportioning research expenses

in the calculation of “combined taxable income

income” is reasonable and not arbitrary or .

- 29

C. In enacting the FSC provisions in 1984, Con-

gress ratified application of the challenged

research cost allocation regulations to DISCs

and expressly authorized application of those

regulations to FSCs 32

II. The challenged research cost-allocation rules do not

conflict with any provision of the DISC and FSC

statutes or regulations 34

A. The research cost allocation regulations properly

implement, and do not conflict with, the govern-

ing statutes

1. The challanged regulations properly imple-

ment the governing statutes

2. The “principles applicable under Section 861”

do not require a “factual relationship” be-

tween income and expense in allocating and

apportioning current expense to current

income 37

Table of Contents—Continued: Page

B. The research cost allocation rules in 26 C.F.R.

1.861-8(e(3) do not conflict with the “group-

ing” rules in the DISC and FSC regulations ......... 41

Conclusion 46

Appendix la

TABLE OF AUTHORITIES

Cases:

Albemarle Paper Co. v. Moody, 422 U.S. 405

(1975) 33

American Automobile Ass'n v. United States, 367

U.S. 687 (1961) 28-29

Archer-Daniels-Midland Co. v. United States, 37

F.3d 321 (7th Cir. 1994), cert. denied, 514 U.S. 1077

(1995) 30

Batterton v. Francis, 432 U.S. 416 (1977) 21

Bowles v. Seminole Rock & Sand Co., 325 U.S. 410

(1945) 45

Chevron U.S.A. Inc. v. Natural Resources Defense

Council, Inc., 467 U.S. 837 (1984) 20-21

Commissioner v. Estate of Noel, 380 U.S. 678

(1965) 34

Commissioner v. Idaho Power Co., 418 U.S. 1

(1974) 24

Commissioner v. Stidger, 386 U.S. 287 (1967) ................. 30

Heard v. Commissioner, 326 F 2d 962 (8th Cir.),

cert. denied, 377 U.S. 978 (1964)

Helvering v. Northwest Steel Mills, 311 U.S. 46

(1940)

INDOPCO, Inc. v. Commissioner, 503 U.S. 79

(1992) 24, 25, 35, 41

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

1995) 30, 33

Interstate Transit Lines v. Commissioner, 319 U.S.

590 (1943) 35-36

Cases—Continued: Page

LeCroy Research Sys. Corp. v. Commissioner,

751 F.2d 123 (2d Cir. 1984) 38

Lorillard v. Pons, 434 U.S. 575 (1978) 16, 33

National Muffler Dealers Ass'n v. United States,

440 US. 472 (1979) 30

Schweiker v. Gray Panthers, 453 U.S. 34 (1981) ............. 21

St. Jude Med., Inc. v. Commissioner:

34 F.3d 1394 (8th Cir. 1994) 12, 33, 44, 45

97 T.C. 457 (1991) 12, 36, 37, 40, 43-44, 45

Thor Power Tool Co. v. Commissioner, 439 U.S.

522 (1979) 28

Udall v. Taliman, 380 U.S. 1 (1965) 45

United States v. Borden Co., 308 U.S. 188 (1939) ......... 14,45

United States v. Correll, 389 U.S. 299 (1967) ............... 21,30

United States v. Hughes Props., Inc., 476 US.

593 (1986) 28

United States v. Mead Corp., 533 U.S. 218

(2001) 15, 20

United States v. Moore, 95 U.S. 760 (1878) 30

United States v. Morton, 467 U.S. 822 (1984) 21

White v. United States, 305 U.S. 281 (1938) 35

Statutes and regulations:

Consolidated Omnibus Budget Reconciliation Act of

1985, Pub. L. No. 99-272, § 13211, 100 Stat. 324 ............. 33

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

98 Stat. 494:

§ 126, 98 Stat. 648 33

§ 805(b), 98 Stat. 1000-1001 — 3

§ 805(b)(2)(A), 98 Stat. 1001 3

Economic Recovery Tax Act of 1981, Pub. L. No.

97-34, 95 Stat. 172:

§ 223, 95 Stat. 249 33

Vil

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

Section 63(a) 23, 27

Section 114 4

Section 174 11, 15, 40, 41, la

Section 174 (1988) passim

Section 174(a)(1) 24, la

Section 861 (1976 & Supp. III 1979) 2, 6, 7, 19,

20, 22, 40, 44

Section 861(a) 6

Section 861(b) 6, 18, 20, 23, 40

Section 863(a) passim

Section 921 3

Sections 921-927 (1988) 3

Section 923 3

Section 925 (1988) 2, la

Section 925(a) (1988) 4, 5, 41, 42, 2a

Section 925(a)(2) (1988) 5, 2a

Section 925(b)(2) (1988) 20, 3a

Sections 991-997 (1976 & Supp. III 1979) 2

Section 994 (1976 & Supp. III 1979) 2

Section 994(a) 4, 5, 41, 42, 44

Section 994(a)(2) ... 5, 13

Section 994(b) 19

Section 994(b)(1) 20

Section 994(b)(2) 3, 20

Section 995(b)(1)(E) (1988) on 3

Section 995(f) (1988) 3

Section 7805 29

Revenue Act of 1916, ch. 463, 39 Stat. 756:

§ l(a), 39 Stat. 756 19

§ 10, 39 Stat. 765-766 ste 19

Tax Reform Act of 1986, Pub. L. No. 99-514, § 1216,

100 Stat. 2085 33

Vill

26 C.F.R.:

Section 1.861-8 2, 43, 44

Section 1.861-8(a)(2) 37, 38

Section 1.861-8(b)(1) 7, 23

Section 1.861-8(b)(2) 14, 25, 26

Section 1.861-8(b)(5) 7, 23

Séction 1.861-8(c)(1) 7, 18, 23, 37

Section 1.861-8(c)(2) 7, 18, 22, 25, 37

Section 1.861-8(c)(6)(iii) 40

Section 1.861-8(d)(1) 25

Section 1.861-8(e)(1)-(11) 28

Section 1.861-8(e)(3) 11-12, 13, 14, 22, 28, 32, 33

Section 1.861-8(e)(3)(i MA) 8, 15, 18,

25, 27, 29, 38, 43

Section 1.861-8(f)(1)iii) 22, 43, 44, 45

Section 1.861-8(g) 44

Section 1.861-17 2, 10a

Section 1.861-17(a)(2)(ii) 8, 27

Section 1.925(a)-1T 2, 4a

Section 1.925(a)-1T(c\6)iii(D) 22, 43, 5a-Ga

Section 1.925(a)-1T(¢\8) 5, 42, 7a

Section 1.994-1 2

Section 1.994-1(a)(1) 43

Section 1.994-1(c)6) 6, 22, 31

Section 1.994-1(c)(6)iii) 7, 13, 32, 37, 43, 44

Section 1.994-1(¢)(6)iv) (1979) 12, 42

Section 1.994-1(¢c)(7) 17, 42, 43

Section 1.994-1(c)(7)i) 5, 42

Miscellaneous: Page

B. Bittker & J. Eustice, Federal Income Taxation of

Corporations and Shareholders:

(4th ed. 1979) 4

(5th ed. 1987) 4,6

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

Estates and Gifts (Supp. 1999) 22-23

Miscellaneous—Continued: Page

R. Doernberg, International Taxation (4th ed.

1999) fs 3,4

41 Fed. Reg. 49,160 (1976) 39

H.R. Conf. Rep. No. 861, 98th Cong., 2d Sess.

(1984) 16, 33, 46

H.R. Rep. No. 533, 92d Cong., Ist Sess. (1971) anna 6, 13, 19

J. Oyola, A Fresh Look at Foreign Sales Corporation

Beneficiaries (Tax Analysts Reference: 2001 WTD

122-15) 30

J. Oyola, Foreign Sales Corporation Beneficiaries:

A Profile, 88 Tax Notes 933 (2000) 30

S. Rep. No. 437, 92d Cong., 1st Sess. (1971) 2, 30

N. Singer, Sutherland Statutory Construction

(6th ed. 2002) 34

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

Sess., Deficit Reduction Act of 1986 (Comm, Print

1984) 32

T.D. 7364, 1975-2 C.B. 315 40

T.D. 8646, 1996-1 C.B. 144 8, 27, 10a

1972 T.M. Lexis 14 (June 29, 1972) 39

World Trade Organization, Appellate Body, United

States—Taz Treatment for “Foreign Sales Corp-

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

European Communities, AB-2001 3 (Jan. 14, 2002)....... 4

Jn the Supreme Court of the Gnited States

No. 01-1209

THE BOEING COMPANY AND

CONSOLIDATED SUBSIDIARIES, PETITIONERS

vz.

UNITED STATES OF AMERICA

No. 01-1382

UNITED STATES OF AMERICA, CROSS-PETITIONER

Vv.

BOEING SALES CORPORATION, ET AL.

ON PETITIONS FOR WRITS OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

BRIEF FOR THE UNITED STATES

OPINIONS BELOW

The opinion of the court of appeals (Pet. App. la-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. The petition for a writ of certiorari

was filed on February 15, 2002, and a conditional cross-

petition was filed on March 20, 2002. Both were

(1)

granted on May 28, 2002. The jurisdiction of this Court

rests upon 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

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

to those provisions, the relevant portions of Sections

174 and 925 of the Internal Revenue Code, 26 U.S.C.

174, 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-12a.

STATEMENT

1. Congress has authorized the Secretary of the

Treasury to prescribe regulations “to properly ap-

portion{]}” expenses in calculating income resulting from

foreign sales of goods. 26 U.S.C. 863(a). This case

concerns a challenge to the regulations adopted by the

Secretary to properly allocate research and develop-

ment costs under that statute. The question presented

in this case arose under two separate sets of statutory

and regulatory provisions, 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 1979). The DISC provisions sought to

- “provide 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 share-

holder 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.

taxation until actually distributed.” R. Doernberg,

International Taxation 395-396 (4th ed. 1999).?

b. Soon after their enactment, the DISC provisions

were challenged by other Nations as impermissible

export subsidies under the General Agreement on

Tariffs and Trade. See R. Doernberg, supra, at 396. As

a consequence, Congress replaced the DISC provisions

in 1984 with the “foreign sales corporation” (FSC)

provisions of the Code. 26 U.S.C. 921-927 (1988). See

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

§ 805(b), 98 Stat. 1000-1001.

Under the FSC provisions, a U.S. parent would

establish a foreign subsidiary 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. That portion can be distributed as a

dividend tax-free to the U.S. parent corporation

* * * .” R. Doernberg, supra, at 397. To escape

taxation entirely on the portion of the income allocated

to the FSC, “many U.S. corporations organize FSCs in

! This, at least, was the theory when the DISC provisions were

enacted. When the DISC provisions were replaced in 1984, how-

ever, previously accumulated and undistributed DISC income was

effectively exempted from tax in many cases. See Deficit Reduc-

tion Act of 1984, Pub. L. No. 98-369, § 805(b)(2)(A), 98 Stat. 1001.

2 The DISC provisions were left in effect only “for small cor-

porations” (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).

3 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.

foreign countries imposing relatively low, or no,

corporate and dividend withholding taxes on that in-

come.” Ibid.‘

2. a. The DISC and FSC 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 | 17.14, at 17-43 (4th ed. 1979); id.

q 17.14, at 17-55 (5th ed. 1987). The central feature of

each regime is the allocation of the income resulting

from export transactions between the parent and its

sales subsidiary. In general, under these provisions,

the parent has an incentive to maximize the portion of

the profits from export sales allocated to its sales sub-

sidiary, rather than to the parent, in order to defer

(under the DISC) or exempt (under the FSC) that

income from tax.

b. Under the DISC regime, the portion of the export

income attributed to the DISC is based on an assumed

“transfer price” for the exported good that would allow

the DISC to derive net income that does not exceed the

4 After the World Trade Organization concluded that the FSC

provisions provided a prohibited export subsidy (World Trade

Organization, Appellate Body, United States—Tax Treatment for

“Foreign Sales Corporations,” Recourse to Article 21.5 of the DSU

by the European Communities, AB-2001-8, at 91-93 (Jan. 14,

2002)), Congress repealed and replaced the FSC provisions with

the “extraterritorial income exclusion” of Section 114 of the

Internal Revenue Code. 26 U.S.C. 114.

5 The “transfer price” is the hypothetical price at which the

good is assumed to have been transferred from the U.S. parent to

its DISC or FSC. Once calculated under the DISC and FSC pro-

visions, this price is used in allocating the net income from the

transaction between the parent and its sales subsidiary. 26 U.S.C.

994(a); 26 U.S.C. 925(a).

greatest of (i) 4% of the export receipts, (ii) 50% of the

“combined taxable income” of the parent and the sales

subsidiary, or (iii) the income that would result from an

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

regime has a similar profit allocation procedure. 26

U.S.C. 925(a) (1988). The DISC and FSC regulations

permit the taxpayer to apply one transfer price method

for one group of sales while applying a different

transfer price method for another group of sales made

during the same year. 26 C.F.R. 1.994-1(c)(7)(i)

(DISCs); 26 C.F.R. 1.925(a)-1T(ce)(8) (FSCs).

c. Petitioner elected to use the “transfer price”

method that is based on the “combined taxable income”

of the parent and the sale subsidiary for all of its groups

of DISC and FSC export sales.° The specific questions

addressed in this case concern the proper method for

calculating “combined taxable income” under the

governing regulations.

Congress did not define the term “combined taxable

income” in either the DISC (26 U.S.C. 994(a)(2)) or the

FSC (26 U.S.C. 925(a)(2) statutes. In enacting these

provisions, however, Congress made clear that it

intended that the term “combined taxable income from

the sale of the export property is to be determined

generally in accordance with the principles applicable

§ As used 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 income attributable to the sale of the property in

an amount that does not exceed “50 percent of the combined tax-

able income of such DISC and [the parent] which is attributable to

the qualified export receipts on such property derived as the result

of a sale by the DISC.” 26 U.S.C. 994(a)(2). The cognate rule for a

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

“combined taxable income.” 26 U.S.C. 925(a)(2).

under section 861 for determining the s~urce (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).

Section 861, to which the DISC committee reports

refer, distinguishes between United States and foreign

source income for various income tax purposes.’

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 source

income. 26 U.S.C. 861(a). Section 861(b) provides, in

turn, that expenses “properly apportioned or allocated”

to the items of United States source 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, are to be deducted to arrive at United

States source taxable income. 26 U.S.C. 861(b). Con-

gress specified that the determination whether an

expense is “properly apportioned or allocated” to an

item of gross income for this purpose is to be made

“under regulations prescribed by the Secretary [of the

Treasury].” 26 U.S.C. 863(a), (b).

d. The regulations adopted by the Secretary to

implement the DISC provisions track the legislative

reports. 26 C.F.R. 1.994-1(c)(6) provides that the “com-

bined taxable income” from a sale of export property “is

the excess of the gross receipts * * * of the DISC

from such sale over the total costs of the DISC and

7 Whether income has a domestic or foreign source has

importance for several purposes. The primary role of this

determination is in the calculation of permissible foreign tax

credits and the avoidance of double taxation of foreign source

income. See generally B. Bittker & J. Eustice, Federal Income

Taxation of Corporations and Shareholders {4 17.10, 17.11, 17.30 -

(5th ed. 1987).

related supplier which relate to such gross receipts.”

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

are treated as relating to those gross receipts as:

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

finitely 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.

26 C.F.R. 1.994-1(c)(6)(iii) (emphasis added). As Con-

gress contemplated, the DISC regulations thus specifi-

cally incorporate the cost allocation regulations adopted

by the Secretary under Section 861.

In 1977, following public notice and comment, the

Secretary adopted final regulations under Section 861

that specifically address cost allocation for DISCs and

other purposes. In general, under these regulations,

expenses and other deductions are allocated and

apportioned to the item or class of gross income to

which they are “definitely related.” 26 C.F.R. 1.861-

8(b)(1). Deductions that are related to all of a

taxpayer’s gross income, or that are not “definitely re-

lated” to any specific class of gross income, are ratably

apportioned to all gross income. 26 C.F.R. 1.861-8(b)(5),

(c)(1), (c)(2).

In adopting this general cost allocation rule, the

Secretary determined that special provision was re-

quired for the proper treatment of research expendi-

tures. The regulations note “that research and develop-

ment is an inherently speculative activity, that findings

may contribute unexpected benefits, and that the gross

income derived from successful research and develop-

ment must hear the cost of unsuccessful research and

development.” 26 C.F.R. 1.861-8(e)(3)(i(A) (1979). In

light of these facts, the Secretary determined that

research and development expenses are properly to be

“considered deductions which are definitely related to

all income reasonably connected with the relevant

broad product category (or categories) of the taxpayer

and therefore allocable to all items of gross income as

a class (including income from sales, royalties, and

dividends) related to such product category (or

categories).” Ibid. The regulations adopted in 1977

used the two-digit categories in the Standard Industrial

Classification Manual published by the Office of

Management and Budget (SIC codes) as the relevant

product categories. Ibid. When the regulations were

revised in 1995, however, the narrower three-digit

standard industrial classification codes were adopted as

the wppropriate 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 elected to group its export sales

according to petitioner’s internally designated “Air-

plane Programs” and to use the “combined taxable

income” method for determining the transfer price

applicable to each grouping. Petitioner therefore

computed the “combined taxable income” separately for

each program. Pet. App. 2a-3a. In doing so, however,

petitioner failed to follow the requirement of the

governing regulations that research and development

expenses be allocated on the basis of the (then) two-

digit industrial classification codes specified in 26

C.F.R. 1.861-8(e)(3)(i(A). Instead, petitioner allocated

the majority of its research and development expenses

along narrower, airplane-by-airplane product lines.

Pet. App. 3a. The result of the narrower allocation

method followed by petitioner was to reduce the re-

search and development expenses allocated to its

export sales, thereby increasing the “combined taxable

income” from those sales and decreasing the resulting

United States taxes owed by petitioner during the

relevant years. Id. at 3a-4a.

b. Petitioner’s principal business division is its Com-

mercial Airplane Division, which is divided for manage-

ment and accounting purposes into programs dealing

with specific airplane models or with spares, sundry or

other activities. Pet. App. 2a. For internal accounting

purposes, petitioner divided its research expenditures

into two categories: “Blue Sky R&D” and “Company

Sponsored Product Development.” Of the approxi-

mately $4.6 billion in research costs incurred by peti-

tioner during the relevant years, approximately $1.0

billion was classified as “Blue Sky” and $3.6 billion was

classified as “Company Sponsored” research. Id. at

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

Blue Sky research involved both basic airplane

technology and the development of new airplane models

prio: to the Board’s approval of those models as

“programs” for production. A large portion of peti-

tioner’s Blue Sky research expenses were incurred in

“projects” that were the precursors to specific formally

identified “programs.” For example, during the years

involved in this case, petitioner incurred substantial

Blue Sky research costs related to what petitioner

referred to as the “7X7” project, which eventually

became the 767 Program when petitioner’s Board of

Directors later authorized the production phase of the

program. Pet. App. 3a, 17a; C.A. E.R. 62-63, 102.*

8 The commitment of the Board of Directors to authorize

production of a particular airplane model was contingent on

petitioner’s having received significant firm customer orders for

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

“Company Sponsored” research costs were, by

contrast, the research costs that petitioner’s accounting

system identified with particular airplane programs

- after those programs were approved for production by

the Board. The difference between “Blue Sky” and —

“Company Sponsored” research is thus solely a function

of the way petitioner chose to divide its commercial

airplane business for internal cost accounting and

management purposes. Pet. App. 16a-18a; C.A. E.R. 4.”

c. During the years at issue, petitioner had com-

mercial sales of airplanes and services of approximately

$64 billion, of which $43 billion (67%) were export sales.

C.A. E.R. 2-3, 6, 152. In computing “combined taxable

income” for these export sales, petitioner followed the

requirements of the governing regulations in part, by

allocating its “Blue Sky” research costs among all of its

airplane programs (although petitioner incorrectly did

so on the basis of the number of direct labor hours

incurred in each program rather than on the basis of

sales). Pet. App. 3a; C.A. E.R. 157. With respect to

“Company Sponsored” research, however, petitioner

declined to follow the regulations and instead sought to

allocate those research costs to the particular programs

for which they were ostensibly incurred. Applying that

method, petitioner routinely made substantial

allocations of “Company Sponsored” research costs to

specific airplane programs in years before any sales

were made by those programs. Of the $3.6 billion

classified as “Company Sponsored” research during the

years relevant to this case, petitioner allocated

® During the tax years at issue in this case, petitioner estab-

lished or maintained separate management and accounting sys-

tems for each of the following airplane models: 707, 727, 737, 737-

300, 747, 757 and 767. Pet. App. 16a.

approximately half ($1.75 billion) to programs that had

no sales in the year the research was conducted.

Although all of this $1.75 billion was deducted by

petitioner (under 26 U.S.C. 174) in calculating its “tax-

able income” for the years at issue, petitioner asserts

that none of that amount should be deducted in deter-

mining the “combined taxable income” for the export

sales made under the DISC and FSC provisions. Pet.

App. 3a; C.A. E.R. 152-153.

d. On audit, the Commissioner determined that peti-

tioner’s failure to follow the requirements of the

regulation unrealistically inflated the amount of income

deferred or exempted under the DISC and FSC

provisions. Applying the text of the governing regu-

lation (26 C.F.R. 1.861-8(e)(3) (1979)), the Commissioner

allocated all of petitioner’s research expenses (both

“Blue Sky” and “Company Sponsored”) to all of peti-

tioner’s income from sales of commercial airplanes

(since all such airplanes are within the two-digit

Standard Industrial Classification Code 37 for trans-

portation equipment) and apportioned those expenses

among petitioner’s programs on the basis of the sales

income in each program. This resulted in a higher

allocation of research expenses to petitioner’s qualified

export sales, a lower “combined taxable income” for

those sales under the DISC and FSC provisions, and

therefore a greater tax liability for petitioner for each

of the years in question. Pet. App. 3a-4a, 18a.

4. Petitioner paid the additional tax and brought this

timely suit for refund in the United States District

Court for the Western District of Washington. Pet.

App. 4a. Petitioner claimed that the regulation adopted

by the Secretary to allocate research expenditures in

the calculation of “combined taxable income” under 26

C.F.R. 1.861-8(e)(3) is invalid as applied to DISC and

FSC transactions.

The district court agreed with petitioner. The court

held that there is a “conflict” between the two-digit

Standard Industrial Classification Code product cate-

gories mandated by 26 C.F.R. 1.861-8(e)(3) and the

statement in the DISC regulation that a taxpayer’s

choice in the grouping of transactions is “controlling”

(26 C.F.R. 1.994-1(c)(6)(iv) (1979)). Pet. App. 21a.

Adopting the reasoning of the Eighth Circuit in St.

Jude Medical, Inc. v. Commissioner, 34 F.3d 1394

(1994), rev’g 97 T.C. 457 (1991), the district court held

that this conflict should be “resolved in Boeing’s favor.”

Pet. App. 21a. Having concluded that the research

cost-allocation rule of 26 C.F.R. 1.861-8(e)(3) is invalid

for DISC computations, the court awarded a refund of

tax and interest to petitioner in the amount of

$419,110,539. Pet. App. 4a.”

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

14a. The court emphasized at the outset that Congress

has given the Secretary wide latitude to adopt “legis-

lative regulations” to implement these complex statu-

tory provisions. Jd. at 5a. In view of the considerable

deference owed to the Secretary’s exercise of these

“explicit grants” of rulemaking authority, the court

10 Because the decision of the district court resulted in a corre-

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

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

Boeing Sales Corporation. See United States v. Boeing Sales

Corp., Cond. Cross Pet. 01-1382 (March 20, 2002) at 3. Petitioners

have agreed with the submission of our cross petition that, if the

judgment of the court of appeals in favor of the government is

reversed in No. 01-1209, the judgment of the court of appeals in

favor of Boeing Sales Corporation should be reversed in No. 01-

1382 as a purely computational matter. See Pet. Br. 15 n.10.

concluded that the challenged regulations reflect a

“permissible interpretation” of the statutes and should

therefore be sustained. Jd. at 5a-Ga.

In particular, the court of appeals upheld the

Secretary’s determination that 26 C.F.R. 1.861-8(e)(3)

provides an appropriate method for allocating research

expenses in calculating “combined taxable income”

under the DISC and FSC provisions. Pet. App. 10a-

lla. The court noted that, under the plain text of

Section 994(a)(2), “[combined taxable income] 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 product.” Jd. at lla.

Instead, as the legislative history of the statute makes

clear, “Congress recognized some of the costs incurred

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

specific income items * * * [and] that those costs not

‘directly related’ would be allocated to export-related

sales on a pro rata basis.” bid. (quoting H.R. Rep. No.

533, supra, at 74). The court explained that the chal-

lenged regulation “is a permissible interpretation” of

the statute and “effectuates this Congressional intent”

to ensure that the “total costs” related to export sales—

including a pro rata share of research costs—are

deducted in calculating the “combined taxable income”

from the sale of exported goods. Pet. App. 6a, 11a.

The court of appeals rejected the conclusion of the

Eighth Circuit in St. Jude that the allocation require-

ments of 26 C.F.R. 1.861-8(e)(3) are inconsistent with

the statement in the DISC regulations (26 C.F.R. 1.994-

1(c)(6)(ili)) that expenses “definitely related” to a

transaction are to be allocated to that sale. The court

emphasized that the DISC regulations cited in St. Jude

do not define what costs are “definitely related” to a

transaction “other than by reference to § 1.861-8.” Pet.

App. 9a. And, while the Section 861 regulations

themselves contain the same general requirement that

costs “definitely related” to a particular product are to

be apportioned to that product (26 C.F.R. 1.861-8(b)(2)),

these regulations further provide that, in view of the

inherently speculative and broad nature of research

activities, research costs are to be treated as “definitely

related” to “relevant broad product categor{ies]” rather

than to particular products. Pet. App. 12a (quoting 26

U.S.C. 1.861-8(e)(3)). No “conflict” could exist between

these regulations because the research allocation rule is

merely a specific application of the general principles of

the regulation in which it is contained, and “[iJt is a

cardinal principle of construction that . . . [w]hen

there are two acts upon the same subject,” courts are

“to give effect to both if possible.” Pet. App. 12a

(quoting United States v. Borden Co., 308 U.S. 188, 198

(1939)).

SUMMARY OF ARGUMENT

I. A. The court of appeals correctly concluded that

the regulations adopted by the Secretary to determine

the proper allocation of research costs in calculating the

“combined taxable income” from export sales represent

a “permissible interpretation” of the governing statutes

and should therefore be sustained. Congress did not

define the term “combined taxable income” in the DISC

or FSC statutes. Instead, Congress directed the

Secretary to promulgate regulations to determine the

“proper” allocation and apportionment of various

expenses to items of income (26 U.S.C. 863(a)) and to

apply those rules in determining the “combined taxable

income” from export sales. Because Congress directed

the agency to fill a statutory gap in determining how

expenses are to be “properly allocated” for this pur-

pose, the ensuing legislative regulations are “binding in

the courts” unless they are arbitrary or capricious or

“manifestly contrary to the statute.” United States v.

Mead Corp., 533 U.S. 218, 227 (2001).

B. The cost allocation regulations adopted by the

Secretary generally specify (i) that costs are to be

assigned to items of gross income to which they are

“definitely related” and (ii) that costs that are related to

all of a taxpayer’s income, or that are not definitely

related to any specific item of income, are to be ap-

portioned ratably to all income. In adopting these

regulations, the Secretary determined that special pro-

vision was required for the apportionment of research

expenses for two separate but related reasons. First,

research costs that are currently deducted under

Section 174—and are not capitalized and amortized

over time—lack a “definite” relationship to any discrete

item of income for they are properly attributable to the

income of several years, not of a single year. Second,

the relationship of research costs to any discrete

product is inherently tenuous and difficult to determine,

especially when (as in this case) the taxpayer produces

more than one product of a related general type. In

view of the characteristically broad and speculative

nature of research activities, the Secretary reasonably

determined in the final regulations that research costs

that are currently deducted under Section 174 should

be allocated to the “broad product category” to which

the research relates and not be allocated simply on the

basis of the taxpayer’s internal accounting choices. 26

C.F.R. 1.861- 8(e)(3)(i)(A).

The use of the 2-digit and later 3-digit) SIC product

codes in defining the relevant “broad product cate-

gories” for this purpose was a reasonable choice among

the alternatives. In adopting a regulation that applies

for all taxpayers, the Secretary appropriately adopted

a general standard and was not required to leave this

determination to the maze of conflicting management

and accounting practices of individual taxpayers.

C. In enacting the FSC provisions in 1984, Congress

reviewed the agency’s cost allocation regulations and

concluded that those rules should continue to apply in

“the computation of combined taxable income of a DISC

(or FSC) and its related supplier.” H.R. Conf. Rep. No.

861, 98th Cong., 2d Sess. 1263 (1984). Congress thereby

ratified the past application of those regulations and

approved their future use. When, as in this case,

Congress enacts “a new law incorporating sections of a

prior law” and, in doing so, approves the administrative

interpretation of those terms, Congress should be

understood to have “adopt{ed] that interpretation.”

Lorillard v. Pons, 434 U.S. 575, 580-581 (1978).

II. A. Petitioner incorrectly claims that the chal-

lenged regulation violates a “fundamental principle” of

the governing statutes that costs be allocated based on

their “factual relationship” with a product. These

statutes contain no such requirement. Instead, they

state only that if the Secretary determines that an

expense cannot “definitely” be allocated to some item of

income, a “ratable part” of that expense is then to be

charged to all items of income. 26 U.S.C. 863(a). The

challenged regulation, which allocates research costs

ratably among the “broad product category” to which

the research relates, is consistent with that statutory

principle. The regulation falls directly within the broad

authority conferred on the Secretary to determine how

various expenses are to be “properly apportioned or

allocated” to specific items of income. 26 U.S.C. 863(a).

B. The use of the 2-digit SIC code to designate the

“broad product group” to which research costs are

allocated under the challenged regulation does not, as

petitioner asserts, “conflict” with the “grouping” rule of

the DISC and FSC regulations. The cost-allocation

rules specify the manner in which expenses are

allocated in determining “combined taxable income” for

DISCs and FSCs. The “grouping” rule has an entirely

unrelated function: it allows the taxpayer to select the

“groups” of sales that are to be evaluated under the

various alternative transfer pricing methods. 26 C.F.R.

1.994-1(c)(7). Whatever “group” of sales is selected by

the taxpayer for that purpose, however, the calculation

of “combined taxable income” for that group must be

made in accordance with the procedures specified in the

challenged cost-allocation regulations. The cross-

references contained in these two sets of regulations

make clear that these coordinated provisions work in

tandem and are not “in conflict.”

Petitioner’s contrary assertion would make the

research cost allocation regulation a nullity for the very

purpose for which it was adopted. As the court of

appeals emphasized, any suggestion that such expressly

interrelated regulatory provisions are “in conflict”

ignores the “cardinal principle” that, when “there are

two acts upon the same subject,” courts are “to give

effect to both if possible.” Pet. App. 12a.

ARGUMENT

I. IN COMPUTING THE “COMBINED TAXABLE IN-

COME” FROM EXPORT SALES FOR THE PUR-

POSES OF THE DISC AND FSC PROVISIONS OF

THE INTERNAL REVENUE CODE, PETITIONERS

MUST TAKE RESEARCH AND DEVELOPMENT

EXPENSES INTO ACCOUNT IN THE MANNER

REQUIRED BY 26 C.F.R. 1.861-8(e)(3)

In 1977, the Secretary of the Treasury issued

regulations to determine how expenditures are to be

“properly apportioned or allocated” in computing com-

bined taxable income for purposes of the DISC

provisions. 26 U.S.C. 861(b); see 26 U.S.C. 863(a). The

regulations adopted by the Secretary generally require

that all expenses “definitely related” to the “income”

from sales of an exported product, and a pro rata share

of expenses “definitely related” to all or no items of

“income” of the taxpayer, be allocated to the export

sales in determining the “combined taxable income” of

the U.S. supplier and its export subsidiary from those

sales. 26 C.F.R. 1.861-8(c)(1), (c)(2). The regulations

further specify that, in view of the characteristically

broad and speculative nature of research activities,

costs related to research are to be “considered deduc-

tions which are definitely related to all income rea-

sonably connected with the relevant broad product

category [to which the research relates] * * * and

therefore allocable to all items of gross income * * *

related to such product category * * * .” 26C.F.R.

1.861-8(e)(3)(i(A). The court of appeals correctly con-

cluded that these regulations establish a permissible

interpretation of the statute and should therefore be

sustained.

A. Congress Directed The Secretary Of The Treasury To

Issue Regulations To Determine The Manner In

Which Expenses Are To Be Taken Into Account In

Computing The “Combined Taxable Income” From

Export Sales Under The Disc And FSC Provisions Of

The Internal Revenue Code

The regulations challenged by petitioners in this case

“are legislative regulations because they were

promulgated pursuant to [26 U.S.C.] 863(a) and 994(b),

which contain explicit grants of authority from

Congress.” Pet. App. 5a. In enacting the DISC and the

FSC provisions, Congress did not attempt to define the

statutory construct of “combined taxable income.””

The history of the DISC provisions, however, reveals

that Congress intended that, in implementing this

provision, the Treasury would apply “the principles

applicable under section 861 for determining” the

domestic or foreign source of income. H.R. Rep. No.

533, supra, at 74.

Section 861, in turn, has long provided a mechanism

for dividing the “source” of income between United

States and foreign activities.” Under that statute, ex-

penses that are “properly apportioned” to United

States source income, and a “ratable part” of expenses

that “cannot definitely be allocated” to an item of gross

The role that the statutory concept of “combined taxable

income” plays in determining petitioner’s tax liability is set forth in

- detail at pages 4-5, supra.

2 The geographic “sourcing” of income has been a feature of

income tax law since the enactment of Sections 1(a) and 10 of the

Revenue Act of 1916, ch. 463, 39 Stat. 756, 765-766, which imposed

a tax on income from sources within the United States received by

nonresident aliens and foreign corporations. These “sourcing”

rules have relevance for several different tax calculation purposes.

See note 7, supra.

income, are deducted from United States source income

in arriving at United States source “taxable income.”

26 U.S.C. 861(b). In the 86 years since the first

enactment of Section 861, Congress has not attempted

to prescribe detailed rules for implementing this pro-

vision. Instead, Congress has specified that the deter-

mination whether an expense is “properly apportioned”

to an item of gross income is to be made “under regu-

lations prescribed by the Secretary.” 26 U.S.C. 863(a).

In enacting these interrelated statutory provisions,

Congress thus authorized the Secretary to adopt

regulations to determine the “proper” allocation and

apportionment of deductions to items of income and to

apply those rules in determining the “combined taxable

income” from export sales.“ Because Congress

“explicitly left a gap for [the] agency to fill” and made

“an express delegation of authority to the agency to

elucidate [the] specific provision[{s] of the statute by

regulation,” the “ensuing regulation” adopted by the

Secretary to implement that authority is “binding in the

courts” unless it is “procedurally defective,” “arbitrary

or capricious” or “manifestly contrary to the statute.”

United States v. Mead Corp., 533 U.S. at 227 (quoting

Chevron U.S.A. Inc. v. Natural Res. Def. Council, Inc.,

13 As the court of appeals noted (Pet. App. 5a), in addition to the

broad authority conferred on the Secretary of the Treasury to

prescribe general regulations for the proper allocation of costs and

to use those rules in determining “combined taxable income” for

export sales, Congress also authorized the Secretary to “prescribe

regulations” for determining the proper “allocation of expenditures

in computing combined taxable income” in related contexts in-

volving other distinct types of DISC and FSC transactions. 26

U.S.C. 994(b)(2) (marginal costing rules). See 26 U.S.C. 994(b)(1)

(rules for commissions, rentals and other income); see 26 U.S.C.

925(b)(2) (1988) (same under FSC).

467 U.S. 837, 843-844 (1984); see United States v.

Morton, 467 U.S. 822, 834 (1984).

A regulation issued under such an express authority

to “prescribe standards” has “legislative effect” (Batter-

ton v. Francis, 432 U.S. 416, 425 (1977)) and is entitled

to the highest degree of deference accorded admini-

strative actions. When Congress has made an “explicit

delegation of substantive authority” to the agency, the

agency’s legislative regulation is entitled “to more

than mere deference or weight.” Schweiker v. Gray

Panthers, 453 U.S. 34, 44 (1981) (cited in Chevron, 467

U.S. at 844 n.12). While the Court has made clear that

it “do[es] not abdicate review in these circumstances,”

it has emphasized that its “task is the limited one of

ensuring that the Secretary did not ‘excee[d] his

statutory authority’ and that the regulation is not

arbitrary or capricious.” Schweiker v. Gray Panthers,

453 U.S. at 44 (quoting Batterton v. Francis, 432 U.S. at

426).

As the court of appeals noted (Pet. App. 6a), even if

the challenged regulations were regarded as inter-

pretive, rather than legislative, the standard of de-

ference owed to the agency’s regulations would remain

extremely high. As this Court explained in United

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

Congress has delegated to the Commissioner, not to

the courts, the task of prescribing “all needful rules

and regulations for the enforcement” of the Internal

Revenue Code. 26 U.S.C. § 7805(a). * * * 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 congres-

sional mandate in some reasonable manner.

B. The Challenged Regulations Establish A Permissible

Implementation Of The Governing Statutes And

Should Therefore Be Sustained

Recognizing the high degree of deference that applies

to both legislative and interpretive regulations under

the Internal Revenue Code, the court of appeals

correctly concluded that 26 C.F.R. 1.861-8(e)(3) estab-

lishes a “permissible interpretation” of the statutes and

is therefore valid whether reviewed “under an ‘arbi-

trary or capricious’ standard, or under the arguably less

deferential ‘reasonableness’ standard.” Pet. App. 5a-6a.

1. The Basic Framework for Cost Allocation Under 26

C.F.R. 1.861-8 Directly Implements The General

Provisions of the Statute

_ In 1977, following public notice and comment, the

Secretary adopted regulations under Section 861 that

specifically address cost allocation in computing

“combined taxable income” for DISCs.“ These regu-

lations are designed “principally to ensure that foreign

operations of domestic corporations are charged with a

proper share of deductions.” B. Bittker & L. Lokken,

4 The cost-allocation regulations adopted in 1977 state specifi-

cally that they govern the allocation and apportionment of re-

search and development deductions in the calculation of “the

combined taxable income of the DISC and the related supplier.” 26

C.F.R. 1.861-8(f)(1)(iii). Petitioner’s assertion that “it would be

best to interpret Treas. Reg. § 1.861-8(e)(3) not to apply at all to

the computation of CTI” (Pet. Br. 29) is therefore frivolous. More-

over, the DISC regulations expressly incorporate the cost-alloca-

tion procedures of the challenged regulations in the calculation of

“combined taxable income” for the DISC and its supplier. 26

C.F.R. 1.994-1(c\6). And, following enactment of the FSC pro-

visions in 1984, these same cost-allocation rules were expressly

made applicable to FSCs by 26 C.F.R. 1.925(a)-1T(c)(6)(iiiD).

Federal Taxation of Income, Estates and Gifts

7 70.10.1, at S70-26 (Supp. 1999). The general pro-

visions of these regulations specify that expenses,

losses and other deductions are to be allocated and

apportioned to the item or class of gross income to

which they are “definitely related.” 26 C.F.R. 1.861-

8(b)(1), (c)(1). Deductions that are related to all of a

taxpayer’s gross income, or that are not “definitely re-

lated” to any specific item of income, are to be appor-

tioned ratably to all gross income. 26 C.F.R. 1.861-

8(b)(5), (c(2). This general framework of the regula-

tions directly follows the statutory pattern of 26 U.S.C.

861(b) (see pages 19-20, supra), and the validity of this

general framework is not in question.

2. Within This Basic Framework, the Secretary Deter-

mined That Special Provision Was Required To

Ensure That Research Expenses Are Properly Ap-

portioned in Calculating “Combined Taxable

Income”

Congress directed the Secretary to determine, within

this general framework, how various expenses are to be

“properly apportioned or allocated” to items of income

(26 U.S.C. 863(a)), and to apply those rules in cal-

culating “combined taxable income” for DISCs and

F'SCs. In adopting the cost allocation regulations in

1977, the Secretary concluded that special provision

was required for the apportionment of research ex-

penses for two separate, but related reasons.

a. Research costs that are deducted currently under

Section 174 of the Internal Revenue Code are not

“definitely related” to specific items of income. The

Internal Revenue Code generally defines “taxable

income” as the gross income of the taxpayer less

allowable deductions. 26 U.S.C. 63(a). Although tax-

payers may deduct ordinary business expenses in the

year they are incurred, “capital” expenses that are

related to the production of income in several periods

are instead to be “amortized and depreciated” over

their useful life. JNDOPCO, Inc. v. Commissioner, 503

U.S. 79, 83-85 (1992). In this manner, “the Code en-

deavors to match [capital] expenses with the revenues

of the taxable period to which they are properly

attributable, thereby resulting in a more accurate

calculation of net income for tax purposes.” Jd. at 84.

See also Commissioner v. Idaho Power Co., 418 U.S. 1,

16 (1974).

Research and development expenses are a quin-

tessential example of the type of business expenditures

that give rise to income, if ever, in a later year. By

their very nature, such expenses are logically to be

capitalized and recovered over time as a component of

the costs of goods sold. See JNDOPCO, Inc. v.

Commissioner, 503 U.S. at 84. In 1954, however, Con-

gress authorized taxpayers to elect to treat research

expenses “as expenses which are not chargeable to

capital account” and are, instead, “allowed as a

deduction” in the year they are incurred. 26 U.S.C.

174(a)(1). When (as in the present case) the taxpayer

elects to treat its research expenses as current

deductions under Section 174, rather than as capital

expenditures, the logical or “factual” link between such

costs and the income that they generate is thereby

severed. If the taxpayer elects to deduct such expenses

immediately—before the results of the research bear

fruit in the generation of income—a “direct” or

“definite” relationship between the research expense

and the associated future income disappears.” As this

Court pointed out in JINDOPCO, Inc. v. Commissioner,

503 U.S. at 84, capital costs are “properly attributable”

to the income of several years, not of a single year.

Because research costs deducted currently under

Section 174 thus lack a “definite” relationship to items

of income, the Secretary could have concluded that the

deductions resulting from those expenses should, under

the general framework of the statute, be “properly

apportioned” (26 U.S.C. 863a)) among all items of

income during the year the deductions are taken.”* See

26 C.F.R. 1.861-8(c)(2); page 23, supra.

4 As Amicus Tax Executives emphasizes (Br. 24 n.17), an

expense that is “definitely related” to an item of income may be

deducted in determining “combined taxable income” whether or

not there is any item of income which is received or accrued during

the taxable year (26 C.F.R. 1.861-8(b)(2)) and even if “no gross

income in such class is received” in that year (26 C.F.R. 1.861-

8(d)(1)). Under the regulations, the taxpayer may thus have a

negative “combined taxable income” when “there is an excess of

deductions” over the income received in that year. 26 C.F.R.

1.861-8(b)(2)._ In every case, however, the regulations permit

expenses allocated in their entirety (rather than pro rata) against

an item of income only if the expense “bears a definite relationship

to” the item of income. 26 C.F.R. 1.861-8(d)(1). The regulations

further specify that, for this purpose, research expenses are

treated as “definitely related” to the broad class of products to

which the research relates. 26 C.F.R. 1.861-8(e)(3)(i)(A).

16 When research costs are deducted currently under Section

174, and are not amortized over the period of the product sales,

there is no “definite” relationship between those deductions and

the income from any associated product or activity. In this case,

for example, petitioner attempted to “allocate” $1.75 billion of the

research costs that it deducted currently under Section 174 to

programs that had no sales in the years the research was con-

ducted. See page 11, supra. When ordinary principles of capital

cost accounting are not followed, and research costs are not

b. Research costs inherently benefit a broad class of

products for any manufacturer. The Secretary deter-

mined, however, that one additional characteristic of

research expenses required further refinement in the

treatment of such expenses in the final regulations.

The relationship of a research cost to any discrete

product is inherently tenuous and difficult to determine,

especially when (as in this case) the taxpayer produces

more than one product of a related general type. The

mere fact that a taxpayer, in its internal accounting,

may allocate such costs to a single product obviously

does not mean that the research does not in fact benefit

the production of other related products of the same

type. For example, in this very case, petitioner’s

officers acknowledged (as common sense suggests) that

its research activities are not hermetically sealed and

that knowledge and expertise garnered in the develop-

ment and construction of one airplane model carries

over to the production of others. C.A. E.R. 103, 127-

128."

In the final regulations, the Secretary determined

that, in view of the characteristically broad and specu-

deducted against the income to which those expenses are logically

and properly attributable, the “definite” relationship that other-

wise generally exists between an expense and the “activity” or

“property” to which it is “incident” (26 C.F.R. 1.861-8(b)(2)) is

severed. Special provision for allocating research costs that are

currently deducted under Section 174 was therefore required

within the general framework of the regulations.

17 Petitioner has also acknowledged that a large portion of its

research expenses (denominated as “Blue Sky” research) are

properly to be allocated among all of its aircraft programs. “Blue

Sky” costs differ from the research costs involved in this case

primarily in that they were incurred before a specific aircraft

model was authorized for production under petitioner’s internal

accounting and management practices. See page 9, supra.

lative nature of research activities, research costs that

are deducted currently under Section 174 should not be

allocated based on the taxpayer’s internal accounting

choices but should instead be treated as “definitely

related” to the “broad product category” to which the

research relates.” The final regulations initially

specified that the applicable “broad product category”

is to be determined by reference to the two-digit SIC

codes established by the Office of Management and

Budget. 26 C.F.R. 1.861-8(e)(3)(i(A). After further

experience with the regulation, the Secretary refined

the relevant “broad product category” for this purpose

by reference to the narrower, three-digit SIC codes. 26

C.F.R. 1.861-17(a)(2)(ii) (1996).

The product categories established in the Standard

Industrial Classification Manual published by the Office

8 In determining its “taxable income” for the current period,

the taxpayer who elects a current deduction for research costs

under Section 174 applies those costs as a deduction against its

gross income from all sales in the current period. 26 U.S.C. 63(a).

The final regulations require that these expenses be treated

similarly in determining “combined taxable income” for DISCs and

FSCs by providing that research expenses “which a taxpayer de-

ducts under section 174” are to be treated as deductions “definitely

related” to income received in the current period. 26 C.F.R. 1.861-

8(e)(3)(i)(A).

'9In adopting the 3-digit SIC code standard in 1996, the

Treasury rejected a proposal to employ instead a 5-digit SIC code

standard “because such a rule would too narrowly restrict the

necessarily broad scope of the deduction.” T.D. 8646, 1996-1 C.B.

144, 145. The agency explained that it “continues to believe that

research and experimentation is an inherently speculative activity,

that findings may contribute unexpected benefits, and that gross

income derived from successful research and experimentation

must bear the cost of unsuccessful research and experimentation.”

Ibid.

of Management and Budget provide a rational and

administrable standard for this purpose. Utilization of

the two-digit SIC Codes ameliorates the effect of a

more general treatment of such costs, which could re-

quire a taxpayer to allocate its currently deducted

research costs among all items of current income. See

pages 23-25, supra. And, although petitioner objects to

the breadth of the two-digit SIC code classifications, it

is obvious that some administrable rule is required for

this purpose. No alternative classification standard or

method (other than petitioner’s own internal accounting

practices) has been suggested by petitioner for this

purpose. In adopting a general regulation that applies

for all taxpayers, the Secretary properly may establish

a general standard and is not required to leave this

determination to the vagaries of the management and

accounting practices of individual taxpayers.” As this

Court has emphasized, “[iJn view of the Treasury’s

markedly different goals and responsibilities, * * *

any presumptive equivalency between tax and financial

accounting would be unacceptable.” Thor Power Tool

Co. v. Commissioner, 439 U.S. 522, 542-543 (1979).

Accord, United States v. Hughes Props., Inc., 476 U.S.

593, 603 (1986); American Automobile Ass’n v. United

2 In exercising the responsibility to promulgate regulations

that specify how costs are to be “properly apportioned” for this

purpose (26 U.S.C. 863(a)), the Secretary has adopted specific

regulatory standards to govern the allocation of numerous specific

items of expense, such as interest costs, attorneys fees and taxes.

26 C.F.R. 1.861-8(e)(1)-(11). The treatment of research costs under

26 C.F.R. 1.861-8(e)(3) is merely one of the several situations in

which a general standard—rather than the individual accounting

choices and methodologies of individual taxpayers—controls under

the regulations.

States, 367 U.S. 687, 693 (1961) (industry accounting

practices are not “binding on the Treasury”).

3. The Secretary’s Choice Among Alternative Methods of

Apportioning Research Expenses in the Calculation of

“Combined Taxable Income” is Reasonable and not

Arbitrary or Capricious

a. The court of appeals correctly concluded that the

final rules adopted by the Secretary for the allocation

and apportionment of research costs represent a rea-

sonable choice among the alternatives. The regulation

reveals on its face that, in determining the items of

income to which research costs are to be regarded as

“definitely related,” the Secretary carefully considered

(i) the character of the current deduction allowed for

such expenses under Section 174 and (ii) the inherently

broad and general relationship of research costs to

product development. Based on a detailed considera-

tion of these factors, the Secretary concluded that re-

search expenses “which a taxpayer deducts under

Section 174” are to be “considered deductions which are

definitely related to all income reasonably connected

with the relevant broad product category” of the

taxpayer because research “is an inherently speculative

activity” that routinely provides broad benefits for the

taxpayer. 26 C.F.R. 1.861-8(e)(3)(i)(A).

That determination by the Secretary falls within the

core of his statutory authority to establish regulations

for the proper allocation of expenditures in computing

“combined taxable income” for DISC and FSC pur-

poses. See page 20 & note 13, swpra. Even when the

Secretary exercises only the general interpretive

authority under 26 U.S.C. 7805 to apply the provisions

of the Code to the “limitless factual variations” of

commerce, this Court has emphasized that “it is the

province of Congress and the Commissioner, not the

courts, to make the appropriate adjustments.” United

States v. Correll, 389 U.S. at 307 (quoting Commis-

sioner v. Stidger, 386 U.S. 287, 296 (1967)). Deference

to the Secretary’s detailed judgment in the adoption of

such regulations “guarantee[s] that the rules will be

written by ‘masters of the subject,’ United States v.

Moore, 95 U.S. 760, 763 (1878), who will be responsible

for putting the rules into effect.” National Yusjler

Dealers Ass’n v. United States, 440 U.S. 472, 477 (1979).

b. Contrary to petitioner’s assertion (Pet. Br. 39),

the research cost allocation regulations adopted by the

Secretary do not “penalize exporters who perform

R&D on new products by diminishing the tax ad-

vantages related to their current exports.” Even

without the additional tax benefit of approximately $25

million per year that petitioner seeks in this case,

Boeing is reported to have been the largest beneficiary

of the FSC regime, with a “total FSC tax benefit” of

approximately $1.2 billion during the 1990’s. J. Oyola,

A Fresh Look at Foreign Sales Corporation Benefi-

ciaries (Tax Analysts Reference: 2001 WTD 122-15).

See also J. Oyola, Foreign Sales Corporation Benefi-

ciaries: A Profile, 88 Tax Notes 933, 936 (2000).

The DISC regime was not intended to provide

unlimited or “undue tax advantages” to export activi-

ties. S. Rep. No. 437, supra, at 13. “(T]he question is

whether Congress legislated th{e] degree of encourage-

ment” that petitioner seeks. Archer-Daniels-Midland

Co. v. United States, 37 F.3d 321, 323 (7th Cir. 1994),

cert. denied, 514 U.S. 1077 (1995). “Obviously it was

necessary to control the amount of export income that

the parent could defer by use of a DISC.” Intel Corp. v.

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

function of the “combined taxable income” deter-

mination made under the regulations “is to fix a

‘transfer price’ between the parent and the DISC

which, in turn, limits the amount of income of which the

parent can defer realization.” [bid.

If the Secretary had adopted the rule that petitioner

proposes, and had allowed research costs to be attri-

buted to specific products without regard to a “definite”

relationship to the income from such products, the most

basic objectives of the statute and regulations would

have been defeated. Under petitioner’s theory, re-

search costs routinely would be ignored in the cal-

culation of “combined taxable income.” This is because

the bulk of research costs are commonly incurred in

years before production and sales occur. See note 16,

supra. By failing to apportion research costs to income

to which they are “definitely” related, petitioner’s

proposed allocation method would vastly overstate the

“combined taxable income” from export sales by

violating the fundamental requirement that “the total

costs of the DISC and related supplier which relate to

such gross receipts” be deducted in computing “com-

bined taxable income.” 26 C.F.R. 1.994-1(c)(6)

(emphasis added).”

21 For example, in the present case alone, petitioner’s alterna-

tive method of calculating “combined taxable income” overstates

the actual net income resulting from its sales by approximately

$1.75 billion. That is the amount of research costs that petitioner

seeks to (i) charge to specific programs in years when no sales in

those programs occurred and (ii) thereafter ignore in the later

periods when sales occurred and income was in fact received. See

note 16, supra.

C. In Enacting The FSC Provisions In 1984, Congress

Ratified Application Of The Challenged Research Cost

Allocation Regulations To Discs And Expressly

Authorized Application Of Those Regulations To FSCs

By the time that Congress enacted the FSC

provisions in 1984, the regulations that allocate re-

search expenses in “combined taxable income” calcu-

lations (26 C.F.R. 1.861-8(e)(3)) had been in place for

seven years. In enacting the FSC provisions, which

borrowed heavily from the DISC provisions, Congress

stated that it “intends that rules comparable to the

rules in regulations issued under th{e DISC] provisions

will be appli[cable] to the FSC.” 1 Staff of the Senate

Comm. on Finance, 98th Cong., 2d Sess., Deficit

Reduction Act of 1984, at 636 (Comm. Print 1984). The

DISC regulations to which Congress referred expressly

incorporate the cost allocation rules of 26 C.F.R. 1.861-

8(e)(3). See 26 C.F.R. 1.994-1(c)(6)(iii). The reference

in the legislative history of the FSC provisions to the

existing DISC regulations demonstrates that Congress

intended the cost-allocation rules established in those

prior regulations to apply under the FSC provisions as

well.

This conclusion was made manifest in another portion

of the FSC legislative history. As part of the legislation

that enacted the FSC, Congress specifically addressed

and extended a moratorium that had been imposed in

1981 on the application of the Section 861 cost allocation

regulations for the limited purpose of determining

whether income has a United States or foreign source.”

2 Due to concerns relating to the sourcing of income in making

foreign tax credit calculations, Congress imposed a temporary

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

§ 126, 98 Stat. 648. In doing so, Congress specified that

the moratorium on that use of the cost-allocation

regulations “does not apply for other purposes, such as

the computation of combined taxable income of a DISC

(or F'SC) and its related supplier.” H.R. Conf. Rep. No.

861, supra, at 1263 (emphasis added). See Intel Corp. v.

Commissioner, 76 F.3d at 983 (holding that the morato-

rium does not apply to the computation of DISC

“combined taxable income”); St. Jude Medical, Inc. v.

Commissioner, 34 F.3d at 1403-1405 (same).

In enacting the FSC provisions, Congress thus

expressed the clear understanding and intention that

the cost-allocation rules of 26 C.F.R. 1.861-8(e)(3) are

controlling in the calculation of “combined taxable in-

come” not only for DISCs but also for FSCs. Congress

thereby ratified the past application of those regula-

tions and approved their future use.

As this Court has frequently observed, when Con-

gress enacts “a new law incorporating sections of a

prior law” and, in doing so, approves the administrative

interpretation of those terms, Congress should be

understood to have “adopt{ed] that interpretation.”

Lorillard v. Pons, 434 U.S. 575, 580-581 (1978). See

Albemarle Paper Co. v. Moody, 422 U.S. 405, 414 n.8

(1975) (Congress has thereby “ratified this con-

struction”). In particular, this Court has “held in many

moratorium on the application of the cost allocation rules of 26

C.F.R. 1.861-8(e)(3) solely for the sourcing of income. See Section _

223 of the Economic Recovery Tax Act of 1981, Pub. L. No. 97-34,

95 Stat. 249; Section 126 of the Deficit Reduction Act of 1984, Pub.

L. No. 98-369, 98 Stat. 648; Section 13211 of the Consolidated

Omnibus Budget Reconciliation Act of 1985, Pub. L. No. 99-272,

100 Stat. 324. That moratorium was lifted in 1986. See Tax Re-

form Act of 1986, Pub. L. No. 99-514, § 1216, 100 Stat. 2549.

cases” that a “long-standing administrative interpreta-

tion” set forth in a Treasury regulation that interprets

the predecessor of “a substantially reenacted statute, is

deemed to have received congressional approval and

has the effect of law.” Commissioner v. Estate of Noel,

380 U.S. 678, 682 (1965) (citing cases). See also Heard

v. Commissioner, 326 F.2d 962, 966 (8th Cir.), cert.

denied, 377 U.S. 978 (1964); N. Singer, Sutherland

Statutory Construction § 22:33, at 399 & n.11 (6th ed.

2002).”

Il. THE CHALLENGED RESEARCH COST-ALLOCA-

TION RULES DO NOT CONFLICT WITH ANY

PROVISION OF THE DISC AND FSC STATUTES

OR REGULATIONS

Petitioner argues that the Secretary’ s treatment of

research costs under the regulations is invalid for two

reasons. First, petitioner asserts that the regulations

violate a “rule * * * established by the plain language

of the DISC statute” that “costs that are factually

—_—_—_—_—_

2 Petitioner suggests that the FSC provisions need not be

addressed in this case because the parties “agreed that there are

no differences between DISC and FSC that are relevant to this

case” (Pet. Br. 3 n.2). Although the parties agreed that “differ-

ences between the DISC and FSC rules” are not material to this

case (Stip. { 28), the parties have not agreed that the history of the

enactment of the FSC is irrelevant. To the contrary, the govern-

ment pointed out in the court of appeals that this history reflects

an express approval by Congress of the regulation involved in this

case and, indeed, that “it is difficult to make a stronger case for the

application of the legislative reenactment doctrine.” Gov't C.A. Br.

40. See Gov’t C.A. Reply Br. 24. Petitioners also addressed the re-

enactment doctrine in their brief in the court of appeals. Pet. C.A.

Br. 55-59. The court found it unnecessary to reach the issue, how-

ever, because it upheld the regulation on the merits as a permis-

sible interpretation of the statute. See Pet. App. 5a-6a.

related to one product (or product group) may not be

deducted from revenue arising from the sale of a

different product (or product group).” Pet. Br. 15.

Second, petitioner claims that the requirement of the

regulations that research costs be allocated to the broad

product group to which those costs relate violates the

“grouping” rules of the DISC and F'SC regulations that

allow the taxpayer to group its export sales within

narrower product categories in applying the transfer

price rules of those statutes. Pet. Br. 16-17. Neither of

these objections to the challenged regulations is valid.

A. The Research Cost Allocation Regulations Properly

Implement, And Do Not Conflict With, The Governing

Statutes

1. The Challenged Regulations Properly Implement

the Governing Statutes

Petitioner errs in claiming (Pet. 15) that it is a

“fundamental principle” of the governing statutes that

costs are to be allocated based on their “factual

relationship” with a “product” or “product group.” The

applicable statutes do not contain any such require-

ment.”

* Amicus Tax Executives Institute errs in suggesting (Br. 25)

that any ambiguity in the statutes that govern this case should be

construed against the government. In White v. United States, 305

U.S. 281, 292 (1938), this Court expressly rejected the proposition

that “doubts should be resolved in favor of the taxpayer.” The

Court has instead long applied “the ‘familiar rule’ that ‘an income

tax deduction is a matter of legislative grace and that the burden

of clearly showing the right to the claimed deduction is on the

taxpayer.” INDOPCO, Inc. v. Commissioner, 503 U.S. at 84

(quoting Interstate Transit Lines v. Commis: ‘er, 319 U.S. 590,

593 (1943)). This rule applies with special for: vo the DISC and

FSC, for “{iJt has been said many times that provisions granting

a. Section 863(a) directs the Secretary to determine,

by regulations, which expenses are to be “properly

apportioned and allocated” to specific items of “income.”

26 U.S.C. 863(a). This statute does not state whether a

“factual relationship” or a “logical relationship” or some

other type of “relationship” is sufficient. The statute

states only that, if the Secretary determines that an

expense “cannot definitely be allocated to some item

* * * of gross income,” then a “ratable part” of that

expense is to be charged to all items of income. Ibid.

As we have explained above, the challenged regulation

is based on, and conforms with, these broad statutory

principles. See pages 19-29, supra.

b. The DISC and the FSC statutes and their

legislative histories also do not define how the Secre-

tary is to determine which costs are, or are not,

“definitely related” to items of income. The “statutory

text does not confine the relevant costs to those

‘definitely related’ to sales of a particular product.”

Pet. App. lla. As the Tax Court stated in upholding

the challenged regulations, “[a] requirement that an

expense be ‘definitely related’ to gross income from

export receipts in order to be allocated to the item does

not exist in the text of sections 994(a) or (b) or 861(b)

for 925(a)].” St. Jude Medical, Inc. v. Commissioner, 97

T.C. at 478.

c. The phrase that is the centerpiece of petitioner’s

argument appears only in the Secretary's regulations,

and not in the statutes. It is the DISC and FSC

regulations—and not the statutes—that specify that

costs that are ‘definitely related’ to gross receipts from

the sales of export property and costs that are ‘not

special tax exemptions are to be strictly construed.” Helvering v. -

Northwest Steel Mills, 311 U.S. 46, 49 (1940) (citing cases).

definitely related’ to a class of gross income * * * are

treated as costs ‘relating’ to gross receipts from sales of

export property and therefore enter into the combined

taxable income computation.” St. Jude Medical, Inc. v.

Commissioner, 97 T.C. at 478 (citing 26 C.F.R. 1.994-

1(c)(6)(iii)); see also 26 C.F.R. 1.861-8(c)(1), (e)(2)).

The portion of the regulation challenged in this case

—which defines research expenses currently deducted

under Section 174 to be “definitely related” to income

generated by a broad class of similar products—is

simply an elaboration by the Secretary of the general

standard established in the agency’s own regulations.

As we describe above (pages 23-29, supra), this fact-

specific elaboration of this regulatory standard falls

directly within the broad authority of the Secretary to

“promulgate regulations” to determine how various

expenses are to be “properly apportioned or allocated”

to specific items of income. 26 U.S.C. 863(a).

2. The “Principles Applicable Under Section 861” do not

Require a “Factual Relationship” Between Income

and Expense in Allocating and Apportioning Current

Expense to Current Income

a. Ignoring the text of the governing statutes,

petitioner nonetheless argues that the “fundamental

principles” of these statutes require that expenses be

assigned only to products to which they are “factually

related.” The “factually related” standard on which

petitioner rests its argument, however, appears only in

the portion of the Treasury’s regulations that describes,

in general terms, how expenses are allocated under the

regulations. After setting forth the general rule of the

regulations that expenses are allocated to the income to

which they are “definitely related” (26 C.F.R. 1.861-

8(a)(2)), the sentence of the regulation on which peti-

tioner relies states that, “/a]s further detailed below,

allocations and apportionments are made on the basis of

the factual relationship of deductions to gross income.”

26 C.F.R. 1.861-8(a)(2) (emphasis added). Of course, it

was in adopting these very regulations that the Secre-

tary clearly specified in the provisions “further detailed

below” that a sufficient factual and logical relationship

exists for this purpose between research expenses

currently deducted under Section 174 and the income

earned during that period from sales of products within

the related broad product groups. 26 C.F.R. 1.861-

8(eX(3)(i( A). The full text of the regulation thus

refutes petitioner’s reliance on the small portion of the

regulation that it chose to quote.

b. Petitioner asserts (Pet. 24-26) that the Secretary

should not be permitted to adopt the research cost

allocation rule of the final regulation because the 1973

proposed regulations contained no such provision. Peti-

tioner is unquestionably wrong, however, in suggesting

that the Secretary is bound by each and every phrase in

a proposed regulation. A proposed regulation is

nothing more than a “suggestion[{] made for comment.”

LeCroy Research Systems Corp. v. Commissioner, 751

F.2d 123, 127 (2d Cir. 1984). “If the Commissioner

wanted [the proposed] regulation to have binding

effect, it could have been issued as a temporary regu-

lation.” Jbid. Furthermore, in adopting the final

regulations, the Secretary plainly was not required to

give each phrase of the proposed regulations the

meaning that petitioner now seeks.”

* For example, while petitioner makes much of the supposed

need for a “factual relationship” between income and expenses—a

phrase that is nowhere to be found in the governing statutes—it

In claiming that the 1973 proposed regulation should

govern this case, petitioner errs in relying on a selected

portion of the Technical Memorandum that accom-

panied the proposed DISC regulations (Pet. Br. 23). In

quoting that Memorandum, petitioner has omitted the

sentences that underscore that the regulations had not

been cast in concrete at the time they were first

proposed. The omitted sentences state (1972 T.M. Lexis

14, at *8-*9 (June 29, 1972) (emphasis added)):

In determining deductible expenses attributable to

the property and transaction, the rules of section

861(b) and 1.861-8 are to be applied in whatever

form they ultimately take in a new notice to be

prepared. * * * It is anticipated that rules will be

later developed under 1.861-8 or the Treasury

decision containing 1.994-1 to allocate expenses in-

curred in one year to items of gross income received

in another year.

This Technical Memorandum reflects the agency’s

understanding, at the time that the proposed regula-

tions were issued, that timing problems in the appor-

tionment of costs incurred in one year to revenues

earned in other periods needed to be further addressed

in the final rules.

The challenged research cost allocation rules -ulti-

mately adopted in the final regulations, of course,

respond directly to this timing concern. See pages 23-

29, supra. And, prior to the final adoption of these

regulations in 1977, the research cost-allocation rules

were issued as amended proposed rules for public

comment in 1976. 41 Fed. Reg. 49,160 (1976).

studiously avoids explaining why aircraft research is not “factually

related” to the income from aircraft sales.

Petitioner incorrectly suggests (Pet. Br. 24) that the

provisions of the 1973 proposed regulations, rather than

the provisions of the 1977 final regulations, should be

understood as the cost allocation “rules set forth in

$1.861-8” (26 C.F.R. 1.861-8(c)(6)(iii)) that were incor-

porated by the DISC regulations in 1975. In issuing the

DISC regulations in 1975, the agency clearly stated

that the 1973 “proposed regulations” under Section 861

had relevance only “for informational purposes.” T.D.

7364, 1975-2 C.B. 315, 316. The agency also made clear

that a cross reference in the DISC regulations to other

regulations that were, at that time, only proposed is

“intended to refer to such regulations as will be finally

adopted.” Jbid.

c. Petitioner also errs in claiming (Pet. Br. 19) that

the Secretary may not allocate deductions “partly to

the particular sale in question and partly to completely

unrelated sales.” The text of the governing statute

clearly provides that “a ratable part of any expenses,

losses, or other deductions which cannot definitely be

allocated to some item or class of gross income” shall be

deducted in arriving at taxable income. 26 U.S.C.

861(b) (emphasis added). As the Ninth Circuit (Pet.

App. 11a) and the Tax Court in St. Jude (97 T.C. at 478)

have correctly recognized, the governing statutes and

regulations explicitly require that a ratable part of

expenses that are not definitely related to any specific

item of income are to be charged against all items of

income. !

Even though research expenses deducted currently

under Section 174 are not “definitely” or “directly” -

related to the “income” earned from specific products in

any specific period (see pages 23-25, supra), petitioner

suggests that the mere existence of some relationship

between its research and futwre income should suffice.

If petitioner had capitalized its research costs, thc

annual amortization of such costs would then have had a

logical or “factual” relationship to its future income and

could then be said to be “properly attributable” to that

income as it is earned. [NDOPCO, Inc. v. Commis-

sioner, 503 U.S. at 84. But when, as in this case, the

taxpayer elects currently to deduct its research costs

(as Section 174 allows), the taxpayer thereby destroys

any “definite” or “factual” relationship between those

expenses and the income earned. See note 16, supra.

The improper treatment of research costs that peti-

tioner advocates in this case would vastly overstate the

benefits to which petitioner is entitled under the DISC

and the FSC regimes. Petitioner seeks to exclude

approximately $1.75 billion in research expense deduc-

tions in calculating its “combined taxable income” even

though those expenses were in fact deducted in deter-

mining its “taxable income” under the general pro-

visions of the Code. See note 16, supra. Through this

inconsistent treatment, petitioner seeks to treat a

substantial portion of its aggregate taxable income as if

it were export-related, when in fact it is not.

B. The Research Cost Allocation Rules In 26 C.F.R.

1.861-8(e)(3) Do Not Conflict With The “Grouping”

Rules In The DISC And FSC Regulations

1. Under the DISC and FSC provisions, the tax-

payer has three options for calculating the “transfer

price” that is used in determining the amount of income

that is deferred under DISC or exempted under FSC.

26 U.S.C. 994(a); 26 U.S.C. 925(a). Only one of these

options requires a calculation of the “combined taxable

income” of the taxpayer and its sales subsidiary. The

others are based on a percentage of export sales

revenues or on an assumed “arms length price” for the

transfer. See page 5, supra.

In the ordinary case, the “transfer price” is to be

determined on a transaction-by-transaction basis for

each individual “sale of export property.” 26 U.S.C.

944(a); 26 U.S.C. 925(a). The DISC and FSC regula-

tions, however, allow a taxpayer to elect to apply the

“transfer price” rules on the basis of “groups” of ex-

ported products or product lines. Different “grouping”

regulations were adopted for this purpose under the

DISC and FSC regimes. 26 C.F.R. 1.994-(c)(7)(i)

(DISC); 26 C.F.R. 1.925(a)-1T(c)(8) (FSC). These

“grouping” rules are administratively efficient, for they

make it unnecessary for the taxpayer to file a separate

transfer price schedule for each and every sale. The

“grouping” rules also provide flexibility, for they permit

a taxpayer to elect one of the three “transfer price”

rules for one group of products and a different “transfer

price” option for another group.

The regulations generally give taxpayers a wide

discretion in determining which group of products to

select for separate transfer price determinations. The

regulations specify that the taxpayer’s choice to group

a “product or product line will be accepted” if it con-

forms either to “a recognized industry or trade usage”

or the “two-digit major groups * * * of the [SIC

codes].” 26 C.F.R. 1.994-1(c)(7). The DISC regulations

further state that a grouping choice made by the

taxpayer “in accordance with” these criteria will be

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

2. Petitioner claims (Pet. Br. 30) that the statement

in these regulations that the taxpayer may “group” its

28 The FSC regulations do not contain a similar statement. See

26 C.F.R. 1.925(a)-1T(eX(8).

sales for transfer price determinations by reference to

“recognized industry or trade usage” (26 C.F.R. 1.994-

1(c)(7)) conflicts with the requirement in the cost-

allocation regulation that, in calculating “combined

taxable income,” research costs are to be allocated

among all related products within the two-digit SIC

code (26 C.F.R. 1.861-8(e)(3)(i)(A)). As the Tax Court

explained in rejecting this assertion in the St. Jude

case, however, “[t]he grouping provisions do not

supersede the * * * allocation and apportionment

provisions because the provisions are not in conflict.”

97 T.C. at 480.

a. The cost-allocation regulations specify the manner

in which expenses and other deductions are allocated

and apportioned in determining “combined taxable

income” for DISCs and FSCs. 26 C.F.R. 1.861-

8(f)(1)(iii). It is, of course, for this very reason that the

cost-allocation rules of 26 C.F.R. 1.861-8 are expressly

cited and specifically incorporated in the DISC and

FSC regulations. 26 C.F.R. 1.994-1(c)(6)(iii); 26 C.F.R.

1.925(a)-1T(c)(6)Gii)(D). A calculation of “combined tax-

able income” has relevance, however, only if the tax-

payer elects that option from among the three available

choices for determining the “transfer price” for the

transactions.

b. The “grouping” rules of 26 C.F.R. 1.994-1(c)(7)

have an entirely different and separate function. The

grouping rules do not purport to prescribe rules for

allocating or apportioning expenses. They instead

merely allow the taxpayer to elect which groups of

sales will be evaluated under one, or another, of the

three alternative transfer pricing methods. See 26

C.F.R. 1.994-1(a)(1). As the Tax Court explained in St.

Jude (97 T.C. at 480):

The grouping provisions permit taxpayers to group

transactions for purposes of applying the three

DISC transfer pricing methods allowed by section

994(a). That is, a taxpayer may use the 4-percent

gross receipts method, the 50-50 combined taxable

income method, or the [arm’s length pricing]

method for different product-line groups during the

same year. However, regardless of the product-line

groups a taxpayer uses, and whether based on

recognized industry trade usage or otherwise, if the

taxpayer uses the 50-50 combined taxable income

method, research and development expenses are

allocable and apportionable, with respect to export

receipts attributable to that product-line group,

consistent with [the cost-allocation requirements of

26 C.F.R. 1.861-8].

In view of the coordination intended between (and

specified within) the provisions of these related regu-

lations, it makes no sense to assert that there is a fatal

“conflict” in their application. The research expense

allocation requirements of the Section 861 regulations

expressly state that they apply in determining “com- .

bined taxable income” for DISC and FSC purposes. 26

C.F.R. 1.861-8(f)(1)(iii), (8)(g) (Examples 22-23). The

DISC and FSC regulations also expressly state that

cost allocations for DISC and FSC purposes “are to be

determined in a manner consistent with the rules set

forth in [the Section 861 regulations].” 26 C.F.R. 1.994-

1(¢)(6)(iii).”

27 In St. Jude, the Eighth Circuit reversed the Tax Court and

accepted petitioner’s assertion that these two regulations are in

“conflict.” 34 F.3d at 1402. In doing so, however, the court of

appeals did not address or respond to the Tax Court’s explanation

of the separate and limited purpose served by the “grouping”

ce. In arguing that these regulations should be

viewed as in “conflict,” petitioner ignores not only their

plain text but also the applicable legal principles.

Under petitioner’s theory that the research expense

allocation rules are inapplicable for the determination of

“combined taxable income” for exported products, the

allocation rule would be made a nullity for the express

purpose for which it was adopted. See 26 C.F.R. 1.861-

8(f)(1)(iii). As the court of appeals emphasized in this

case, petitioner's Suggestion that such interrelated

regulatory provisions are “in conflict” ignores the

“cardinal principle of construction that . . . [wJhen

there are two acts upon the same subject,” courts are

“to give effect to both if possible.” Pet. App. 9a

(quoting United States v. Borden Co., 308 U.S. at 198).

Similarly, petitioner’s assertion that a “conflict”

exists between these regulations ignores the settled

rule that the agency’s interpretation of its own regu-

lations is “entitled to controlling weight unless it is

plainly erroneous or inconsistent with the regulation.”

Udall v. Tallman, 380 U.S. 1, 16 (1965) (quoting Bowles

v. Seminole Rock & Sand Co., 325 U.S. 410, 413-414

(1945)). The Secretary’s consistent and reasoned expla-

nation of the way in which these provisions cooperate,

rather than “conflict,” is entitled to special-weight in

this case because, in enacting the FSC, Congress

ratified application of the challenged regulations for

“the computation of combined taxable income of a DISC

regulations. The court instead simply assumed (as petitioner does

in its brief here) that, once an election is made under the “group-

ing” regulations, “costs should be allocated and apportioned

accordingly.” Jd. at 1401. As we describe in the text, however, the

plain text of the regulations refutes that assumption.

(or FSC) and its related supplier.” H.R. Rep. No. 861,

supra, at 1333. See page 33, supra.

CONCLUSION

The judgment of the court of appeals should be

affirmed.”

Respectfully submitted.

THEODORE B. OLSON

Solicitor General

EILEEN J. O’CONNOR

Assistant Attorney General

LAWRENCE G. WALLACE

Deputy Solicitor General

KENT L. JONES

Assistant to the Solicitor

General

DAVID ENGLISH CARMACK

FRANK P. CIHLAR

Attorneys

OCTOBER 2002

2% For the reasons acknowledged by petitioners (Pet. Br. 15

n.10), if the portion of the judgment of the court of appeals in favor

of the government is reversed, the portion of the judgment of the

court of appeals in favor of cross-respondent should then also be

reversed.

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. Section 174 of the Internal Revenue Code, 26

U.S.C. 174, provides in relevant part:

(a) Treatment as Expenses.—

(1) In general.—

A taxpayer may treat research or experimental

expenditures which are paid or incurred by him

during the taxable year in connection with his trade

or business as expenses which are not chargeable to

capital account. The expenditures so treated shall

be allowed as a deduction.

* * * * *

(b) Amortization of Certain Research and Experimental

Expenditures.—

(1) In general.—

At the election of the taxpayer, * * * research

or experimental expenditures * * * may be

treated as deferred expenses. In computing taxable

income, such deferred expenses shall be allowed as a

deduction ratably over such period of not less than

60 months as may be selected by the taxpayer

* * *

* * * * *

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

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

(la)

VIII, § 801(a), 98 Stat. 990) (July 18, 1984), 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 person shall be based upon a

transfer price which would allow such FSC 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) 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.

(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.

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

- solicitation (other than advertising), negotiation,

and making of the contract for such sale, have

been performed by such FSC (or by another per-

son 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.

(e) Taxable income.—

For purposes of this section, the taxable income

of a FSC shall be determined without regard to sec-

tion 921.

(f) Special rule for cooperatives.—

In any case in which a qualified cooperative sells

export property to a FSC, in computing the com-

bined taxable income of such FSC and such organi-

zation 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 dividends, 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 FSCs

* * * * *

(cX6) Full costing combined taxable income—

(i) In general. 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)(ii)) which relate to the foreign trading gross

receipts. Interest or carrying charges with respect

to the sale are not foreign trading gross receipts.

(ii) Section 482 applicability. Combined tax-

able income under this paragraph shall be deter-

mined 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 compensate the related supplier an arm’s

length amount under the provisions of § 1.482-2(b)

(1) through (6). Section 1.482-2(b)(7), which pro-

ait re itiiienneerieel

vides 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 F'SC’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 income where

the related supplier is a qualified cooperative share-

holder 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.

(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) AFSC 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.

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).

(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 re-

lated, 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 gross 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 combined 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 allocations and non-

patronage 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 combina-

tions thereof, within a major group) of the Stan-

dard Industrial Classification as prepared by the

Statistical Policy Division of the Office of Man-

agement 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

transactions for a taxable year on a product or

product line basis shall apply to all transactions

with respect to that product or product line

consummated during the taxable year. However,

the choice of a product or product line grouping

applies only to transactions covered by the

grouping and, as to transactions not encompassed

by the grouping, the determinations are 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 de-

termined under the standards of subdivision

(8)(ii) of this paragraph. Non-military property

included within a product or product line group-

ing which includes military property may be

grouped, at the election of the related supplier,

under the general 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

requirements 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 group-

ing rule provides 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

corporations, 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 transactions is required by this subdivision,

and if grouping 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 grouping.

(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)).

* * * + *

10a

(g) Effective date. The provisions of this

section and § 1.925 (b)-1T apply with respect to

taxable year ending after Deceniber 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 Fed. Reg. 66,503 (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 exper-

imental 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 ex-

perimentation 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 pro-

duct category (or categories) of the taxpayer and

therefore allocable to all items of gross income as a

class (including income from sales, royalties, and

dividends) related to such product category (or

categories). For purposes of this allocation, the

product category (or categories) 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 re-

lla

search and experimental expenditures may be divid-

ed between the relevant product categories. Where

research and experimentation is conducted with re-

spect to more than one product category, the tax-

payer 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

classification codes. A taxpayer shall determine the

relevant product categories by reference to the

three digit classification of the Standard Industrial

Classification Manual (SIC code). A copy may be

purchased 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,

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

12a

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 ag-

gregation, disaggregation or change of a previously

selected SIC code category.

* * * * *

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.