Petition for Writ of Certiorari — Brown-Forman Corp. v. Commissioner

Rupreme Cour, Ue

91 BOLE FILED

1 JUN 15 1992

SS GFFOE UP TRE, CLERK

IN THE

Supreme Court of the United States

OCTOBER TERM, 1991

BROWN-FORMAN CORPORATION (a Delaware corporation),

successor by merger to Brown-Forman Corporation (a

Tennessee corporation), successor in interest to South-

ern Comfort Corporation (a Delaware corporation),

Petitioner,

Vv.

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

On Petition for Writ of Certiorari to the

United States Court of Appeals

for the Sixth Circuit

PETITION FOR WRIT OF CERTIORARI

MARK L. EVANS

Counsel of Record

WALTER D. HAYNES

MILLER & CHEVALIER, CHARTERED

Metropolitan Square

655 Fifteenth Street, N.W.

Washington, D.C. 20005-5701

(202) 626-5800

Counsel for Petitioner

WILSON - Eras PRINTING Co., INC. - 789-0096 - WASHINGTON, D.C. 20001

S 1

QUESTION PRESENTED

Whether the regulations under Section 994 of the

Internal Revenue Code, which authorizes a taxpayer to

deduct commissions paid to a Domestic International

Sales Corporation equal to 50 percent of the taxable in-

come from export sales, can be validly applied to allocate

to export sales a class of expenses (federal excise taxes)

related exclusively to domestic products.

(i)

ii

PARTIES AND AFFILIATED COMPANIES

All parties to the proceeding below are named in the

caption. Brown-Forman Corporation, the parent corpo-

ration, has no publicly owned affiliated companies.

TABLE OF CONTENTS

Page

QUESTION PRESENTED ............ se Eo TFS TE a i

PARTIES AND AFFILIATED COMPANIES ............. ii

I RT I RIED cccscoscascsouncesdncsicenssnensccasacses iv

3 2 regan nintninsntncnesacsanmunensnes 1

ESE eo 2

STATUTES AND REGULATIONS INVOLVED........ 2

STATEMENT ............... Sail OS pelea RE Spa? FCO 2

REASONS FOR GRANTING THE WRIT .................... 7

ee . caasnasanbaceetntsnseanonnestontenst 14

APPENDIX

Opinion of Sixth Circuit............ CEE A TO la

i nkcemasdenantnmanunnsoconinanaconnnnncens 14a

Order Denying Rehearing .......................--.---------++-00+- 55a

Computation of OPPL (Overall Profit Percentage

Ne i) cclliambtbininceness 56a

Internal Revenue Code of 1954 .................----.---.....---- 58a

a ase daslidininnbbonbenaishchabeb 60a

(iii)

iv

TABLE OF AUTHORITIES

Cases Page

Arrow Fastener Co. v. Commissioner, 76 T.C. 423

8) PTS SCR Ae ee Nr ee a 7

Caterpillar Tractor Co. v. United States, 589 F.2d

Re ee ee ae 7

Dow Corning v. United States, Fed. Cir., Dkt. No.

| SERENE OE ee 8

Durbin Paper Stock Co. v. Commissioner, 80 T.C.

SO IID cscteiainistotssnsvivcidnasintidccscconmiinpiebiaciaicete 7

Gehl Co. v. Commissioner, 795 F.2d 1824 (7th Cir.

1986) ....... silat dailies tathiia ca ttnanvatltta danainisiglalings 7

Le Croy Research Systems Corp. v. Commissioner,

8 - & 8: Fe | | eee eee 7

Missouri Pacific Railroad Co. v. United States, 411

F.2d 827 (8th Cir. 1969), cert. denied, 396 US.

RE I Shs cere saietaies ss oacttaiedtinieiauices 9

United States v. Cartwright, 411 U.S. 546 (1978)... 11

Statutes and Regulations

Internal Revenue Code

SS LR ca cai Maa a a sa ection 2

ER Re erro mee ere 2

Ci ieee 3, 9, 10

Treasury Regulations

ee NI CD cin cccicinsideicee eck. 9

BE | NE : Ie nenes UEP One 6

8 | | Se ee a 6

Section 1.994-2(e) (Example 1) ................2200.... 6

Tk Bap ba ris ime inene ibe Uhisiacte (ie eas aaah 2

Legislative Materials

S. Rep. No. 437, 92d Cong., Ist Sess. (1971) -......... 10

H.R. Rep. No. 533, 92d Cong., lst Sess. (1971) .... 10

IN THE

Supreme Cowt of the United States

OCTOBER TERM, 1991

No.

BROWN-FORMAN CgRPORATION (a Delaware corporation),

successor by merger to Brown-Forman Corporation (a

Tennessee corporation), successor in interest to South-

ern Comfort Corporation (a Delaware corporation),

¥ Petitioner,

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

On Petition for Writ of Certiorari to the

United States Court of Appeals

for the Sixth Circutt

PETITION FOR WRIT OF CERTIORARI

Brown-Forman Corporation petitions for the issuance

of a writ of certiorari to review the judgment of the

United States Court of Appeals for the Sixth Circuit in

this case.

OPINIONS BELOW

The opinion of the court of appeals (App. la-18a)’ is

not yet reported. The opinion of the Tax Court (App.

14a-54a) is reported at 94 T.C. 919.

1 “App.” refers to the appendix to this petition.

2

JURISDICTION

The judgment of the court of appeals was entered on

February 3, 1992. Petitioner’s timely petition for re-

hearing was denied on March 17, 1992. App. 55a. The

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

§ 1254(1).

STATUTES AND REGULATIONS INVOLVED

The relevant portions of I.R.C. §§ 991, 992, and 994

and Treas. Reg. § 1.994-2 are set forth at App. 58a-68a.

STATEMENT

1. Petitioner, Brown-Forman Corporation, is the trans-

feree of all of the assets of the Southern Comfort Cor-

poration. Brown-Forman brought this suit in the United

States Tax Court to contest income tax deficiencies for the

years ending April 30, 1981, and April 30, 1983, which

had been asserted by the Commissioner against Southern

Comfort.

During the taxable years in issue Southern Comfort

engaged in the production and sale of Southern Comfort

liqueur. It sold the liqueur both for consumption in the

United States and for export to foreign markets. For its

export sales, Southern Comfort paid commissions to a

Domestic International Sales Corporation (DISC). Con-

gress added the DISC provisions to the Code in an effort

to stimulate exports to alleviate the country’s chronic

balance of payment problems. See Sections 991 et seq.’

In part, these provisions authorized taxpayers to de-

duct for federal income tax purposes commissions on

export sales paid to a DISC. For purposes of this case,

the amount of deductible DISC commissions on export

sales was 50 percent of the taxable income from the export

sales. Section 994(a) (2). The issue presented here is

2 Unless otherwise indicated, all Section references are to the

Internal Revenue Code as amended and in effect for the years in

issue.

3

the correct method of computing the taxable income from

the export sales of the Southern Comfort liqueur, which

in turn determines the deductible DISC commissions.

Section 5001(a)(1) imposed an excise tax equal to

$10.50 per proof gallon on the Southern Comfort liqueur

sold for consumption in the United States. That federal

excise tax on distilled spirits is not imposed, however, with

respect to exported distilled spirits. Pursuant to section

5005 (e) (2), liability for such tax terminates at the time

of export. Thus, Southern Comfort incurred no fed-

eral excise tax expense with respect to its liqueur sold

for export.

For purposes of computing the taxable income from

export sales, Congress authorized the issuance of regula-

tions providing that only incremental or marginal costs

had to be allocated to export sales where the taxpayer was

trying to establish or maintain a market for the export

property. Section 994(b)(2). The theory was that a

taxpayer that had already incurred the fixed costs to

produce its product for domestic consumption would have

to incur only incremental or marginal costs to produce

the product for new export sales. Therefore, only the

marginal costs should be taken into account in determin-

ing the taxable income from those export sales.

2. Southern Comfort used this marginal cost method

in determining its taxable income from export sales.

Except for one item, Southern Comfort and the Com-

missioner are in agreement as to all items that should be

deducted in arriving at the taxable income from the ex-

port sales of the Southern Comfort liqueur.

The one item in dispute is excise taxes imposed on the

liqueur sold for consumption in domestic markets. The

Commissioner, in determining the taxable income from the

export sales of Southern Comfort liqueur, allocated to

4

export sales $1.3 million of federal excise taxes that were

imposed on the liqueur produced for consumption in the

domestic market. By deducting from the export sales

excise taxes imposed on the liqueur produced for the

domestic market, the Commissioner reduced the taxable

income from the export sales, thereby reducing the

amount of allowable DISC commissions.

The Commissioner’s position is illustrated by Table 1

set forth below.* Column 1 on the left is reproduced from

Exhibit A, p. 1 of the Commissioner’s own Computation

for Entry of Decision in the Tax Court. The column on

the right is Southern Comfort’s position. Line 8 of Table

1 (printed in bold) reflects the item in controversy,

which is the excise taxes imposed exclusively on the prod-

uct produced for the domestic market, which the Commis-

sioner has applied to reduce the income from export sales:

3 Table 1 above is for the taxable year ending April 30, 1981.

Throughout this petition the issues are illustrated and discussed

using that year. Although different amounts are involved for the

year ending April 30, 1983, the other year before the Tax Court,

the principles involved are the same.

a

es ff PP PP

Table 1

Col. 2

Col. 1 Southern

Commissioner Comfort’s

Southern Comfort FY 4/30/81 Per Tax Court Position

Export Sales 8,184,381.00 8,184,381.00

Marginal or Variable Costs:

Cost of Goods Sold:

Other than Excise Taxes 3,387,860.00 3,387,860.00

Excise Taxes on Domestic Sales —1,311,137.45

Total Cost of Goods Sold 4,698,997.45 | 3,387,860.00

Non-marginal or Non-variable Costs:

Miscellaneous 1,205,215.00 1,205,215.00

Total Costs Allocable to

Export Sales 5,904,212.45 4,593,075.00

_ Combined Taxable Income of DISC

and its Supplier from Export Sales

(Export Sales-Total Costs )

Allocable to Export Sales 2,280,168.55 3,591,306.00

DISC Commission Rate 50.00% 50.00%

1,140,084.28 1,795,653.00

. Add Other DISC Expenses

Miscellaneous 146.00 146.00

State Income Tax 72,771.34 114,616.15

. DISC Commissions 1,213,001.61 1,910,415.15

_ Taxable Income from Export Sales 2,280,168.55 3,5. 1,306.00

. Export Sales 8,184,381.00 8,184,381.00

Overall Profit Percentage

Limitation (OPPL) 38/39 27.86% 43.88%

NOTE: The computation of the worldwide OPPL (i.e., domestic

and export) is reproduced at App. 56a-57a.

6

The basis for the Commissioner’s allocation on line 8

of Table 1 to the export sales of the excise taxes imposed

solely on domestic goods was a regulatory provision, not

found in the statute, called the Overall Profit Percentage

Limitation (OPPL). Treas. Reg. § 1.994-2(b) (3) and

(c) (2). In essence, the OPPL limitation provides that the

profit margin or percentage (i.e., taxable income divided

by gross receipts) for export sales after marginal costing

cannot be greater than the profit margin on a full cost

basis for domestic and export sales combined (i.e., overall

or worldwide sales). If the profit margin on the export

sales does exceed the “overall” profit margin, the OPPL

regulation requires that some non-marginal costs of pro-

ducing the export product must be allocated to export sales

to reduce their profitability to the “overall” profit margin.

See Treas. Reg. § 1.994-2(e) (Example 1).

As Table 1 shows (see line 15, column 2), Southern

Comfort does not disagree with the OPPL regulations and

concept in general, and it agreed to allocate to export

sales $1,205,215 of non-marginal costs of producing the

export product. Southern Comfort allocated those non-

marginal costs to export sales to reduce the profit margin

on export sales to 43.88%, which is the “overall” profit

margin or OPPL for domestic and export sales combined

as computed by Southern Comfort. See App. 56a. But

Southern Comfort argued that, because domestic excise

taxes are not costs of producing the export product, the

Commissioner could not lawfully allocate those taxes to

export sales.

The Commissioner allocated the domestic excise taxes

- to the export product to reduce the profit margin on

export sales to 27.86%. Table 1, line 40. The 27.86%

is the “overall” profit margin or OPPL according to the

Commissioner’s computation. See App. 57a. The OPPL of

only 27.86% produced by that computation (instead of

Southern Comfort’s 43.88%) was the Commissioner’s

justification for allocating domestic excise taxes to export

sales even though no such taxes were incurred in produc-

ing the export product.

7

3. The Tax Court agreed with the Commissioner’s posi-

tion in this respect. App. 14a-54a. A divided Sixth Cir-

cuit affirmed. Jd. at la-13a. Judge Nelson dissented,

finding that the regulation as interpreted by the Commis-

sioner did not “represent a rational method of carrying

out the task assigned to the Commissioner by Congress.”

Id. at 10a. He found the Commissioner’s position irra-

tional because “[b]y no stretch of the imagination can

excise taxes paid on products sold domestically be consid-

ered part of the marginal costs of producing property for

sale abroad.” Jd. at 1la.

REASONS FOR GRANTING THE WRIT

1. This case is one of a series that illustrate a con-

certed effort by the Internal Revenue Service to restrict

and deny DISC benefits legitimately authorized by Con-

gress. The Congress enacted the DISC provisions in an

effort to stimulate domestic production and export sales

to relieve this country’s balance of payment problems.

The Internal Revenue Service has not administered the

DISC provisions in that spirit. Instead, by a series of

hostile interpretations of the Code and Regulations, the

Internal Revenue Service has sought to restrict the DISC

benefits and stimulations to export that Congress intendec.

On three occasions the courts have had to invalidate

various provisions of the DISC regulations. Durbin Paper

Stock Co. v. Commissioner, 80 T.C. 252, 261 (1983) ;

Arrow Fastener Co. v. Commissioner, 76 T.C. 423, 431

(1981); Caterpillar Tractor Co. v. United States, 589

F.2d 1040 (Ct. Cl. 1978). In two other cases, two differ-

ent coufts of appeals stated that the Service’s adminis-

tration of the DISC provisions “smells of a bushwhack.”

Le Croy Research Systems Corp. v. Commissioner, 751

F.2d 123, 128 (2d Cir. 1984) ; Gehl Co. v. Commissioner,

795 F.2d 1324, 1333 (7th Cir. 1986).

In this case, however, the court of appeals deferred to

the Commissioner and incorrectly upheld his effort to

——————eEeEeEeEeEeEeEOEOE

s

8

restrict the DISC treatment conferred by Congress. The

issue presented here is of substantial importance. All

similarly situated taxpayers will be subjected to exces-

sive income tax liabilities on an ongoing basis for many

years as a result of the Sixth Circuit’s erroneous deci-

sion. Moreover, the decision will have ramifications not

only for DISCs but aiso for FSCs (Foreign Sales Cor-

porations), which are governed by analogous regulations.

See App. 47a-48a. Unless the Court steps in to correct

this error, the Secretary of the Treasury will be permitted

to use the regulatory process to advance short-term reve-

nue enhancement objectives by undermining export incen-

tives enacted by Congress to relieve our country’s balance

of payment problems.

Although there is no direct conflict in the circuits at

present, a case raising the issue of the validity of the

OPPL regulations has been under submission for more

than a year in the United States Court of Appeals for

the Federal Circuit (Dow Corning v. United States, No.

90-5150 (argued Mar. 4, 1991)). If the taxpayer pre-

vails in that case, the decision will create a direct conflict

with the decision of the Sixth Circuit in this case. If the

Court is not inclined to grant certiorari in this case at

this time, it should hold ths petition pending the Federal

Circuit’s decision in Dow Corning.

2. The court of appeals erred in computing the allow-

able DISC commissions. Reducing taxable income from

the export sales of the liqueur by the amount of excise

taxes imposed exclusively on the liqueur produced for

sale in the domestic market is improper and unlawful for

two reasons. First, by law the liqueur sold in the export

market is not subject to excise taxes, and therefore it

cannot be allocated to export sales.

Second, the statute authorized the Commissioner to

allocate to export sales only costs incurred in producing

the export. product. The domestic excise taxes are not

costs incurred in producing the export product. The Com-

missioner does not have any authority to allocate to

9

export sales costs (here federal excise taxes) that are

incurred exclusively in producing the domestic product.

See Missouri Pacific Railroad Co. v. United States, 411

F.2d 327, 338-385 (8th Cir. 1969), cert. denied, 396 U.S.

1087 (1970) (for foreign tax credit purposes, it was

improper to allocate to Mexican source income U.S. state

property taxes on railroad cars because such taxes were

not “related to or necessary for the production of in-

come” from Mexico).

As a matter of simple cost accounting, it is improper

to allocate to export sales excise tax costs that are not

incurred in producing the liqueur sold in the export mar-

kets. Regulation § 1.994-2(b) with respect to the margi-

nal costing method applicable to this case provides :

Marginal costing rules for allocations of costs—(1)

In general. Marginal costing is a method under

which only marginal or variable costs of producing

and selling a particular item, product, or product

line are taken into account for purposes of section

994.

The excise taxes imposed with respect to the liqueur sold

in the domestic markets are not “costs of producing and

selling” the liqueur for export. Increases or decreases in

the quantity of export sales will not vary the excise taxes

imposed with respect to the domestic sales. Accordingly,

it is improper to allocate the domestic excise taxes to the

export sales that by law are not subject to those taxes.

Code Section 994(b) (2) provides the authority for the

issuance of regulations dealing with the allocation of

costs to export sales in order to determine the taxable in-

come from those sales for purposes of determining DISC

commissions. Section 994(b) (2) provides as follows:

(b) Rules for Commissions, Rentals and Marginal

Costing.—The Secretary shall prescribe regula-

tions setting forth—

* * * *

10

(2) rules for the allocation of expenditures in

computing combined taxable income under

subsection (a) (2) in those cases where a

DISC is seeking to establish or maintain a

market for export property.

The Senate Finance Committee Report issued in connec-

tion with the enactment of Section 994(b) (2) explains

the authority granted by that section as follows:

Where a DISC is attempting to establish a market

abroad, or seeking to maintain a market abroad, for

exports, the Secretary of the Treasury may prescribe

by regulations special rules governing the allocation

of expenses incurred on the sale of the export prop-

erty for purposes of determining the combined tax-

able income of the related person and the DISC. It

is expected that in the appropriate cases the regula-

tions will aiiow, for purposes of applying the second

pricing rule, the combined taxable income on the sale

of export property to reflect a profit equal to that

which the DISC and a related party would earn if_

they took into account only the marginal costs of pro-

ducing the property.

S. Rep. No. 437, 92d Cong., Ist Sess. 75 (1971) (em-

phasis added). The same statement appears in the House

Report. H.R. Rep. No. 533, 92d Cong., 1st Sess. 108

(1971).

The Committee Report explicitly states that the regu-

lations authorized to be issued are to govern the “alloca-

tion of expenses incurred on the sale of the export prop-

erty” (emphasis added). Here, the domestic excise taxes

the Commissioner has allocated to the export sales were

not incurred on the sale of export property. Further-

more, the last sentence of the Committee Report makes it

clear that in determining the “taxable income on the sale

of export property,” there shall be taken into account

“only” the “costs of producing the property’ (emphasis

added). The phrase “the property” refers back to “export

property.” Thus, Section 994(b) (2) authorizes regula-

Si 5 Nien ck Ain Wn en inline ab I Henao aL ND uel

11

tions that will provide for costs incurred only in produc-

ing export property to be deducted in determining the

taxable income from the sale of export property. In con-

trast, the Commissioner here has interpreted and applied

the OPPL Regulation to allocate to export property costs

(excise taxes) incurred to produce domestic property.*

By interpreting and applying the OPPL Regulation to

allocate to export sales the excise taxes imposed only with

respect to domestic sales, the Commissioner has exceeded

the congressional authorization of Section 994(b) (2).

That is an invalid exercise of regulatory authority.

United States v. Cartwright, 411 U.S. 546, 550 (1973).

Contrary to Southern Comfort’s position, the Sixth Cir-

cuit majority held “that the OPPL does not allocate

costs,” that the OPPL is merely a “limitation” on export

taxable income, and accordingly that no domestic excise

taxes were allocated to export sales. App. 7a. These con-

clusions cannot withstand analysis. As the dissent below

forcefully pointed out, the majority’s analysis is contrary

both to the Tax Court’s findings and to the Commission-

er’s own computations (App. 1la-12a):

_By no stretch of the imagination can excise taxes

paid on products sold domestically be considered part

of the marginal costs of producing property for sale

abroad. Yet as the Tax Court specifically acknowl-

edged at page 29 of its opinion in this case, “the fact”

is that the application of the Commissioner’s overall

. profit percentage limitation “results in the allocation

of some excise tax costs to gross receipts from ex-

port sales... .”

In computations submitted to the Tax Court on be-

half of the Commissioner after the Tax Court opinion

4The majority opinion of the Sixth Circuit, in attempting to

deal with the language of the Committee Reports (App. 8a, n.3),

fails to address the language of the report which states that “only”

costs “incurred” on the sale of the export property can be allocated

to the sales of export property.

12

was issued (Jt. App. p. 84), the Commissioner set

forth the exact dollar amount of the taxpayer’s do-

mestic excise taxes “[a]llocable” to export sales un-

der the marginal cost method endorsed by the Tax

Court. (Jt. App. p. 93.) For tax year 1981, the

excise taxes thus allocable to export sales came to

$1,311,137.45—which is more than 22 percent of

the total costs considered allocable to export sales.

Id.

The Commissioner contends that his marginal cost-

ing rules do not really result in the allocation of

excise taxes to export sales, despite what his own

computations show, because excise taxes are merely

included in an overall profit percentage formula used

“to limit the amount of profit that could be earned

by the DISC from export sales under the marginal

costing method.” Brief of respondent-appellee, p. 15.

The Commissioner may be correct in a purely formal

sense, but not, I think, in any substantive sense.

Indeed, the only difference between the parties in this

case is that the Commissioner in computing export taxable

income used a profit margin (OPPL) for export sales

that included domestic excise taxes as a cost while South-

ern Comfort used a profit margin for export sales that

did not include excise taxes, since export sales are not

subject to those taxes. There can be no doubt that the

Commissioner’s methodology reduces export taxable in-

come by the domestic excise taxes since that is the only

difference in the profit margins used by the parties.

The decision below fails to recognize that Southern

Comfort’s position complies with the basic purpose of the

OPPL. The majority opinion states that the purpose of

the OPPL limitation is to permit the use of “marginal

costing only to the extent that the profitability of its

export activities does not exceed the profitability of the

corporation’s worldwide activities, including domestic

sales.” App. 4a (emphasis added). The opinion further

states incorrectly that Southern Comfort’s position fails

to take excise taxes into account in computing world-

13

wide profitability. Jd. at 6a. To the contrary, South-

ern Comfort’s position does take excise taxes into ac-

count in computing worldwide profitability. But world-

wide profitability is not in dispute. Only export profita-

bility is in dispute because Southern Comfort is entitled

to deduct as DISC commissions 50 percent of export

profits. Furthermore, and most importantly, export prof-

itability after applying the OPPL limitation as computed

by Southern Comfort does not exceed worldwide profit-

ability.

This point is illustrated by Table 2 below. Set forth

in Column A for Fiscal 1981 is the stipulated world-

wide profit per case of $6.16, which is not in dispute and

which takes into account excise taxes as shown on line 2.

In Column B is the export profit per case of $5.61 as com-

puted by Southern Comfort. The $5.61 of export profit

does not exceed the agreed worldwide profit of $6.16. Thus,

the stipulated facts demonstrate that Southern Comfort

has complied with the two key principles of the majority

opinion. Export profit does not exceed worldwide profit,

and worldwide profit takes excise taxes into account.

Table 2

Amounts Per Case Fiscal Year Ending 4/30/81

Col. A Col. B Col. C

Agreed Taxpayer Commissioner

Worldwide Export Export

1 Sales $48.26 $24.93 $24.93

2 Excise Taxes — 20.89 —2.43

3 Total 27.87 24.93 ~ 22.50

4 Other Costs — 21.21 —19.32 —-19.32

5 Profit ~ $6.16 ~ $5.61 $3.18

Source: Col. A—Stip. Ex. 41-AO, Col. A, Lines 11-20; Stip. Ex.

44-AR, Col. 1, Lines 11-20

Col. B—Stip. Ex. 41-AO, Col. 3, Lines 11-20

Col. C—Stip. Ex. 44-AR, Col. 3, Lines 11-20

The problem in this case is shown by Column C. There

the Commissioner, after applying his methodology for

the OPPL, has allocated excise taxes to export sales on

i4

line 2, even though export sales are not subject to those

excise taxes. This allocation dramatically reduced export

profit to $3.18, which is only 52 percent of the $6.16

worldwide profit. That reduction is contrary to the key

principle of the majority opinion, namely, that worldwide

profit is only a limit on export profit.

There is no rationale to support the Commissioner’s

reduction of export profit to only 52 percent of world-

wide profit. That result undermines the purpose of the

DISC provisions by creating a disincentive to export.

The basic mechanical problem with the Commissioner’s

methodology is that he computes the OPPL profit margin

limitation as a percentage of sales that includes excise

taxes. However, even if export profits per case are ex-

actly the same as worldwide profits, the export profit

percentage will always be higher because the worldwide

selling price, which includes domestic excise taxes, is

approximately double the export selling price, which does

not include excise taxes. See Table 2, supra, line 1.

When the export profit per case is the same, or, as

in this case, less than worldwide profit per case, there

is no merit in the suggestion that export sales are more

profitable merely because they have a higher profit mar-

gin. Southern Comfort does not put more money in its

pocket from export sales as shown by Table 2, line 5.

CONCLUSION

The petition for a writ of certiorari should be granted.

Respectfully submitted,

MARK L. EVANS

Counsel of Record

WALTER D. HAYNES

MILLER & CHEVALIER, CHARTERED

Metropolitan Square

655 Fifteenth Street, N.W.

Washington, D.C. 20005-5701

(202) 626-5800

JUNE 1992 Counsel for Petitioner

INS EE

.

oO

y

rr

a

a.

<f

ae Sire ies eS Ss Be

VO 4 OTS

hn OPER Saar Xt * ss

PT ap epeeetnet

PRES RESIN ESO Ret Ae I aI

% *

is

>

~ ;

% <

x -. -

a Ma

n SY

° — 0

-

= he — _

. ¢

- -

_

3 .

—

~a " _-

me

-_

‘ >

. bd Dy

. = ~

. :

= ~ :

<—

~

>) x 7

* < S

? ~* - fn

la

APPENDIX

UNITED STATES COURT OF APPEALS

FOR THE SIXTH CIRCUIT

No. 91-1108

BROWN-FORMAN CORPORATION (a Delaware corporation),

successor by merger to Brown-Forman Corporation (a

Tennessee corporation), successor in interest to South-

ern Comfort Corporation (a Delaware corporation),

Petitioner-A ppellant,

V.

COMMISSIONER OF INTERNAL REVENUE,

Respondent-A ppellee.

On Appeal from the United States Tax Court

Decided and Filed February 3, 1992

Before: NELSON and SUHRHEINRICH, Circuit

Judges ; and ENGEL, Senior Circuit Judge.

SUHRHEINRICH, Circuit Judge, delivered the opin-

ion of the court in which ENGEL, Senior Circuit Judge,

joined. NELSON, Circuit Judge (pp. 10-13), delivered

a separate dissenting opinion.

SUHRHEINRICH, Circuit Judge. The Brown-Forman

Corporation appeals a decision of the United States Tax

Court holding that, for the purposes of computing the

2a

overall profit percentage limitation, Treas. Reg. § 1.994-

2(b) (8), the taxpayer’s gross receipts are not reduced

by federal excise taxes paid during the tax year. We

affirm.

I

The Brown-Forman Corporation now holds all the as-

sets of the Southern Comfort Corporation (“Southern

Comfort”). Southern Comfort engages in the production

and sale of Southern Comfort liqueur for domestic con-

sumptior and for export to foreign markets. In 1981

and 1983, Southern Comfort conducted export sales

through a Domestic International Sales Corporation

(“DISC”), Jack Daniel International (“JDI’’).

Congress enacted legislation permitting the establish-

ment of DISCs out of concern over the balance of trade.

Congress found that tax considerations were causing do-

mestic companies to supply foreign markets through for-

eign subsidiaires rather than by exporting domestically

produced commodities. The DISC legislation was adopted

as a vehicle through which domestic enterprises would re-

ceive a tax deferral for export-related income, providing

an incentive to produce goods for export in the United

States.

The actual process by which a DISC yields a tax de-

ferral is fairly complicated. The DISC does not pay tax

on its income. Instead, the DISC’s shareholders, typically

the domestic producer that conducts export activities

through the DISC, are taxed on a specified percentage

of the DISC’s current income. The remainder of the

DISC’s income is not taxed until it is actually distributed

to shareholders, the shareholders dispose of their stock,

or the corporation ceases to qualify as a DISC. I.R.C.

§ 995(b)-(c). Thus, the more income allocated to the

DISC, the greater the tax deferral.

The Internal Revenue Code provides three methods to

determine the amount of income that may be allocated

to a DISC. At issue in this case is the Combined Taxable

oe The 4 Aisi ta EDO

AOI petites 6 > Mla

hii. pn ee ae ee ee

3a

Income method. This method allocates to the DISC fifty

percent of the combined taxable income of the DISC and

its related supplier, in this case Southern Comfort, at-

tributable to export sales plus ten percent of the DISC’s

export promotion expenses. I.R.C. § 994(a) (2).2. Com-

bined taxable income is generally derived using the full

costs involved in generating the export income. Thus,

combined taxable income is equal to gross receipts from

export sales minus the total costs of these sales to the

Dise and its related supplier. Treas. Reg. § 1.994-1(c)

(6).

As an exception to this general formula, the Commis-

sioner of Internal Revenue has promulgated regulations

allowing a taxpayer to compute combined taxable income

using the marginal, rather than full, costs of the DISC

and its related supplier. This exception applies only if

the DISC is “seeking to establish or maintain a foreign

market.” Treas. Reg. § 1.994-2(a). However, the com-

bined taxable income derived through marginal costing

may not exceed the Overall Profit Percentage Limitation

(“OPPL”). The OPPL restricts the combined taxable

income from export sales of a DISC and its related sup-

plier to “gross receipts (determined under [Treas. Reg. |

§ 1.993-6) . . . multiplied by the overall profit percent-

1 Section 994(a)(1) allows a DISC to earn taxable income equal

to four percent of combined taxable income plus 10% of its export

promotion expenses. Section 994(a) (3) allows a DISC to earn in-

come based on the actual price charged by its related supplier, sub-

ject to the arm’s length pricing rules of section 482.

These rules apply to “buy/sell” DISCs, those that actually pur-

chase product from a related supplier and resell them on an export

market. Some DISCs, such as JDI, never actually purchase the

product exported. Instead, they arrange export sales on a commis-

sion basis. These are referred to as commission DISCs. Section

994(b) directed the commissioner to promulgate regulations govern-

ing the computation of taxable income for commission DISCs in a

manner consistent with the three methods set forth in section

994(a). In Treas. Reg. § 1.994-1(c)(1)-(4), the commissioner es-

tablished rules that give commission DISCs the same options for

income computation that are available to buy/sell DISCs.

4a

age.” Id. § 1.994-2(b) (3). The overall profit percentage

is the combined worldwide taxable income of the DISC

and its related supplier (including the related supplier’s

income from domestic sales) divided by its worldwide

gross receipts, determined under § 1.993-6. Expressed

mathematically,

Combined Taxable

Comb. Taxable < Income (worldwide) x Gross Receipts

Income (export) Gross Receipts (export).

(worldwide) ,

The effect of this provision is to allow a DISC that is

establishing or maintaining an export market to use mar-

ginal costing only to the extent that the profiability of

its export activities does not exceed the profitability of

corporation’s worldwide activities, including domestic sales.

In their original returns for 1981 and 1983, South-

ern Comfort and JDI did not use marginal costing to com-

pute DISC commissions. However, Southern Comfort

and JDI have filed amended returns for these years that

utilize marginal costing. In computing the OPPL, South-

ern Comfort and JDI reduced worldwide gross receipts

by the amount of federal excise tax paid.

A federal excise tax is imposed on each proof gallon of

distilled spirits sold for domestic consumption. I.R.C.

§ 5001(a) (1). This tax liability is represented by a lien

attaching at the moment the distilled spirits are created.

Id. § 5004. The lien and tax liability are extinguished

when the spirits are exposed. The distiller retains tax

liability for spirits not exported, even after the distiller

sells the spirits for consumption. Distillers, including

Southern Comfort, typically recoup this liability by in-

creasing the price of the spirits by a corresponding

amount.

The issue raised here is whether worldwide gross re-

ceipts include funds received in domestic sales that are

used to pay the federal excise tax.

5a

II

The regulations establishing the OPPL expressly adopt

the definition of “gross receipts” contained in Treas. Reg.

§ 1.993-6, see Treas. Reg. § 1.994-2(b) (3); id. § 1.994-

2(c) (2), which defines gross receipts as “(t]he total

amounts received or accrued by the person from the sale

or lease of property held primarily for sale or lease in the

ordinary course of a trade or business . . . .” Treas. Reg.

§ 1.998-6(a). “The total amounts received” plainly in-

cludes excise tax receipts.

The Ninth Circuit construed a similar definition of

gross receipts in Lucky Lager Brewing Co. v. Commis-

sioner, 246 F.2d 621 (9th Cir. 1957). At issue in Lucky

Lager was interpretation of I.R.C. § 485, enacted to re-

capture “excess profits” that manufacturers received dur-

ing the Korean War. In particular, the court was asked

whether gross receipts included excise taxes paid by the

manufacturer and passed on to its customers. The Ninth

Circuit held that “[t]he language .. . that ‘gross receipts’

are ‘the total amount received or accrued. . . from the

sale. . . of stock in trade’ is irrefutably plain.” Jd. at

623 (quoting I.R.C. § 435(e)). The court continued, “[i]t

is a logical absurdity to contend that the ‘total amount

received’ from the sales is not what the customer paid but

a lesser amount determined by a deduction of a particular

tax paid, here required to be paid and in fact paid by the

seller, before the delivery of the [goods].” Id.

Southern Comfort urges us to ignore the definition in

section 1.993-6 in favor of interpreting gross receipts

under Treas. Reg. § 1.936-5(b) (5) (Q&A #1). This

regulation excludes federal excise taxes from the compu-

tation of gross receipts from sales of “possession prod-

ucts.” But this section does not apply to DISCs. See

LR.C. §936(f). Given the clarity of the definition of

gross receipts in section 1.993-6, we are unmoved by

Southern Comfort’s argument.

6a

Southern Comfort contends that the OPPL is designed

to limit export profitability, derived under marginal

costing, to worldwide profitability. If worldwide profit-

ability is computed without a reduction for excise taxes,

the argument continues, worldwide profitability ceases

to be a valid parameter because export profitability does

not include excise taxes. This argument assumes its con-

clusion: that excise taxes are not a valid component of

worldwide profitability.

This assumption is misplaced. The federal excise tax is

a cost of doing business. See Thompson v. United States,

142 U.S. 471 (1892); Schenley Distillers, Inc. v. United

States, 255 F.2d 334 (3d Cir. 1958). Liability for the

federal excise tax attaches when the distilled spirits come

into existence and remains constant regardless of the

price the customer pays. Southern Comfort did not add

the excise tax separately to the sales price on customer

invoices or otherwise differentiate this amount. It did not,

and was not required to, maintain a separate bank ac-

count to hold and pay the excise tax. Because tax liability

attached as soon as the distilled spirits were created,

Southern Comfort was liable for the tax regardless of its

ability to pass this cost on to customers. It is thus per-

fectly appropriate to consider excise taxes when deter-

mining profitability.

Ill

Southern Comfort also argues that the inclusion of

federal excise taxes among its gross receipts exceeds the

scope of the commissioner’s authority. Treasury regula-

tions are to be accorded deference and “ ‘must be sus-

tained unless unreasonable and plainly inconsistent with

the revenue statutes.’”’ Commissioner v. Portland Cement

Co., 450 U.S. 156, 169 (1981) (quoting Commissioner v.

South Texas Lumber Co., 333 U.S. 496, 501 (1948) ).

Even greater deference is accorded to legislative regula-

olen eet PI Aaah a Sil on

Se anata sor oe

:

:

;

:

;

|

|

;

|

5

7a

tions. Rowan Cos. v. United States, 452 U.S. 247, 253

(1981) .?

According to Southern Comfort, Congress created

DISCs to put exporters in the shoes of foreign sub-

sidiaries. This, however, is inaccurate. Congress sought

only to create an incentive for domestic corporations to

export their goods. For instance, federal tax is generally

not paid on the income of a foreign subsidiary until that

income is distributed to the subsidiary’s shareholders in

the United States. However, DISCs must pay tax on a

fixed percentage of their income in the year it is acquired,

regardless of whether the DISC distributes any income.

LR.C. § 995(a). This discrepancy indicates that by estab-

lishing the DISC, Congress did not attempt or intend to

replicate precisely the treatment of a foreign subsidiary.

Even if gross receipts are not reduced by payments at-

tributable to the federal excise tax, Southern Comfort

receives a tax deferral through its DISC and may still

employ marginal costing.

Brown-Forman claims that the OPPL allocates the cost

of excise taxes to export sales, which exceeds the Com-

missioner’s authority because excise taxes are a solely

domestic cost. This argument is misconceived. The OPPL

does not allocate costs; it serves to limit the profitability

under marginal costing of a DISC and its related supplier

to the related supplier’s worldwide profitability. Because

no reduction for excise taxes is allowed, this cost decreases

worldwide profitability and limits the combined taxable

income of the DISC and its related supplier. However,

the same is true for any other exclusively domestic cost.

2A legislative regulation is promulgated pursuant to specific

congressional direction. An interpretive regulation is issued in the

absence of a specific directive in order to interpret a congressional

enactment. The OPPL is a legislative regulation promulgated in

response to I.R.C. § 994(b)(2), which directed the commissioner

to prescribe “rules for the allocation of expenditures in computing

combined taxable income .. . where a DISC is seeking to establish

or maintain a[n export] market.” Id.

——_— ia

By accepting the validity of the OPPL scheme, Brown-

Forman accepts that worldwide profitability is an appro-

priate limit on the use of marginal costing.* Although

a particular cost of doing business is exclusively domestic,

it may nevertheless be a valid component of worldwide

profitability. As indicated earlier, federal excise taxes

are properly viewed as a cost of doing business. See

3In considering marginal costing, the House and Senate com-

mittees both stated:

Where a DISC is attempting a market abroad, or seeking to

maintain a market abroad, for exports, the Secretary of the

Treasury may prescribe by regulations special rules governing

the allocation of expenses incurred on the sale of the export

property for purposes of determining the combined taxable in-

come of the related person and the DISC. It is expected that in

the appropriate cases the regulations the regulations will allow,

for purposes of applying the second pricing rule, the combined

taxable income on the sale of export property to reflect a profit

equal to that which a DISC and a related party would earn if

they took into account only the marginal costs of producing the

property.

H.R. Rep. No. 92-533, at 75; S. Rep. No. 93-427, at 108. We read

this passage to indicate an intent to have the commissioner promul-

gate marginal costing rules “in the appropriate cases.’”’ The dissent

defines appropriate cases as any instance where a DISC is attempt-

ing to establish or maintain an export market. However, the re-

port’s first sentence directs the commissioner to issue regulations

governing the allocation of expenses between a DISC and its related

supplier for DISCs seeking to establish or maintain an export

market. The second sentence directs the commissioner to promul-

gate marginal costing regulations in the appropriate cases. Given

this structure, “in the appropriate cases” modifies attempting to

establish or maintain an export market; that is, not all instances

where a DISC is attempting to establish or maintain an export

market are appropriate cases for full marginal costing, and the

OPPL determines the extent to which it is appropriate for a par-

ticular DISC to use marginal costing. As we have explained, the

OPPL limits the use of marginal costing to worldwide profitability.

In so doing, the commissioner has determined “the appropriate

cases” to be those cases in which export profitability does not ex-

ceed worldwide profitability. This does not exceed the scope of the

commissioner’s authority. :

{

a

4

3

:

9a

Thompson v. United States, 142 U.S. 471 (1892) ; Schen-

ley Distillers, Inc. v. United States, 255 F.2d 334 (3d

Cir. 1958). ‘Thus, it is neither unreasonable nor incon-

sistent with the revenue statutes that gross receipts are

not reduced to exclude payments attributable to the fed-

eral excise tax.

IV

For the foregoing reasons, we affirm the decision of the

Tax Court.

| 10a

| DAVID A. NELSON, Circuit Judge, dissenting. The

taxpayer raises two issues in this appeal. The first in-

volves the proper construction of the “overall profit per-

centage limitation” that the Commissioner’s marginal

costing rules (Treas. Reg. § 1.994-2) purport to impose

for purposes of applying the combined taxable income

price rule of 26 U.S.C. § 994(a) (2).

The Commissioner interprets his marginal costing rules

as imposing a profit limitation determined by taking

worldwide taxable income from the product line question,

dividing this income by worldwide gross receipts that in-

clude a domestic excise tax component, and applying the

resultant fraction to gross receipts from export sales. The

taxpayer, on the other hand, would have us interpret the

rules as permitting domestic excise taxes to be deducted

from worldwide gross receipts.

The Tax Court and the panel majority agree with the

Commissioner’s interpretation of the regulations. So do I.

The regulations may be complicated, but it seems to me

they are clear enough in saying that worldwide gross

receipts include whatever portion of such receipts is at-

tributable to domestic excise taxes.

The second issue raised by the taxpayer is, for me, a

more difficult one. The issue is this: Assuming the Com-

missioner’s marginal costing rules say what the Commis-

sioner says they say, do the rules represent a rational

method of carrying out the task assigned to the Commis-

sioner by Congress? On this issue I part company with

my colleagues.

In 26 U.S.C. §994(b) (2), Congress directed the

Commissioner to prescribe special rules for the allocation

of expenditures “in those cases where a DISC is seeking

to establish or maintain a market for export property.”

The statute furnishes the Commissioner no guidance on

the content of the expenditure-allocation rules he is to

prescribe for this class of cases, but the congressional

lla

committee reports furnish rather precise guidance. The

reports of both the House Ways and Means Committee

and the Senate Finance Committee have this to say on the

subject:

“Tt is expected that in the appropriate cases [1.e.,

“those cases where a DISC is seeking to establish or

maintain a market for export property” | the regula-

tions will allow, for purposes of applying the [26

U.S.C. § 994(a) (2)] pricing rule, the combined tax-

able income on the sale of export property to reflect

a profit equal to that which the DISC and a related

party would earn if they took into account only the

marginal costs of producing the property. The pro-

duction expenses not considered marginal costs in this

case would, of course, be allocable to the production

of the related party which is not sold to the DISC.”

H.R. Rep. No. 92-533 at 75 (1972-1 Cum. Bull. at

538); S.Rep. No. 92-437 at 108 (1972-1 Cum. Bull.

at 619) (emphasis supplied).

What this says to me—and what I think it should have

said to the Commissioner—is that the committees ex-

pected the Commissioner’s marginal costing rules to al-

low export property income to reflect the income that

would result if “only the marginal costs of producing the

[export] property” were taken into account. (Emphasis

supplied.) All other costs, the committee reports say,

would “of course” be allocated to non-export property.’

By no stretch of the imagination can excise taxes paid

on products sold domestically be considered part of the

marginal costs of producing property for sale abroad.

Yet as the Tax Court specifically acknowledged at page

29 of its opinion in this case, “the fact” is that the ap-

plication of the Commissioner’s overall profit percentage

1 Committee reports are not legislation, to be sure, but the Com-

missioner makes no contention here that the very general language

of 26 U.S.C. § 994(b) (2) should not be read in light of the very

specific language of the committee reports.

12a

limitation “results in the allocation of some excise tax

costs to gross receipts from export sales... .”

In computations submitted to the Tax Court on behalf

of the Commissioner after the Tax Court opinion was is-

sued (Jt. App. p. 84), the Commissioner set forth the

exact dollar amount of the taxpayer’s domestic excise

taxes “[a]llocable” to export sales under the marginal

eost method endorsed by the Tax Court. (Jt. App. p. 93.)-

For tax year 1981, the excise taxes thus allocable to ex-

port sales came to $1,311,137.45—which is more than 22

percent of the total costs considered allocable to export

sales. Id.

The Commissioner contends that his marginal costing

rules do not really result in the allocation of excise taxes

to export sales, despite what his own computations show,

because excise taxes are merely included in an overall

profit percentage formula used “to limit the amount of

profit that could be earned by the DISC from export

sales under the marginal costing method.” Brief of re-

spondent-appellee, p. 15. The Commissioner may be cor-

rect in a purely formal sense, but not, I think, in any

substantive sense.

The entire purpose of the marginal cost regulations—

or so Congress thought—was to provide for the allocation

of expenditures under a method showing what the DISC

and its parent would earn if they took into account “only”

the marginal costs of producing the property. It seems

to me indisputable that the practical effect of the non-

statutory “overall profit percentage limitation” adopted

by the Commissioner is to allocate to export sales not

only the marginal costs of producing the export property,

but also a portion of the excise taxes paid on property

sold in this country.

My colleagues suggest that other exclusively domestic

costs may also play a part in lowering export earnings,

under the Commissioner’s rules. If so, it seems to me

that the rules are even more irrational than the taxpayer

__—

4

4

:

13a

has claimed. The taxpayer having challenged only the

inclusion of excise taxes, however, I would not go beyond

those taxes in granting relief.

Because of the way in which it disposed of this case, the

Tax Court did not find it necessary to address the issue of

whether the taxpayer’s domestic international sales

corporation was a qualified DISC during the years at

issue, I would therefore remand the case for a resolution

of this issue. Should the Tax Court conclude that the

DISC was in fact qualified, I would ask the court to

compute the combined taxable export income of the DISC

and its parent without taking into account the excise taxes

paid by the parent on its domestic production.

|

;

;

|

|

!

j

|

ail |

14a

UNITED STATES TAX COURT

Docket No. 27494-87

BROWN-FORMAN CORPORATION (A DELAWARE CORPORA-

TION), SUCCESSOR BY MERGER TO BROWN-FORMAN

CORPORATION (A TENNESSEE CORPORATION), SUCCESSOR

IN INTEREST TO SOUTHERN COMFORT CORPORATION (A

DELAWARE CORPORATION ),

Petitioner '

¥.

COMMISSIONER OF INTERNAL REVENUE,

Respondent

Filed June 25, 1990.

Manufacturer of alcoholic beverages paid Federal

excise tax on distilled spirits sold domestically and

utilized DISC as commission agent for export sales

of its liqueur product. Held, for purposes of comput-

ing the overall profit percentage limitation (OPPL)

under sec. 1.994-2, Income Tax Regs., “gross receipts”

from domestic sales includes the total sales proceeds

received from customers, without reduction for manu-

facturer’s payment of excise tax on distilled spirits.

1 The deficiencies relate to the tax liability of Southern Comfort

Corp. for the years in issue. During those years, Southern Comfort

Corp. filed its returns with the Internal Revenue Service Center in

Kansas City, Missouri. Brown-Forman Corp., a Delaware corpora-

tion (hereafter, petitioner), is the proper petitioner in the instant

case by reason of being the successor by merger to Brown-Forman

Corp., a Tennessee corporation, which in turn was the transferee of

the assets of Southern Comfort Corp.

15a

Held, further, for purposes of the OPPL, gross re-

ceipts from export sales does not include any amount

attributable to the Federal excise tax on distilled

spirits, which is relieved upon export. Held, further,

sec, 1.994-2(b) (3), Income Tax Regs., imposing the

OPPL, is valid. Held, further, the aggregation rule

of sec. 1.994-2(c) (2) (ii), Income Tax Regs., may be

used to calculate the overall profit percentage (OPP)

with respect to a single related supplier even if ag-

gregation is not used in determining the OPP for any

other member of the controlled group.

Walter D. Haynes, for the petitioner.

Aubrey C. Brown, for the respondent.

WELLS, Judge: Respondent determined deficiencies in

Federal income tax as follows:

TYE Amount

eee $1,668,237

Se | See ee 319,381

After concessions by petitioner, the issues for consider-

ation herein are as follows: (1) Whether “gross receipts”

from domestic sales, for purposes of the “overall profit

percentage limitation” (OPPL) imposed by section 1.994-

2(b) (8), Income Tax Regs., may be reduced to reflect the

seller’s payment of the Federal excise tax on distilled

spirits, (2) whether “gross receipts,” for purposes of the

OPPL, includes amounts attributable to the extinguish-

ment of the excise tax lien on distilled spirits which are

exported, (3) whether section 1.994-2(b) (3), Income Tax

Regs., imposing the OPPL, is valid, and (4) whether the

aggregation rule of section 1.994-2(c) (2) (ii), Income

Tax Regs., may be applied unilaterally or requires con-

formng treatment from “related suppliers” with which

aggregation is desired.

l6a

FINDINGS OF FACT

Many of the facts have been stipulated. The stipula-

tions of fact and accompanying exhibits are incorporated

herein by this reference. Petitioner had a principal place

of business in Louisville, Kentucky, at the time it filed

the petition in the instant case.

During the taxable years in issue, Brown-Forman Dis-

tillers Corp. owned all of the outstanding stock of its two

subsidiaries, the Southern Comfort Corp. (hereafter

Southern Comfort) and Jack Daniel Distillery Lem Mot-

low Prop., Inc. (hereafter Jack Daniel). Jack Daniel in

turn owned all of the outstanding common stock of its

subsidiary, the Jack Daniel International Co. (hereafter

JDI), a domestic international sales corporaton under sec-

tion 992.

Southern Comfort during the years in issue engaged in

the production and sale of Southern Comfort liqueur.

Southern Comfort sold the liqueur in the United States

and for export to foreign markets. On December 1, 1979,

Southern Comfort entered into an agreement with JDI

appointing JDI as its commission agent for its export

sales. Such agreement provided that the commission pay-

able by Southern Comfort to JDI would be “the maximum

permissible under Section 994 of the Code.” Jack Daniel

during the years in issue engaged in the production and

sale of “Jack Daniel’s Tennessee Whiskey.”” On December

1, 1979, Jack Daniel entered into an agreement with JDI

identical to the one entered into between Southern Com-

fort and JDI.

Section 5001(a) (1)? imposes an excise tax on “all dis-

tilled spirits produced in or imported into the United

2 Unless otherwise indicated, all section references are to the In-

ternal Revenue Code as amended and in effect for the years in

issue, and all Rule references are to the Tax Court Rules of Practice

and Procedure.

17a

States,” at the rate of $10.50 on each proof gallon.’ Sec-

tion 5001(b) provides that “the tax shall attach to dis-

tilled spirits as soon as this substance is in existence as

such,” and section 5004(a)(1) provides the general rule

that “the tax imposed by section 5001(a) (1) shall be a

first lien on the distilled spirits from the time the spirits

are in existence as such until the tax is paid.” Under sec-

tion 5171, distilling operations can be conducted only on

“bonded premises,” and section 5173(a) (1) requires the

furnishing of a bond before operations at a distilled

spirits plant may commence. Southern Comfort’s alcoholic

beverage production process was, during the years in

issue, a “distilled spirits operation” performed on “bonded

premises.”

Under section 5005(b), the persons liable for the ex-

cise tax on domestically produced distilled spirits are,

generally, all distillers or proprietors of distilling appara-

tus. Southern Comfort and Jack Daniel fell within such

category. Although under section 5004 the excise tax rep-

resents a lien on distilled spirits from the time they come

into existence, the actual amount of tax is generally not

“determined” or made payable until a later time. More

specifically, under section 5006, the excise tax on distilled

spirits is generally determined at the time that the spirits

are withdrawn from “bonded premises.” Such tax deter-

mination is accomplished in part through the use of

gauging instruments which ascertain the proof of the

spirits. Secs. 5006(a) (1), 5204; 27 C.F.R. secs. 19.25,

19.91-19.93 (1989).

The lien imposed by section 5004 terminates by opera-

tion of law (1) at the time that the spirits are withdrawn

from bonded premises and the tax “determined,” (2)

upon export of the spirits or deposit of the spirits in a

customs bonded warehouse, or (3) under certain other

circumstances including the withdrawal of distilled spirits

3 A “proof gallon” is equivalent to 1 gallon of spirits at 100 proof.

One gallon of 150 proof spirits would equal 1.5 “proof gallons.”

rs,

18a

from bond for certain exempt uses (such as laboratory

use or uSe in the manufacture of certain nonbeverage

products). Section 5008 provides that, upon preseniation

of satisfactory proof, no tax will be imposed with respect

to distilled spirits which are lost or destroyed while in

bonded premises, subject to various exceptions concerning

negligent, intentional, or collusive (i.e., fraudulent) loss

of the spirits.

Southern Comfort manufactured its liqueur by pur-

chasing “grain neutral spirits” from unrelated distillers

and then mixing the neutral spirits with a flavoring con-

centrate to make the final product. Under section 5005,

the unrelated distillers and Southern Comfort were jointly

and severally liable for payment of the excise tax. Sec-

tions 5005(c) (2) and 5212, however, provide for a pro-

cedure under which the liability of the unrelated distillers

could be relieved and the spirits transferred to Southern

Comfort’s facilities without immediate payment of the

excise tax. In order to take advantage of such procedure

(presumably to lessen the price of the neutral spirits),

Southern Comfort posted a “unit bond” in the sum of

$1,300,000 with the Department of the Treasury, Bureau

of Alcohol, Tobacco, and Firearms.

The bond posted by. Southern Comfort also allowed

Southern Comfort to withdraw cased bottles of liqueur

from its “bonded premises” and ship them to customers

after “determination” of the tax but before payment. See

sec. 5173 and 27 C.F.R. sec. 19.515(b) (1989). The date

of withdrawal fixed the date by which the tax was re-

quired to be paid, and returns were required to be filed

reporting the amounts of spirits withdrawn from bonded

premises in each semimonthly period. See 27 C.F.R. secs.

19.522-19.523 (1989). The bond posted by Southern Com-

fort could be collected upon by the Government if South-

ern Comfort defaulted in its return filing and tax pay-

ment obligations. Sec. 5173(e) and (g).. The excise tax

was payable during 1981 within 10 days after the last day

Nn

as oe ee ee

19a

of the succeeding semimonthly “withdrawal” period, and,

starting in 1982, by the end of the second succeeding

semimonthly period. Sec. 5061(d). Such due date was un-

related to the time of sale, if any, of liqueur to Southern

Comfort’s customers.

The excise tax on distilled spirits is not imposed with

respect to exported distilled spirits. See sec. 5005(e) (2)

(liability terminates at time of export). As noted above,

the lien imposed by section 5004 terminates when the dis-

tilled spirits are exported or deposited in a customs bonded

warehouse, and section 5214(a)(9) allows the distilled

spirits to be transferred without payment of tax to a

customs bonded warehouse for storage pending exporta-

tion. Thus, during the years in issue, Southern Comfort

was not required to remit any excise tax to the Govern-

ment with respect to its exported liqueur. Under the ex-

cise tax statute as in effect prior to January 1, 1980,

however, Southern Comfort was required to pay the tax

on all liqueur transferred out of its warehouse to its

bottling facilities and then obtain a “drawback” of the tax

allocable to the exported items. Such procedure arose

from the fact that, prior to January 1, 1980, bottling fa-

cilities were not considered part of a distiller’s “bonded

premises,” and there was no provision in effect permitting

the withdrawal of distilled spirits for bottling pending

export without payment of tax.

In its accounting records, Southern Comfort recorded as

“sales” the total sales proceeds received from customers

(not reduced by the excise tax on distilled spirits). South-

ern Comfort’s internal financial statements classified the

excise tax as a compenent of “total production costs,”

which costs made up part of the “cost of goods sold.” For

the fiscal year ended April 30, 1981, the excise tax is

shown on such financial statements as representing 63.9

percent of total production costs; for the fiscal year ended

April 30, 1982, the excise tax is listed as representing

20a

62.61 percent of total production costs.‘ On its Federal

income tax returns (Form 1120) for the years in issue,

Southern Comfort included in gross receipts (on line 1)

the total amount received from its customers for the pur-

chase of the liqueur and deducted the excise tax on dis-

tilled spirits as an expense (on line 17).

In collecting sales proceeds from its customers, South-

ern Comfort did not separately state distilled spirits ex-

cise taxes on its invoices, and did not maintain a segre-

gated bank account for payment of the excise tax. The

tax was not based upon sales price to customers, and the

customers were not liable for the tax. Southern Comfort

generally paid the excise tax with respect to a particular

shipment of distilled spirits prior to the time that the

account receivable with respect to such shipment was

paid by the customer.’ During the years in issue, Brown-

Forman Distillers Corp. made substantial efforts in oppo-

sition to a proposed increase in the Federal excise tax on

distilled spirits.*

OPINION

Background

As part of the Revenue Act of 1971, Pub. L. 92-178, 85

Stat. 497, Congress created the Domestic International

Sales Corporation (DISC) as a tax incentive designed to

stimulate exports and to remove a tax disadvantage faced

by U.S. firms engaged in exporting through domestic cor-

4The large amount of the excise tax paid by Southern Comfort

mandated its disclosure within the sales figures included in Southern

Comfort’s annual reports filed with the SEC.

5 We agree with respondent that the timing of Southern Comfort’s

payment of the excise tax is relevant to the excise tax issue in the

instant case. See Lucky Lager Brewing Co. v. Commissioner, 246

F.2d 621, 623 (9th Cir. 1957), affg. 26 T.C. 836 (1956).

® Petitioner’s relevancy objections to the stipulated exhibits indi-

cating Brown-Forman Distillers Corp’s opposition to such excise tax

increases are overruled, as we find the existence of such opposition

relevant to the excise tax issue herein.

mi...

2la

porations, instead of through foreign manufacturing sub-

sidiaries. H. Rept. 92-5383 (1971), 1972-1 C.B. 498, 502,,

529; S. Rept. 92-487 (1971), 1972-1 C.B. 559, 565, 609.

The DISC provisions are contained in sections 991

through 997. A qualifying DISC provides a deferral

mechanism for a portion of the Federal income tax on in-

come derived from exports. The DISC itself is not taxed.

See. 991. Instead, the DISC’s shareholders are taxed cur-

rently on a portion of the DISC’s earnings and profits, the

other portion enjoying tax deferral until withdrawn from

the DISC or until the corporation ceases to qualify as a

DISC. CWT Farms, Inc. v. Commissioner, 755 F.2d 790,

794 (11th Cir. 1985), affg. 79 T.C. 86 (1982). See also

Dresser Industries v. Commissioner, 92 T.C. 1276, 1280

(1989), on appeal (5th Cir., October 23, 1989) ; Bentley

Laboratories, Inc. v. Commissioner, 77 T.C. 152, 162-163

(1981); Staff of the Joint Committee on Taxation, Gen-

eral Explanation of the Revenue Provisions of the Deficit

Reduction Act of 1984 at 1037-1041 (J. Comm. Print

1984).

In order to qualify as a DISC, at least 95 percent of a

corporation’s gross receipts must be export related

(“qualified export receipts”), and at least 95 percent of

the corporation’s assets must be export related (“qualified

export assets”). Secs. 992(a) (1), 993(a) through (c), S.

Rept. 92-437, supra at 613-614. An entity which meets

the requirements for qualification as a DISC is treated

as a separate corporation for Federal tax purposes even

though such entity would not otherwise be treated as a

corporation for Federal tax purposes. Sec. 1.992-1{a),

Income Tax Regs. Thus a DISC may function solely “as

an accounting device for measuring the amount of export

earnings subject to tax deferral.” Anchor Hocking Corp.

v. United States, 11 Cl. Ct. 178, 174 (1986). JDI was a

“shell” corporation entitled to be treated as a separate

corporation under section 1.992-1(a), Income Tax Regs.

A DISC may operate on a “buy-sell” basis (by taking

title to the property to be exported) and/or on a commis-

22a

sion basis (under which it functions as a commission

agent for export sales). During the years in issue, JDI

operated on a commission basis with respect to products

exported by Southern Comfort and Jack Daniel.

Section 994(a) sets forth three intercompany pricing

methods that apply in determining the amount of income

a DISC may earn when it purchases property from a

related company and resells the property for export.’

The methods contained in section 994(a) serve to allocate

the profit from an export sale between the DISC and its

“related supplier.” Bentley Laboratories, Inc. v. Com-

missioner, supra at 163.

The first two intercompany pricing methods contained

in section 994(a) are safe harbors which permit a DISC

to earn the greater of 4 percent of “qualified export

receipts” on the sale of export property or 50 percent of

the “combined taxable income” attributable to such re-

ceipts plus (in either case) 10 percent of the DISC’s “‘ex-

port promotion expenses” (sec. 994(c)). The legislative

history of section 994 indicates that Congress intended

those safe harbor rules “to avoid the complexities of the

present pricing rules [of section 482].” S. Rept. 92-437,

7SEC. 994. INTER-COMPANY PRICING RULES.

(a) IN GENERAL.—In the case of a sale of export property to a

DISC by' a person described in section 482, the taxable income of

such DISC and such person shall be based upon a transfer price

which would allow such DISC to derive taxable income attributable

to such sale (regardless of the sales price actually charged) in an

amount which dsves not exceed the greatest of —

(1) 4 percent of the qualified export receipts on the sale of

such property by the DISC plus 10 percent of the export pro-

motion expenses of such DISC attributable to such receipts.

(2) 50 percent of the combined taxable income of such DISC

and such person which is attributable to the qualified export

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

DISC plus 10 percent of the export promotion expenses of such

DISC attributable to such receipts, or

(3) taxable income based upon the sale price actually charged

(but subject to the rules provided in section 482).

;

i

28a

supra at 618. Under section 994(a) (3), however, the

rules of section 482 may be used by the taxpayer to allo-

cate an arm’s-length profit to the pisc if such rules would

allow a greater allocation of profit to the DISC than either

safe harbor. S. Rept. 92-437, supra. The choice of an in-

tercompany pricing method is made either on a transaction-

by-transaction basis, or, at the annual choice of the tax-

payer, on the basis of groups made up of products or

product lines. See. 1.994-1(c) (7), Income Tax Regs.

Southern Comfort liquer and Jack Daniel’s Tennessee

Whiskey fell within the same “product line” for such

purpose.

Although the three intercompany pricing methods con-

tained in section 994(a) literally apply only to DISCs

operating on a “buy-sell” basis, Dresser Industries v.

Commissioner, supra at 1290, section 994(b) (1) provides

that rules consistent with those set forth in section 994 (a)

shall be prescribed by regulation for DISC’s operating on

a commission basis. See sec. 1.994-1(d) (2), Income Tax

Regs. The regulations promulgated under section 994 (b)

(1) permit a commission DISC to earn the same amount

of income as a DISC operating on a buy-sell basis. Sec.

1.994-1(d) (2) (i), Income Tax Regs.* The instant case

involves the “50 percent combined taxable income” method

of section 994(a) (2) as applied to a commission DISC,

and arises out of respondent’s disallowance of deductions

claimed by Southern Comfort for commissions paid to JDI.

The term “combined taxable income,” for purposes of

section 994(a) (2), is not defined in the DISC provisions.

The legislative history of section 994, however, indicates

that “combined taxable income,” in the case of a buy-sell

DISC, is merely the DISC’s receipts on the sale of export

property less the related supplier’s cost of goods sold for

8 Under sec. 1.994-1(d)(2), Income Tax Regs., “in essence, a

fictional sale is deemed to have occurred between the related sup-

plier and such DISC.” Dresser Industries v. Commissioner, 92 T.C.

1276, 1281 (1989), on appeal (5th Cir., Oct. 23, 1989)._

24a

the property and the applicable other expenses of the

parent company and the DISC. S. Rept. 92-437, supra at

618-619 n.6. In the case of a commission DISC, the “gross

income” of the DISC is deemed to be the gross receipts de-

rived by the principal from the sale, lease, or rental of

the property on which the commissions arose. Sec 993 (f)

and sec. 1.993-6, Income Tax Regs. Thus, “combined tax-

able income,” in the case of a commission DISC, is deter-

mined without regard to commission income of the DISC,

and the amount of commission which the DISC may earn

on a sale is “backed into” under section 994(a) (2) and

the applicable regulations.

Combined taxable income generally is computed under

a “full costing’? method; that is, by subtracting from gross

receipts all expenses, losses, and other deductions defi-

nitely related to such receipts plus a ratable part of any

Other expenses, losses, and other deductions not definitely

related to a class of gross income (consistent with the

rules of section 1.861-8, Income Tax Regs.). Sec. 1.994-1

(c) (6) (iii), Income Tax Regs. “Cost of goods sold,”

under the full costing method, is generally determined in

accordance with section 1.61-3, Income Tax Regs., and

sections 471 and 472 (with respect to inventories). Sec.

1.994-1(c) (6) (ii), Income Tax Regs.

As an alternative to the full costing method for deter-

mining combined taxable income under section 994 (a) (2),

section 994(b) (2) authorizes the Secretary to issue spe-

cial rules governing the allocation of expenditures “in

those cases where a DISC is seeking to establish or main-

tain a market for export property.” The Senate Finance

Committee Report issued in connection with the enactment

of section 994(b) (2) states:

Where a DISC is attempting to establish a mar-

ket abroad, or seeking to maintain a market abroad,

for exports, the Secretary of the Treasury may pre-

scribe by regulations special rules governing the al-

location of expenses incurred on the sale of the export

25a

property for purposes of determining the combined

taxable income of the related person and the DISC.

It is expected that in the appropriate cases the regu-

lations will allow, for purposes of applying the second

pricing rule, the combined taxable income on the sale

of export property to reflect a profit equal to that

which the DISC and a related party would earn if

they took into account only the marginal costs of pro-

ducing the property. * * * [S. Rept. 92-437 (1971),

1972-1 C.B. 559, 619.]

Section 1.994-2, Income Tax Regs., contains the “mar-

ginal costing rules” authorized by section 994(b) (2) and

its legislative history. Marginal costing, as a general

proposition, permits an increased allocation of commission

or other income to a DISC by allowing combined taxable

income to be computed taking into account only the “mar-

ginal,”’ or “variable,” costs of producing exported items.

The marginal costs taken into account under section

1.994-2, Income Tax Regs., generally include only direct

production costs, i.e., costs of labor and materials iden-

tifiable with particular units of the product or which be-

come an integral part of the specific product. Sec. 1.994-2

(b) (2) (i), Income Tax Regs., referring to sec. 1.471-11

(b) (2) (i), Income Tax Regs.’

An important limitation on the use of marginal costing

in computing combined taxable income is imposed by sec-

tion 1.994-2(b) (3), Income Tax Regs. More specifically,

the “overall profit percentage limitation” (hereafter,

OPPL) limits combined taxable income under marginal

costing to a percentage of gross receipts from export

sales. Such percentage, referred to as the “overall profit

percentage” (hereafter, OPP) is a measure of worldwide

sales profitability, with “profitability” being expressed

® Export promotion expenses are also treated as “marginal costs”

for this purpose, but only if the taxpayer claims such costs for

purposes of the “ten percent” allowance contained in sec. 994(a) (2).

Sec. 1.994-2(b) (2) (iii), Income Tax Regs.

26a

through a comparison of worldwide taxable income with

worldwide gross receipts. See sec. 1.994-2(c¢) (2) (i), In-

come Tax Regs. (defining OPP). The OPPL essentially

limits the “profitability” of export sales, for purposes of

computing taxable income under marginal costing, to the

“profitability” of worldwide sales, or “overall” profit-

ability, of the product or product line (determined under

a full costing method). That concept may be expressed

mathematically as follows:

Combined taxable Gross

Combined taxable income income from receipts

from export sales of product worldwide sales of from

or product line product or product line X export

(subtracting marginal COPPL= (full costing method) sales

costs only) ‘Gross receipts from of

worldwide sales product

of product or or

product line product

line

The above formula represents a four-step procedure.

The first step is to tentatively compute the combined tax-

able income of the DISC and its related supplier from ex-

port sales, taking into account marginal costs only. The

second step is to compute the OPP, by dividing the taxable

income of the DISC and its related supplier from worldwide

sales of the product or product line (using full costing)

by the gross receipts from such worldwide sales.’° The

third step is to determine the OPPL, by multiplying the

OPP by the gross receipts from export sales of the product

or product line. The fourth step is to compare the com-

bined taxable income figure computed in the first step

with the OPPL. The lesser of those two amounts must be

used as “combined taxabie income” for purposes of section

994(a) (2) under the marginal costing method.

10 Sec. 1.994-2(c) (2) (iii), Income Tax Regs., provides special rules

for determining gross receipts in cases in which property is initially

transferred among members of a controlled group of which the DISC

is a member.

i |

27a

By placing a cap on the amount of “combined taxable

income” which may result from marginal costing, the

OPPL functions to allocate some amount of indirect, or

“nonmarginal” costs to export sales. See sec. 1.994-2(e),

Income Tax Regs. (examples of application of OPPL).

Such allocation of nonmarginal costs occurs when the allo-

cation of marginal costs alone would result in a profit

margin fer export sales of the product or product line

greater than the worldwide (or “overall”) profit margin

for sales of such product.

If the full costing method would result in a higher

combined taxable income amount for purposes of section

994(a) (2) than that produced under the rules described

above, full costing must be utilized by the taxpayer. The

Treasury regulations accomplish that result by way of

the definition of “establishing or maintaining a foreign

market.” More specifically, under section 1.994-2(c) (1),

Income Tax Regs., if the combined taxable income from

export sales of the product or product line computed

under the full costing method exceeds the combined tax-

able income produced after application of marginal cost-

ing and the OPPL, the taxpayer is not “seeking to estab-

lish or maintaining a foreign market” for purposes of

section 994(b) (2) and is not wthin the category of tax-

payers for whom marginal costing is allowed.

In their original returns for the years in issue, South-

ern Comfort and JDI computed DISC commissions without

using the marginal costing method. Rev. Rul. 88-81,

1982-1 C.B. 109, however, authorized a DISC and its re-

lated suppliers to file amended returns to change the

method of computing commissions in order to claim the

maximum permissible amount of DISC commissions under

11 For Southern Comfort’s taxable year ended Apr. 30, 1981, the

50 percent combined taxable income method of sec. 994(a) (2) was

applied in the original returns, but using full costing. For Southern

Comfort’s taxable year ended Apr. 30, 1983, the “4 percent” method

of sec. 994(a)(1) was applied in the original returns.

F

pnadasiinaaetits ill

28a

section 994. Southern Comfort and JDI filed such amended

returns so as to adopt the marginal costing method, and

the amended returns were considered by the revenue agent

auditing the years in issue."* The instant case involves

discrete questions arising out of the computation of the

OPPL by Southern Comfort and JDI in those amended

returns. Petitioner alternatively challenges the validity

of the regulation imposing the OPPL.

1. Inclusion of Excise Tax on Distilled Spirits in Com-

puting “Gross Receipts” from Domestic Sales for Pur-

poses of OPPL.

The first issue we must decide involves the impact of

the excise tax on distilled spirits in computing the OPPL.

As shown in the OPPL “formula” above, the denomi-

nator of the OPP fraction is “gross receipts from world-

wide sales of a product or product line.” That denomi-

nator includes gross receipts from domestic sales and

gross receipts from export sales of the product or product

line. In determining the domestic sales component of the

OPP denominator in their amended returns, Southern

Comfort and JDI subtracted from the sales proceeds re-

ceived from customers an amount equal to the excise tax

incurred by Southern Comfort with respect to the liqueur

sold. Respondent disallowed such subtraction, which had

produced an increase in the OPPL and a concomitant in-

12 A first set of amended returns for JDI, which adopted the

marginal costing method, was received by the Internal Revenue

Service Center in Memphis, Tennessee, on Dec. 2, 1985. The cor-

responding amended returns of Southern Comfort were delivered to

the revenue agent auditing the years in issue on Jan. 24, 1986, and

were received by the Internal Revenue Service Center in Cincinnati,

Ohio, on July 9, 1987.

A second set of amended returns of JDI and Southern Comfort,

reflecting various refinements made during the course of the audit,

was received by the Internal Revenue Service Center in Cincinnati,

Ohio, on July 10, 1987.

29a

crease in the commissions payable to JDI under margi-

nal costing.”

In support of its position, petitioner argues that

amounts collected by Southern Comfort from the sale of

its liqueur are not Southern Comfort’s “gross receipts”

to the extent that they represent price increases attrib-

utable to Southern Comfort’s payment of the Federal

excise tax on distilled spirits. Petitioner asserts that

Southern Comfort had no beneficial interest in its sales

revenue to the extent of the applicable excise tax, and

no ownership interest in its liqueur product to the extent

of the excise tax lien imposed on the distilled spirits from

the time that they came into existence. Petitioner char-

acterizes Southern Comfort as a “collector” or “trustee,”

of the tax imposed on distilled spirits, and cites cases

dealing with “implied trusts” in support of such char-

acterization. Petitioner also notes that Southern Com-

fort’s invoices stated that prices would be increased to

reflect increases in Federal tax and that the unrelated

distillers (who supplied Southern Comfort with neutral

spirits) were initially liable for the tax.

Respondent argues that it is inappropriate, for pur-

poses of the OPP, to reduce “gross receipts” to reflect

Southern Comfort’s liability for the excise tax on dis-

tilled spirits because (1) the excise tax is a cost of pro-

duction not excludable from “gross receipts” under sec-

tion 993(f) and section 1.993-6, Income Tax Regs., (2)

Southern Comfort had dominion and control over the

sales proceeds from its liqueur, and was not required

to and did not segregate amounts attributable to the

excise tax, and (3) Southern Comfort treated the total

sales proceeds from its customers as gross receipts for

financial accounting and income tax purposes. Respond-

13 The initial amended return of Southern Comfort for the year

ended Apr. 30, 1981, claimed an additional commission expense

deduction of $936,112, for the year ended Apr. 30, 1983, an addi-

tional commission expense deduction of $525,832 was claimed.

TT

30a

ent also notes the efforts made by Brown-Forman Dis-

tillers Corp. to prevent increases in the excise tax as

proof that the tax was a cost of production. For the fol-

lowing reasons, we agree with respondent.

For purposes of the DISC provisions, section 993(f)

defines “gross receipts” as follows:

SEC. 993(f). Gross RECEIPTS.—For purposes of

this part, the term “gross receipts” means the total

receipts from the sale, lease, or rental of property

held primarily for sale, lease, or rental in the ordi-

nary course of trade or business, and gross income

from all other sources. In the case of commissions

on the sale, lease, or rental of property, the amount

taken into account for purposes of this part as gross

receipts shall be the gross receipts on the sale, lease,

or rental of the property on which such commissions

arose.

Section 1.993-6, Income Tax Regs., further elaborates

that:

(a) General rule. Under Section 993(f), for pur-

poses of sections 991 through 996, the gross receipts

of a person for a taxable year are—

(1) the total amounts received or accrued by the

person from the sale or lease of property held pri-

marily for sale or lease in the ordinary course of a

trade or business, and

(2) gross income recognized from all other sources

* *

.

~ . * *

(c) Nonreduction of total amounts. For purposes

of paragraph (a) of this section, the total amounts

received or accrued by a person are not reduced by

returns and allowances, costs of goods sold, expenses,

losses, a deduction for dividends received under sec-

tion 243, or any other deductible amounts.

I

3la

(d) Method of accounting. For purposes of para-

graph (a) of this section, the total amounts re-

ceived or accrued by a person shall be determined

under the method of accounting used in computing

its taxable income.

Section 1.993-6, Income Tax Regs., thus clearly provides

that amounts properly treated as costs of goods sold or

as deductible expenses may not be subtracted from sales

proceeds in determining “gross receipts.” Petitioner does

not argue that it was incorrect for Southern Comfort to

deduct the excise tax on distilled spirits in computing its

taxable income from domestic sales, and admits that

such tax was treated as part of the “cost of goods sold”

in its accounting records. Furthermore, petitioner does

not challenge the validity of section 1.993-6, Income Tax

Regs."

Petitioner’s argument that Southern Comfort functioned

as no more than a trustee, or “collector,” of the excise

tax is not borne out by the excise tax statute or by the

14 Petitioner argues that “gross receipts,” for purposes of the

OPPL, should be determined in accordance with sec. 1.9365(b) (5)

(Q & A #1), Income Tax Reg., which, by reference to sec. 1.936-

6(a)(2)(Q & A #7), Income Tax Regs., excludes excise taxes from

gross receipts for purposes of measuring sales of a “possession

product.” We reject petitioner’s argument that “gross receipts”

should be given the same meaning for purposes of the OPPL as it is

given for purposes of the possessions corporation regulations, since

“gross receipts” has been defined separately (and differently) in the

applicable DISC regulations. Moreover, we note that the “cost

sharing” fraction referred to in sec. 1.936-6(a)(2)(Q & A #7), In-

come Tax Regs., and cited by petitioner as support for “consistently

excluding excise taxes,”’ is a comparison of “possession sales’? with

“total sales,” unlike the OPPL, which compares “taxable income”

with “gross receipts.” We further note that, in contrast with sec.

1.993-6, Income Tax Regs., the regulations relating to the cost shar-

ing fraction specify that “total sales” is to be reduced by “returns

and allowances” and indirect taxes on the production of the product.

See sec. 1.9366(a)(2)(Q & A #1 and #8), Income Tax Regs.

i

| 82a

cases interpreting such statute.'’ Thus, while Southern

Comfort may have passed the economic burden of the

excise tax on to its purchasers, the statute makes it clear

that its failure to do so would not have relieved it of

liability. As Justice Holmes stated in the case of Lash’s

Products Co. v. United States, 278 U.S. 175, 176 (1929)

in regard to a tax on soft drinks) :

The phrase “passed the tax on” is inaccurate, as

obviously the tax is laid and remains on the manu-

facturer and on him alone. * * * The purchaser does

not pay the tax. He pays or may pay the seller more

for the goods because of the seller’s obligation, but

that is all. [Citation omitted. ]

Numerous courts, moreover, have held that the excise tax

on distilled spirits is not a consumer’s tax but a tax on

the production of distilled spirits, which represents part

of the cost of such spirits. See, e.g., Thompson v. United

States, 142 U.S. 471 (1892); Schenley Distillers, Inc. v.

United States, 255 F.2d 334, 336 (3d Cir. 1958); Erie

Railroad v. United States, 140 Ct. Cl. 398, 401 (1957);

Robert Williams & Co. v. State Tax Commission of Mis-

souri, 498 S.W. 2d 527, 528-529 (Mo. 1973); Dade

County v. Atlantic Liquor Co., 245 So. 2d 229, 231 (Fla.

1970) (where burden of excise tax is upon distillation,

and method of taxation was unrelated to time of sale,

excise tax is a production cost and face value of Federal

excise tax stamp may be included in computation of ad

valorem tax on stock in trade) ; Hoffman v. City of Syra-

cuse, 2 N.Y. 484, 141 N.E.2d 605, 608-610 (1957) ; Cass

v. Colorado Beverage Co., 122 Colo. 101, 220 P.2d 867,

870-871 (1950); Pierce & Hebner, Inc. v. State Tax Com-

mission of Maryland, 194 Md. 254, 71 A.2d 6, 8 (1950)

(rejecting contrary view that distilled spirits excise tax

In connection with its “trustee” argument, petitioner argues

that Southern Comfort’s sales proceeds were not “amounts received

or accrued by the person [i.e., Southern Comfort]” within the mean-

ing of sec. 1.993-6(a)(1), Income Tax Regs.

ae

83a

is on the consumer). It is difficult to understand how

Southern Comfort may be regarded as a mere “collector,”

or “trustee,” of a tax which is its own, and not the con-

sumer’s, to pay. Unlike in Florists’ Transworld Delivery

Association v. Commissioner, 67 T.C. 333 (1976), cited

by petitioner, in which the taxpayer’s use of “members’

advances” was restricted by the taxpayer’s bylaws,

Southern Comfort’s use of the sales proceeds from its

customers was not limited in any way, as the customers

had no interest in petitioner’s disposition of such proceeds.

The fact that Southern Comfort’s invoices stated that

prices included Federal taxes and would be increased to

reflect increases in such taxes is without significance;

such pricing terms do not show that Southern Comfort

functioned as a “collector” or “trustee,” but merely indi-

cate that Southern Comfort was unwilling to accept the

business risk of an increase in excise tax between the

time of a sales order and the time of delivery to the cus-

tomer."® We note, moreover, that Southern Comfort gen-

erally paid the excise tax on a particular shipment of

liqueur prior to collection of the related sales proceeds.

We also reject petitioner’s argument that Southern

Comfort’s liqueur product “belonged to the Government”

to the extent of the tax because of the lien imposed by

section 5004, thereby imposing a trust on the sales pro-

ceeds from the liqueur to such extent. No provision of

law imposed such a trust upon the sales proceeds, and

the “lien” allegedly creating an “ownership interest”

terminated by operation of law at the time the liqueur

was withdrawn from bonded premises on determination

of the tax. Sec. 5004(a) (2) (A). Southern Comfort did

not segregate the sales proceeds allegedly “belonging to

the Government” but maintained dominion and control

over the total proceeds collected from customers. More-

16 Southern Comfort’s invoices for exported liqueur—upon which

no excise tax was imposed—contained the same language about the -

inclusion of Federal tax as the invoices for domestically sold liqueur,

further negating the significance of such language.

34a

over, Southern Comfort was under no obligation to charge

its customers an amount sufficient to pay for the Govern-

ment’s asserted “ownership interest” in the liqueur. Pe-

titioner’s argument that the unrelated distillers’ liability

for the excise tax demonstrates that Southern Comfort

was merely the “collector” of a previously imposed tax is

also without merit; the unrelated distillers and Southern

Comfort were jointly and severally liable for the excise

tax, and the bonding procedure employed by Southern

Comfort relieved the unrelated distillers of their liability

at the time of transfer to Southern Comfort.

The issue herein is similar to that confronted by this

Court and by the Ninth Circuit in Lucky Lager Brewing

Co. v. Commissioner, 26 T.C. 836 (1956), affd. 246 F.2d -

621 (9th Cir. 1957), which also involved the interplay

between a Federal excise tax statute and the definition

of “gross receipts” in an unrelated income tax provision.

In Lucky Lager, the taxpayer, a brewing company, was

subject to the $8,/barrel Federal excise tax on beer, which

it paid prior to the sale of the beer. As in the instant

case, the excise tax was not stated separately on the tax-

payer’s invoices, and the taxpayer included the total sales

proceeds from customers in income on its income tax

returns and deducted the excise tax as part of cost of

goods sold. 26 T.C. at 836-837.

The issue in Lucky Lager was whether the excise tax

on beer could be deducted from sales proceeds, as claimed

by the taxpayers, in calculating “gross receipts” for pur-

poses of the excess profits tax “growth formula” (section

435(e) (1) of the Internal Revenue Code of 1939). Un-

der the growth formula provision, taxpayers whose “gross

receipts” for a certain time period were 150 percent or

more of their “gross receipts” for a preceding time period

(referred to as “growth corporations”) were entitled to

use an alternative formula in calculating income subject

to the excess profits tax. The relevant provision in Lucky

Lager defined “gross receipts” to include “the total

amount received or accrued * * * from the sale * * * of

35a

stock in trade of the taxpayer.” The taxpayer in Lucky

Lager contended that it was a “growth corporation” en-

titled to use the alternative formula, based on its position

that an amount equal to the beer excise tax should be

excluded from “gross receipts” in determining whether

the 150 percent “growth” test had been met.

In rejecting the taxpayer’s argument in Lucky Lager, ©

we initially reasoned that inclusion of the excise tax (an

item which remained stable in its relationship to units

produced) in gross receipts would not frustrate the pur-

pose of the growth formula to measure increases in vol-

ume of production. We further stated that:

Petitioner is in effect asking that we reject a sim-

ple and direct application of the term “total amount

received” as including everything received by the

corporation in its own right, and employ instead a

meaning which will give effect to the statutory pur-

pose. We need not determine whether such an ap-

proach is permissible * * *. [The excise taxes] were

included in the amount received for its stock in trade

by petitioner, and we see nothing in the statute or its

background which will justify their elimination. It

is not contended that such taxes, particularly the

Federal tax, are collected by the brewer as a trustee

or fiduciary. While it may pass the economic burden

of the tax to the purchaser, its failure to do so would

not relieve it of the tax liability. [Citations omitted.]

It cannot hence be said that amounts collected by

petitioner, even though they effectively reimbursed

it-for the beer tax, were not its own “gross receipts.”’

[26 T.C. at 842-843. ]

In affirming our decision in Lucky Lager, the Ninth

Circuit focused on the taxpayer’s liability for the excise

tax and on the definition of “gross receipts” in section

435(e) of the 1939 Code, stating that:

As far as we are able to analyze petitioner’s conten-

tion, it seems to be that the tax, in effect, is on the

36a

buyer and that the selling petitioner here in receiv-

ing his payment for the beer acted in two capacities;

one as a collector for the government of a tax on the

buyer and the other as recipient of payment of the

remainder of the sales prices for the beer itself. [Fn.

ref. omitted. ]

We do not agree. The language * * * that “gross

receipts” are “the total amount received or accrued

* * * from the sale * * * of stock in trade” |em-

phasis supplied] is irrefutably plain. It is a logical

absurdity to contend that the “total amount received”

from the sales is not what the customer paid but a

lesser amount determined by a deduction of a particu-

lar tax paid, here required to be paid and in fact

paid by the seller, before the delivery of the beer.

[246 F.2d at 622-623. ]

The Ninth Circuit went on to quote the case of Liggett &

Myers Tobacco Co. v. United States, 299 U.S. 383 (1937),

for the proposition that:

True the limit of time for making payment is when

the product is sold or removed, but this is a privilege

designed to mitigate the burden; it indicates no pur-

pose to impose the tax upon either sale or removal.

[246 F.2d at 623.]

We find the reasoning of the Ninth Circuit in Lucky

Lager equally applicable herein.’7 See also Hoffman v.

City of Syracuse, 2 N.Y. 484, 141 N.E.2d 605, 608-610

(1957) (for purposes of local sales tax, “receipts” from

17 Although our opinion in Lucky Lager Brewing Co. v. Commis-

sioner, 26 T.C. 836 (1956), affd. 246 F.2d 621 (9th Cir. 1957) states

that the taxpayer had not argued that it was only a trustee or

fiduciary of the excise tax, the Ninth Circuit opinion suggests that

such argument would necessarily have failed. More specifically, the

Ninth Circuit emphasized that the excise tax was imposed upon beer

manufacturers, a fact inconsistent with characterizing such manu-

facturers as “trustees” collecting the tax on behalf of the Govern-

ment.

37a

retail sales should not be reduced by excise tax on dis-

tilled spirits, which is production cost).

In addition to arguing that Southern Comfort was no

more than a “collector” or “trustee” of the excise tax,

petitioner argues that the inclusion of amounts attributa-

ble to the excise tax in domestic gross receipts but not

export gross receipts is an “apples and oranges” com-

parison that gives greater “weight” to domestic Sales,

producing “distortions” in the OPPL. Petitioner also char-

acterizes respondent’s position as involving the “exclu-

sion” of excise tax from the numerator of the OPP and

its inclusion in the denominator. We find such charac-

terization misleading. Because the numerator of the OPP

is a “taxable income” figure, increases in the selling price

of liqueur to reflect an excise tax cost properly result in

a “wash” with respect to such numerator, since the excise

tax is also a deductible expense. The OPP measures profit-

ability by a comparison of taxable income with gross

receipts. So long as amounts attributable to the excise

tax are included in both gross income and gross receipts

from domestic sales and excluded in computing both gross

income and gross receipts from export sales, the amounts

being “compared” as a measure of profitability are not

“apples and oranges.” 8

Contrary to petitioner’s argument, the fact that appli-

cation of the OPPL results in the allocation of some excise

tax cost to gross receipts from export sales is not proof

of any “distortion;” section 994(b) (2) specifically au-

8 Petitioner, while repeatedly asserting that the inclusion of ex-

cise taxes in domestic but not export gross receipts frustrates the

purpose of the OPPL (to measure relative profitability), never has

argued that a comparison of “taxable income” with “gross receipts”

is, in itself, an inappropriate way of measuring profitability. Peti-

tioner’s argument, however, if taken to its logical conclusion, would

require numerous other subtractions from “gross receipts” attribut-

able to other costs of production, significantly changing the profita-

bility quotient specified in the OPP.

38a

thorizes rules for the “allocation” of expenditures between

export gross receipts and domestic gross receipts. More-

over, the fact that gross receipts from domestic sales may

be higher on account of an excise tax cost does not mean

that domestic sales have been given too much “weight”

in the OPP. Petitioner ignores the fact that gross receipts

from export sales may also be increased on account of

costs or factors not applicable in the domestic market.

We also reject petitioner’s argument that respondent’s

position results in a “disincentive to export” that “defeats

the purpose of the DISC provisions.” As pointed out by

respondent, the very feature of the excise tax that gives

rise to the instant dispute—i.e., the fact that such tax

is not imposed on exported liquor—is, in itself, an in-

centive to export.

In a similar vein, we reject petitioner’s argument that,

because its method of computing the OPPL produces a

lower “taxable income per case” for exported liqueur

than for exported and domestic liqueur determined on an

aggregate basis, such method should be upheld. Petition-

er’s argument is essentially that, if its method produces

a result in harmony with the purpose of the OPPL,” it is

correct. Assuming without deciding that petitioner’s posi-

tion in fact produces a result in harmony with such pur-

pose,*? such “end justifies the means” argument neverthe-

less must fail where the “means” contravenes the plain

language of section 1.993-6, Income Tax Regs., defining

“gross receipts” for purposes of the OPPL. As noted above,

19 Petitioner argues with respect to the excise tax issue that the

purpose of the OPPL is “to limit the effect of marginal costing so

that export sales are not more profitable than worldwide sales.”

Petitioner measures compliance with such purpose by presenting

various calculations of ‘taxable income per case” of domestic and

exported liqueur. Petitioner alternatively argues below that the

OPPL is invalid as lacking authority in sec. 994.

20 Respondent asserted in his opening remarks at trial that the

“taxable income per case” amounts presented by petitioner might

be misleading because of differences in the cases.

.

39a

petitioner does not challenge the validity of that regula-

tion, and we are unwilling to rewrite the regulation

herein. Accordingly, we hold that, for purposes of the

OPPL, “gross receipts” may not be reduced by amounts

attributable to the Federal excise tax on distilled spirits.

2. Effect of Excise Tax in Determining Gross Receipts

from Export Sales for Purposes of OPPL

Petitioner alternatively argues that, if we sustain re-

spondent’s position that gross receipts from domestic sales

are determined without reduction for the excise tax on

distilled spirits, then gross receipts from export sales, for

purposes of the OPPL, should be increased to reflect

Southern Comfort Inc.’s “relief from liability” for the

excise tax with respect to such sales”!

Petitioner reasons that, upon export of a quantity of

liqueur, the excise tax lien on such liqueur is relieved,

giving rise to income. Petitioner cites Crane v. Commis-

stoner, 331 U.S. 1 (1947), and Commissioner v. Tufts,

461 U.S. 300 (1983), for the proposition that relief from

a nonrecourse liability gives rise to income upon dispo-

sition of the property securing the liability. In further

support of its position that relief from the excise tax

lien generates “gross receipts” from export sales, peti-

tioner draws our attention to the fact that, prior to 1980,

Southern Comfort actually paid the excise tax with re-

spect to exported liqueur and then received a “drawback”

»

of such amounts.” Petitioner reasons that, at the time

21 Although inclusion of the excise tax amount in gross receipts

from export sales increases the denominator of the OPP, petitioner’s

alternative position nevertheless produces an increase in the OPPL

due to the increase in export gross receipts, by which the OPP is

multiplied.

22 Petitioner notes that such prior law was still applicable during

the first month of JDI’s taxable year ended Nov. 30, 1980. Com-

missions reported by JDI for such year were deducted by Southern

Comfort during its taxable year ended Apr. 30, 1981.

Aili

40a

the OPPL regulation was promulgated, “gross receipts”

would have included such “drawbacks,” and Congress did

not intend the procedural change in the excise tax statute

to reduce allowable DISC commissions.

We find petitioner’s alternative position without merit.

In Commissioner v. Tufts, supra, the Supreme Court

stated that:

Unless the outstanding amount of the mortgage is

deemed to be realized [at the time of sale], the mort-

gagor effectively will have received untaxed income

at the time the loan was extended and will have re-

ceived an unwarranted increase in the basis of his

property. * * * [461 U.S. at 310. Fn. ref. omitted

and emphasis supplied. ]

In the instant case, such reasoning is inapplicable. No

untaxed “income” is produced upon termination of the

lien imposed by section 5004, because there was no trans-

fer of funds to Southern Comfort giving rise to the lien.

While the termination of a liability may give rise to in-

come if the taxpayer previously derived some “tax bene-

fit”’ from the liability, petitioner does not argue that the

tax benefit rule applies; there is no contention that the

termination of liability related to excise taxes which had

been deducted by Southern Comfort in prior tax years.

Cf. Turtle Wax, Inc. v. Commissioner, 43 T.C. 460 (1965)

(where taxpayer deducted Federal excise tax on watches

as part of the cost of the watches and in later years re-

ceived refund of the excise tax, the refunds were prop-

erly treated as income). Nor has petitioner shown that,

under Southern Comfort’s method of accounting, its

claimed basis in the exported liqueur reflected a Federal

excise tax cost. See sec. 1.1001-2(a) (3), Income Tax

Regs. (rule that amount realized from sale includes li-

abilities from which transferor is discharged does not ap-

ply to liabilities incurred on the acquisition of property

but not taken into account in determining the transfer-

or’s basis).

4la

Petitioner’s alternative contention also runs counter to

section 108(e) (2), which applies to both bankruptcy and

nonbankruptcy transactions, and states:

(2) INCOME NOT REALIZED TO EXTENT OF

LOST DEDUCTIONS.—No income shall be realized

from the discharge of indebtedness to the extent that

payment of the liability would have given rise to a

deduction. '**!

Southern Comfort deducted the Federal excise tax on dis-

tilled spirits as an expense on line 17 of its returns. If

Southern Comfort had incurred an excise tax liability on

liqueur which eventually would be exported, the extin-

guishment of such liability would render the deduction

unavailable, but “lost deductions” do not, under section

108(e) (2), give rise to income.™

We also reject petitioner’s argument concerning pre-

1980 excise tax procedure. An excise tax “drawback,” if

received in the same year that the tax was paid, properly

would be treated as an adjustment to Southern Comfort’s

cost basis in its exported liqueur and not as an additional

item of “gross receipts.” See Freedom Newspapers, Inc.

v. Commissioner, T.C. Memo. 1977-429.

We therefore hold that Southern Comfort is not entitled

to increase “gross receipts” from export sales, for pur-

*3 Sec. 108(e)(2) was enacted as part of the Bankruptcy Tax Act

of 1980 and applies to nonbankruptcy transactions occurring after

Dec. 31, 1980. Pub. L. 96-589, 94 Stat. 3389, 3411-3412. See also

S. Rept. 96-1035 (1980), 1980-2 C.B. 620, 630. Counsel for petitioner

recognized the applicability of sec. 108(e) (2) to the excise tax issue

in a letter stipulated into evidence in the instant case. The letter

expressed petitioner’s position on the issues raised in a request for

technical advice submitted by the District Director with respect to

the matters in issue herein.

*4 Petitioner’s argument assumes that the lien imposed by sec.

5004 at the time distilled spirits came into existence constituted a

fixed and determinable excise tax “liability.” We do not imply any

viewpoint as to the time at which the excise tax “liability” attaches,

as it is unnecessary to decide such issue herein.

42a

poses of the OPPL, by any amount attributable to the ex-

cise tax on distilled spirits.

3. Validity of OPPL Regulation

Petitioner also alternatively argues that section 1.994-

2(b) (3), Income Tax Regs., imposing the OPPL, is in-

valid. In support of its position, petitioner argues on

brief that:

Code Section 994(b) (2) provides for the marginal

cost method for determining taxable income from ex-

port sales where a taxpayer is attempting to estab-

lish or maintain a foreign market. That section does

not authorize the percentage limitation imposed by

Regulation Section 1.994-2(b) (3). Without such au-

thorization by the Code, the percentage limitation im-

posed by the Regulations is invalid.

* ee * *

The policy behind section 994(b) (2) was to stimulate

exports by increasing their after tax profitability.

Section 994(b) (2) carried out that policy, by per-

mitting taxpayers to price exports on a marginal cost

basis to increase export taxable income and the DISC

commissions. Respondent’s regulation in issue does

just the opposite. It requires export taxable income

and the DISC commissions to be decreased. Respond-

ent’s regulation defeats, rather than carries out, the

purpose of the statute. The Regulation is therefore

invalid.

Petitioner also cites several cases in which DISC regula-

tions have been held invalid. We disagree with petition-

er’s analysis and hold that the challenged regulation is

valid.

The challenged regulation, section 1.994-2(b) (3), In-

come Tax Regs., was issued under the specific authority

of section 994(b) (2) and is thus classified as a “legisla-

tive regulation.” Accordingly, the regulation is entitled

to “even greater weight and deference than are accorded

48a

to interpretive regulations.” Olson v. Commissioner, 81

T.C. 318, 323 (1983). See also Dresser Industries v.

Commissioner, 92 T.C. 1276, 1290 (1989), on appeal

(5th Cir., October 23, 1989) ; United States v. Vogel Fer-

tilizer Co., 455 U.S. 16, 24 (1982); Rowan Cos. v. United

States, 452 U.S. 247, 258 (1981). In Rowan Cos. »v.

United States, supra, the Supreme Court stated that

“where the Commissioner acts under specific authority,

our primary inquiry is whether the interpretation or

method is within the delegation of authority.” 452 U.S.

at 253. Legislative regulations must be sustained unless

they are “unreasonable and plainly inconsistent” with the

statute they are designed to implement. Estate of Gun-

land v. Commissioner, 88 T.C. 1458, 1457 (1987). The

challenged regulation is neither unreasonable nor plainly

inconsistent with section 994 (b) (2).

Section 994(b) (2) provides the Secretary with broad

discretion to prescribe rules regarding allocation of ex-

penditures. The OPPL operates as an allocation rule, allo-

cating some of the indirect production costs of a product

or product line to export sales in circumstances in which

the profit margin or export sales (determined under

marginal costing) otherwise would exceed the worldwide

profit margin on sales of such product. Petitioner’s argu-

ment misinterprets section 994(b) (2) as a per se rule

that permits only marginal costs to be taken into account

in computing combined taxable income. Petitioner’s argu-

ment also ignores the plain language of section 994

(b) (2), which provides for rules for the “allocation” of

expenditures. The term “marginal costing” itself appears

only in the heading of subsection 994(b), entitled “Rules

for Commissions, Rentals, and Marginal Costing.” See

section 7806(b) (descriptive matter relating to contents

of Internal Revenue Code is of no legal effect), and the

legislative history of section 994(b) (2) states that mar-

ginal costing may be allowed by regulation “in the appro-

priate cases.” S. Rept. 92-437 (1971), 1972-1 C.B. 559,

619.

ee ne mT ee

44a

Petitioner’s argument that section 994(b) (2) “does not

authorize the percentage limitation imposed by the chal-

lenged regulation” implies that every specific provision or

requirement in legislative regulations must find specific

support in the statute. Such notion contradicts the pur-

pose of specific delegations ef rule-making authority—to

allow the Secretary to promulgate rules which, unless

arbitrary, will themselves have the force and effect of law.

Watson Land Co. v. Commissioner, 799 F.2d 571, 579

(9th Cir. 1986); Wolter Construction Co. v. Commis-

sioner, 634 F.2d 1029 (6th Cir. 1980); Craigie, Inc. v.

Commissioner, 84 T.C. 466, 471 (1985). As stated by

the Sixth Circuit (to which the instant case is appealable)

in Wolter Construction Co. v. Commissioner, supra at

1035, quoting National Muffler Dealers Association v.

United States, 440 U.S. 472, 477 (1979):

This grant of legislative authority insures 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.” ‘

We hold that the OPPL is within the broad delegation of

regulatory authority contained in section 994(b) (2).

The cases cited in petitioner’s brief in which DISC reg-

ulations have been held invalid are distinguishable from

the instant case in that they all involve interpretative reg-

ulations which improperly imposed additional require-

ments or created additional exceptions with respect to

unambiguous statutory provisions. In Durbin Paper

Stock Co. v. Commissioner, 80 T.C. 252 (1983), we in-

validated interpretative regulations which imposed upon

DISC’s a “paid-in” capital requirement (sec. 1.992-1(d)

(1), Income Tax Regs.) and a “separate bank account” re-

quirement (sec. 1.992-1(a) (6), Income Tax Regs.). in ad-

dition to the statutorily prescribed requirement that a

DISC have outstanding stock with a par or stated value of

at least $2,500 on each day of the taxable year. In in-

validating such regulations, we found the statutory re

er ne I

45a

quirement of $2,500 par or stated value “unambiguous”

and the regulations without any statutory authority. In

Arrow Fastener Co. v. Commissioner, 76 T.C. 423 (1981),

we invalidated an interpretative regulation limiting the

amount of obligations issued by the Export-Import Bank

of the United States which may constitute “qualified ex-

port assets” (sec. 1.993-2(h) (2), Income Tax Regs.).

The statute in that case provided without exception that

such obligations constitute qualified export assets, and we

reasoned that, in light of the unequivocal language of the

statute, the regulation was an inappropriate attempt to

amend the statute. In Caterpillar Tractor Co. v. United

States, 218 Ct. Cl. 517 (1978), the Court of Claims sim-

ilarly held that a regulation excepting from the definition

of “export property” property sold by a DISC to a related

Western Hemisphere Trade Corp. was invalid in that

it improperly “legislated” an exception to the definitior of

“export property.” The instant case, unlike such cases,

presents a situation in which the statute specifically au-

thorizes the Secretary of the Treasury to create rules

and in which there is no conflict with an unambiguous

term of the statute. See Rowan Cos. v. United States,

supra at 253 (explaining that interpretative regulations

are owed less deference because, unlike legislative regula-

tions, they can be “measured against” specific Code pro-

visions).

Petitioner, however, argues that the OPPL is incon-

sistent withthe purpose of section 994(b) (2) to stimulate

exports. We disagree. Section 994(b) (2) by its terms

limits the use of marginal costing to taxpayers “seeking

to establish or maintain a market for export property.”

The OPPL renders the marginal costing method beneficial

only to those taxpayers whose profit margin for export

sales—determined under a full costing method—is less

than their worldwide profit margin with respect to sales

of such product or product line. We find such effect

25 As discussed supra, the definition of “establishing or maintain-

ing a foreign market” contained in sec. 1.994-2(c)(1), Income Tax

' ‘

46a

reasonable in that it excludes from marginal costing tax-

payers who logically would not need special tax incentives

to be encouraged to export—i.e., those taxpayers whose

export profit margin already is higher than their world-

wide profit margin with respect to the product in ques-

tion, Taxpayers already enjoying a higher profit margin

on export sales than on worldwide sales of a product or

product line hardly would seem to be those Congress had

in mind when it granted the Commissioner regulatory

authority in section 994(b) (2) to allow special rules for

those “seeking to establish or maintain a market for ex-

port property.” 7°

In addition to excluding from the use of marginal cost-

ing taxpayers whose export profit margin is higher than

their worldwide profit margin (in conjunction with the

definition contained in section 1.994-2(c) (1), Income Tax

Regs.), the OPPL also sets a cap on combined taxable in-

come for purposes of section 994(a) (2). We do not find

such cap unreasonable or inconsistent with the under-

Regs., dictates that other taxpayers use the full costing method.

Petitioner has not challenged the validity of sec. 1.994-2(c)(1), In-

come Tax Regs. We refer to the operation of such regulation herein

to the extent that it is intertwined with the operation of the chal-

lenged OPPL regulation.

26 Although neither sec. 994 nor its legislative history provides

any insight into the meaning of “seeking to establish or maintain

a market,” the exclusion from such term of taxpayers enjoying a

higher profit margin on export sales than on worldwide sales is con-

sistent with the use of the phrase “establishing or maintaining a

market” in the sec. 482 regulations. More specifically, sec. 1.482-

2(e)(2) (iv), Income Tax Regs. (which was promulgated in 1968,

several years before the enactment of the DISC provisions), states

in relevant part that “one of the circumstances which may affect

the price of property is the fact that the seller may desire to make

sales at less than a normal profit for the primary purpose of es-

tablishing or maintaining a market for his products.” See also

Webster’s Third New International Dictionary 1362 (1986) (defin-

ing “maintain” to inc!ude “to preserve from failure or decline” and

“to sustain against opposition or danger’’).

47a

lying statute. As noted above, there is no indication in

section 994(b) (2) or its legislative history that Congress

intended to allow an unqualified use of marginal costing

to determine combined taxable income. See Wolter Con-

struction Co. v. Commissioner, supra at 1039 ( regulation

limiting deduction sustained where “conspicuously absent

from the Code is any clear provision which allows the de-

duction in full”). Rather Congress left it to Treasury to

fashion rules for the allocation of expenditures. The cap

created by the OPPL, in our view, functions as a reason-

able allocation rule.2"

Our conclusion that the challenged regulation is valid

is bolstered by Congressional action related to the enact-

ment of the intercompany pricing rules for Foreign Sales

Corporations (FSC’s), which generally replaced DISC’s

as part of the Deficit Reduction Act of 1984, Pub. L. 98-

368, 98 Stat. 494 et seq. The intercompany pricing rules

for transactions between FSC’s and related parties are con-

tained in section 925. The major differences between sec-

tions 925 and 994 is that a FSC, unlike a DISC, must

perform “significant economic functions” (specified in

section 925(c)) in order to take advantage of the safe-

harbor pricing methods contained in section 925(a) (1)

and (2). Those safe-harbor methods are intended to ap-

proximate arm’s-length pricing. See Deficit Reduction

Act of 1984: Explanation of Provisions Approved by the

Committee on March 21, 1984 (S. Prt. 98-169, Vol. I,

April 2, 1984) (hereafter referred to as “Senate Finance

Committee Explanation”) at 646; Staff of the Joint Com-

*7 Congress’ intent to place limits on “combined taxable income”

for purposes of sec. 994(a) (2) also is supported by a statement in

the legislative history of sec. 994 to the effect that “income may

not * * * be allocated to the DISC [under the rules of section 994

(a)(1) and (2)] to the extent that it would result in the related

person who sold the products to the DISC incurring a loss on the

sale.” S. Rept. 92-437, 1972-1 C.B. 559, 618. Such a “no loss” rule

suggests that Congress intended to prevent unlimited allocation of

taxable income to the DISC at the expense of its related supplier,

a policy which also is furthered by the OPPL. 7

48a

mittee on Taxation, General Explanation of the Revenue

Provisions of the Deficit Reduction Act of 1984 (J. Comm.

Print 1984) (hereafter referred to as “Joint Committee

Explanation”) at 1048 n.4, 1054-1055.

Under the safe-harbor rule of section 925(a) (2) (cor-

responding to section 994(a)(2)), and FSC may derive

taxable income equal to 23 percent of the “combined tax-

able income” of the FSC and its related supplier attrib-

utable to “foreign trading gross receipts” derived from

the sale of export property.** Section 925(b) provides:

SEC. 925(b). RULES FOR COMMISSIONS, RENTALS,

AND MARGINAL CosTING.—The Secretary shall pre-

scribe 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.

An examination of section 925(b) (2) reveals that it is

identical to section 994(b) (2) except for the replacement

of the word “FSC” in place of “DISC.” Thus, in replac-

ing the DISC provisions with the FSC provisions, Con-

gress left intact section 994(b) (2), basically renumbering

and incorporating the provision as section 925(b) (2).

28 “Foreign trading gross receipts” under the FSC provisions cor-

responds to “qualified export receipts” under the DISC provisions.

However, FSC’s are generally required to meet certain “foreign

management” and “foreign economic presence” requirements to

derive “foreign trade gross receipts.” See Staff of the Joint Com-

mittee on Taxation, General Explanation of the Revenue Provisions

of the Deficit Reduction Act of 1984 (J. Comm. Print 1984) (here-

after referred to as “Joint Committee Explanation’) at 1047-1048.

49a

The Senate Finance Committee Explanation states:

In general, where the provisions of the bill are iden-

tical or substantially similar to the DISC provisions

under present law, the committee intends that rules

comparable to the rules in regulations issued under

those provisions will be applied to the FSC. [Sen.

ate Finance Committee Explanation at 636.]

See also Joint Committee Explanation at 1043.2°

Moreover, Treasury has promulgated sections 1.925 (b) -

1T(b) (2) and 1.925 (b)-1T (e) (2) (i), Temporary Income

Tax Regs., 52 Fed. Reg. 6428, 6455-6456 (March 3, 1987),

which impose an OPPL and define the OPP for purposes

of section 925(b) (2) in virtually identical fashion as the

challenged regulation and section 1.994-2(c) (2) ( i), In-

come Tax Regs.*°

Accordingly, we hold that the challenged regulation is

valid.*!

2° The Joint Committee Explanation describes the marginal cost-

ing rules of sec. 994 in its “Prior Law” discussion as follows:

Under marginal costing rules, if the 50-50 method is used by the

DISC, only the marginal or variable production and sales costs for

the export property need be included in the computation of combined

taxable income. In general, the benefits of marginal cost pricing are

limited to instances where the variable cost margin on the DISC’s

export sales of a product is less than the full cost margin on the

combined product sales by the DISC and the related supplier. [Joint

Committee Explanation at 1039.]

*© Congress’ focus on the DISC intercompany pricing regulations

in 1984 is confirmed by its suggestion that the Secretary of the

Treasury consider whether the DISC regulations accomplished the

purpose of preventing pricing at a loss to the related supplier, such

“no loss” rule (supra note 27) having been incorporated in the FSC

provisions. See Deficit Reduction Act of 1984: Explanation of

Provisions Approved by the Committee on Mar. 21, 1984 (S. Prt.

98-169, Vol. I, Apr. 2, 1984) at 649.

31 No implication is intended as to the validity of sec. 1.994-2,

Income Tax Regs., axcept as it concerns imposition of the OPPL.

50a

4. Aggregation Election under Section 1.994-2(c)(2)(ti),

Income Tax Regs.

Section 1.994-2(c) (2) (ii), Income Tax Regs., provides:

At the annual option of the related supplier, the

overall profit percentage for the DISC’s taxable year

for all products and product lines may be determined

by aggregating the amounts described in subdivision

(i)(a) [eombined taxable income from worldwide

sales] and (b) [gross receipts from worldwide sales],

of this subparagraph of the DISC, and all domestic

members of the controlled group (as defined in sec-

tion 1.993-1(k)) of which the DISC is a member,

for the DISC’s taxable year and for taxable years

of such members ending with or within the DISC’s

taxable year.

During the years in issue, both Southern Comfort and

Jack Daniel were “related suppliers” of JDI and mem-

bers of a “controlled group” within the meaning of the

above-quoted regulation. In the amended returns filed

for the years in issue, the commissions payable by South-

ern Comfort to JDI were computed by aggregating South-

ern Comfort’s gross receipts and combined taxable income

with that of Jack Daniel in determining the applicable

OPP. The commissions payable by Jack Daniel to JDI

were computed without such aggregation. In his notice

of deficiency, respondent determined that:

Southern Comfort may not aggregate with Jack

Daniel for purposes of calculating its overall profit

percentage, unless Jack Daniel timely makes a con-

forming election to aggregate * * *

Petitioner argues that section 1.994-2(c) (2) (ii), In-

come Tax Regs., does not require a “conforming election”

to be made by any other member of the controlled group

in order for aggregation to be allowed, and that such

a requirement would defeat the purpose of the regulation.

Respondent argues that section 1.994-2(c) (2) (ii), In-

ena eds

“ eteeneenettietttitite,

5la

come Tax Regs., was drafted with a single “related sup-

plier” in mind, rather than multiple “related suppliers’

(as are present in the instant case), and that in order

to avoid “distortions” in taxable income, Southern Com-

fort and Jack Daniel should be treated as a single tax-

payer for purposes of such regulation. We refuse to

adopt respondent’s interpretation of section 1.994-2(c)

(2) (ii), Income Tax Regs.

Section 1.994-1(a) (3) (ii), Income Tax Regs., which

was promulgated at the same time as section 1.994-2

(c) (2) (ii), Income Tax Regs., defines “related supplier”

as follows:

(ii) The term “related supplier” means a related

party which singly engages in a transaction directly

with the DISC which is subject to the rules of section

994 and this section. However, a DISC may have dif-

ferent related suppliers with respect to different

transactions. If, for example, X owns all the stock of

Y, a corporation, and of Z, a DISC, and sells a prod-

uct to Y which is resold to Z, only Y is the related

supplier of Z, and, thus, only the resale from Y to Z

is subject to section 994 and this section. If, how-

ever, X sells directly to Z and Y also sells directly to

Z, then, as to the transactions involving direct sales

to Z, each of X and Y is a related supplier of Z. [Em-

phasis supplied. ]

Such definition reveals that Treasury was aware of

the possibility of multiple related suppliers and intended

the term “related supplier” to be read in the singular.

We reject respondent’s argument that “regulations, like

statutes, are often written in the singular, but cover the

plural,” as being inapposite to the instant case in which

a definition section clearly distinguishes the singular from

the plural.

Respondent concedes that the aggregation rule of sec-

tion 1.994-2(c) (2) (ii), Income Tax Regs., represents a

52a

“liberalization” of the rules of section 994. Assuming

that to be the case, we agree with petitioner that respond-

ent’s position would defeat such “liberalizing” purpose.

Since a “related supplier” would apply the aggregation

rule only to increase the applicable OPP, requiring a con-

forming election from the other “related suppliers” would

force those other suppliers into using a lower OPP than

that to which they would have been entitled separately.

We note, moreover, that there is no provision in section

994 or its regulations requiring related suppliers from

the same controlled group to use the same intercompany

pricing method; under the methods contained in sections

994(a) (1) and 994(a) (3), the OPP is irrelevant, and

the “conforming election” desired by respondent would

be illogical and of no effect.”

Petitioner’s interpretation of section 1.994-2(c) (2) (ii),

Income Tax Regs., is, moreover, consistent with -various

other provisions of the section 994 regulations. The OPPL

generally is computed using the item, product, or product-

line grouping used for the DISC intercompany profit de-

terminations. Sec. 1.994-2(c) (3) (i), Income Tax Regs.

Under section 1.994-2(c) (3) (ii), Income Tax Regs., how-

ever, the taxpayer may, on an annual basis, elect to cal-

culate the OPP using a broader product line grouping than

that used in determining “combined taxable income” from

export sales under section 994(a) (2). Thus, the OPP may

be determined, in the case of a single taxpayer, by in-

cluding in “gross receipts’ and “combined taxable in-

come” amounts attributable to sales which are not subject

82 During the years in issue, the computations required under sec.

994(a)(1) and (a)(2) were made on Schedules P to Forms 1120-

DISC. The instructions for such schedules indicate that a separate

schedule was to be completed for each transaction or group of trans-

actions. Each schedule contained a box to be checked to indicate

application of the aggregation rule, and nothing in the schedules or

instructions thereto suggested that the election of aggregaticn on

one Schedule P required its election on any other Schedule P accom-

panying the return.

mM

58a

to the marginal costing rules at all (so long as the prod-

uct grouping is permissible under section 1.994-1(c) (7),

Income Tax Regs.). See also sec. 1.994-1(e) (1) (iii), In-

come Tax Regs. Such rule supports the notion that the

OPP may be calculated by including data from other

sales which are not themselves subject to the same OPPL.

We are not bound by respondent’s reading of his regu-

lations. Hunt v. Commissioner, 80 T.C. 1126, 1144

(1983). In the instant case, respondent’s reading of sec-

tion 1.994-2(c) (2) (ii), Ineome Tax Regs., is contrary to

the plain language of such regulation, as clarified by the

definition of “related supplier” contained in section 1.994-1

(t) (3) (ii), Income Tax Regs. Accordingly, we hold that

Southern Comfort was entitled to aggregate its gross re-

ceipts and combined taxable income with that of Jack

Daniel without a conforming election being made by Jack

Daniel.

In light of our holdings in favor of respondent on the

excise tax issue and the validity of section 1.994-2(b) (3),

Income Tax Regs., we need not consider respondent’s

alternative determination that JDI is a disqualified DISC

for its tax year ended November 30, 1982, by reason of

Southern Comfort’s alleged failure to timely pay the in-

creased commissions claimed on its amended returns.**

33 The explanation of adjustments in respondent’s notice of defi-

ciency raises the alternative issue of DISC disqualification as fol-

lows:

It is further determined that were your DISC commission ex-

penses allowed as claimed, you would not have timely paid the

required amount within sixty days of the end of the DISC’s

year ended November 30, 1982. The allowance of your informal

claims on the claimed reduction of domestic gross receipts and

the claimed aggregation would result in the disqualification-of

DISC status to Jack Daniel International because the adjusted

basis of the qualified export assets of the DISC failed to equal

or exceed 95 percent of the sum of the adjusted basis of all its

assets at the close of the taxable year.

In his opening brief, petitioner states that the issue of DISC

disqualification would arise only if petitioner prevailed on the excise

54a

Respondent’s motion for leave to amend his answer with

respect to that issue therefore is moot.

To reflect the foregoing,

Decision will be entered under Rule 155.

tax and aggregation issues or if the OPPL were invalidated. Re-

spondent’s reply brief similarly states that the Court need reach

the DISC disqualification issue only if it were to decide “the OPPL

issue” in favor of petitioner, and later refers to the consequences

of Southern Comfort having been correct on both the “gross receipts

and the aggregation issue.”’ Accordingly, we have proceeded on the

basis that the fact that petitioner prevailed on the aggregation issue

is not in itself sufficient to raise the DISC disqualification issue.

55a

UNITED STATES COURT OF APPEALS

FOR THE SIXTH CIRCUIT

Case No: 91-1108

BROWN-FORMAN CORPORATION, (a Delaware corporation),

Successor by merger to Brown-Forman Corporation (a

Tennessee corporation), successor in interest to South-

ern Comfort Corporation (a Delaware corporation),

Petitioner-A ppellant

Cross-A ppellee

V.

COMMISSIONER OF INTERNAL REVENUE

Respondent-A ppellee

Cross-Appellant

ORDER

[Filed Mar. 17, 1992]

Before: NELSON and SUHRHEINRICH, Circuit Judg-

es; ENGEL, Senior Judge

Upon consideration of the petition for rehearing filed

by the petitioner,

It is ORDERED that the petition for rehearing be, and

it hereby is, DENIED.

ENTERED BY ORDER OF THE Court

/s/ Leonard Green

LEONARD GREEN

Clerk

%88'Sb

SOXB], wloxY Surpnpyxq Tddo

00°882‘8z9‘T1z SeXB], asIoxg Zurpnpoxg sareg

00°L0L‘698'%6 ewloouy afqexey,

00°L0L‘F98'26 00°260‘0L8‘S8 00°S19‘F8F'6 sULOOUT a[qexey,

00°LL6‘086‘TP 00°0T8‘SeL‘sz 0O°LOT‘LET‘9T sesuedxg 19430

00°F09‘LE8‘9L 00°T80‘Ers‘09 00°SZ9‘Fér‘9T S9[BS II}SeWI0g UO Saxe], asioxy

BUIPN]OX| PjOg spoory Jo ysog

00°Sh0'E99'TZT 00°898‘F8r‘68 OO'LLI'SLI‘ZE S9[BS I}saulog Uo sexe], astoxq|

3 00°669°009‘86T 00°66‘'LZ8‘6FT 00°002‘2L9‘8F S9[BS II4ySaUIOG] UO Sex¥y, astoxq

© BUIPNOU] P[Og spoon Jo 480g

00°882'8Z9‘TIZ 00°€86‘9PPr‘69T 00°S0¢‘9LT ‘Sr Sox¥], WsloxY Zurpnjoxy saeg

00°Sh0‘E99‘TZI 00°898‘r8r‘68 OO'LLI'SLI‘ZE S9[BS I14ySaWIOG UO Sex¥y, asIoxq

00°Se‘982‘ees 00°TS8‘TS6‘8ez 00°28h ‘FE bz S3[Bg dIjseuI0g uO

SOXB], WIOXY Zurpnpouy sayeg

qaodx qaodxy qodxy S9XB], asI9xy Noy AM

2 OIWSoUIOG 3 II}SouOGg 3? OISOUIOG TddO jo uorzeyndui0,y

[?}0.L etueq your WOsuOy “og 18/08/P Ad

“PANOD XVI, 94} Ul UOTsIIaq Jo AryUy OF uorzepNduI0D s,18U0IsstUIUIOD JO 2 ‘d “VY yIqryxy wor psonpoidsy :ao1nog

TIddO dO NOILVLAdNWOO

57a

% 98°12

00°ees'98z'e¢e

00°202'F98'z6

00°202‘FS8'z6

00°226‘086'TF

00°6F9'009'86T

00°S€s‘98z‘ese

yodxy

77 9IjSaw0g

[2307

00°260‘0L8‘E8

00°0T8*EEz ‘ez

00°6F6'LZ8‘6FT

00°TS8‘TEe6‘sez

qodxy

3 II}sow0g

[arueg your

00°ST9‘F8r‘6

0O'LOT‘LET‘9T

000°002‘ZL9‘aF

00°S8hFoE‘bL

yodxy

7 IIJSOWIOG

JAOFWIOD “og

SexB], SIOxg Zurpnpouy TddO

SOXB], OstIxgq Zurpnpouy SoyBg

dsUlOIUT afqexe y,

sulOIUT ajqexe y,

Sesuedxy 19439

S9[BS d1}Seul0g uo sexe y, estoxy

BUIPNIIUT Pog spoor Jo #809

83/8 dI}seWI0g ug

Soxe esloxg Zurpnjouy sareg

SOXBT, SIOXT YIM

‘IddO J0 uoreynduog

58a

INTERNAL REVENUE CODE OF 1954

SEC. 991. TAXATION OF A DOMESTIC INTERNA-

TIONAL SALES CORPORATION.

For purposes of the taxes imposed by this subtitle upon

a DISC (as defined in section 992(a)), a DISC shall not

be subject to the taxes imposed by this subtitle except for

the tax imposed by chapter 5. Source: New.

SEC. 992. REQUIREMENTS OF A DOMESTIC INTER-

NATIONAL SALES CORPORATION.

(Sec. 992 (a) ]

(a) DEFINITION OF “DISC” AND “FORMER

DISC”.—

(1) DISC.—For purposes of this title, the term

“DISC” means, with respect to any taxable year, a

corporation which is incorporated under the laws of

any State and satisfies the following conditions for

the taxable year:

(A) 95 percent or more of the gross receipts

(as defined in section 993(f)) of such corpora-

tion consist of qualified export receipts (as de-

fined in section 993 (a) ),

(B) the adjusted basis of the qualified export

assets (as defined in section 993(b)) of the cor-

_ poration at the close of the taxable year equals

of exceeds 95 percent of the sum of the adjusted

basis of all assets of the corporation at the close

of the taxable year.

SEC. 994. INTER-COMPANY PRICING RULES.

[Sece. 994(a)]

(a) IN GENERAL.—In the case of a sale of export

property to a DISC by a person described in section 482,

59a

the taxable income of such DISC and such person shall be

based upon a transfer price which would allow such DISC

to derive taxable income attributable to such sale (regard-

less of the sales price actually charged) in an amount

which does not exceed the greatest of —

(1) 4 percent of the qualified export receipts on

the sale of such property by the DISC plus 10 percent

of the export promotion expenses of such DISC at-

tributable to such receipts.

(2) 50 percent of the combined taxable income of

such DISC and such person which is attributable to

the qualified export receipts on such property derived

as the result of a sale by the DISC plus 10 percent of

the export promotion expenses of such DISC attrib-

utable to such receipts, or

(3) taxable income based upon the sale price ac-

tually charged (but subject to the rules provided in

section 482).

Source New.

[Sece. 994 (b) ]

(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 z

section in the case of commissions, rentals, and other

income, and

(2) rules for the allocation of expenditures in com-

puting combined taxable income under subsection

(a) (2) in those cases where a DISC is seeking to

establish or maintain a market for export property.

Source New.

7 . * *

iF

60a

TREASURY REGULATIONS

§ 1.994-2. Marginal costing rules.—(a) Jn general. This

section prescribes the marginal costing rules authorized

by section 994(b) (2). If under paragraph (c) (1) of this

section a DISC is treated for its taxable year as seeking

to establish or maintain a foreign market for sales of an

item, product, or product line of export property (as de-

fined in § 1.993-3) from which qualified export receipts

are derived, the marginal costing rules prescribed in para-

graph (b) of this section may be applied to allocate costs

between gross receipts derived from such sales and other

gross receipts for purposes of computing, under the “50-

50” combined taxable income method of § 1.994-1(c) (3),

the combined taxable income of the DISC and related sup-

plier derived from such sales. Such marginal costing rules

may be applied whether or not the related supplier manu-

facturers, produces, grows, or extracts (within the mean-

ing of § 1.993-3(c)) the export property sold. Such mar-

ginal costing rules do not apply to sales of export prop-

erty which in the hands of a purchaser related under sec-

tion 954 (d) (3) to the seller give rise to foreign base com-

pany sales income as described in section 954(d) unless,

for the purchaser’s year in which it reseils the export

property, section 954(b)(3)(A) is applicable or such

income is under the exceptions in section 954(b) (4).

Such marginal costing rules do not apply to leases of prop-

erty or the performance of any services whether or not

related and subsidiary—services (as defined in § 1.994-1

(b) (3)).

(b) Marginal costing rules for allocations of costs—

(1) In general. Marginal costing is a method under

which only marginal or variable costs of producing and

selling a particular item, product, or product line are

taken into account for purposes of section 994. Where

this section is applicable, costs attributable to deriving

qualified export receipts for the DISC’s taxable year from

sales of an item, product, or product line may be deter-

6la

mined in any manner the related supplier (as defined in

§ 1.994-1(a) (3) (ii) chooses, provided that the require-

ments of both subparagraphs (2) and (8) of this para-

graph are met.

(2) Variable costs taken into account. There are taken

into-account in computing the combined taxable income of

the DISC and its related supplier from sales of an item,

product, or product line the following costs: (i) Direct

production costs (as defined in § 1.471-11(b) (2) (i)) and

(ii) costs which are export promotion expenses, but only

if they are claimed as export promotion expenses in de-

termining taxable income derived by the DISC under the

combined taxable income method of § 1.994-1(c) (3). At

the taxpayer’s option, all, a part, or none of the costs

which qualify as export promotion expenses may be so

claimed as export promotion expenses.

(3) Overall profit percentage limitation. As a result

of such determination of costs attributable to such quali-

fied export receipts for the DISC’s taxable year, the com-

bined taxable income of the DISC and its related supplier

from sales of such item, product, or product line for the

DISC’s taxable year does not exceed gross receipts (de-

termined under § 1.993-6) of the DISC derived from such

sales, multiplied by the overall profit percentage (deter-

mined under paragraph (c) (2) of this section).

(ce) Definitions—(1) Establishing or maintaining a

foreign market. A DISC shall be treated for its taxable

year as seeking to establish or maintain a foreign market

with respect to sales of an item, product, or product line

of export property from which qualified export receipts

are derived if the combined taxable income computed

under paragraph (b) of this section is greater than the

combined taxable income computed under § 1.994-1(c) (6).

(2) Overall profit percentage. (i) For purposes of this

section, the overall profit percentage for a taxable year of

the DISC for a product or product line is the percentage

which—

62a

(a) The combined taxable income of the DISC and its

related supplier plus all other taxable income of its related

supplier from all sales (domestic and foreign) of such

product or product line during the DISC’s taxable year,

computed under the full costing method, is of

(b) The total gross receipts (determined _ § 1.933-

6) from all such sales.

(ii) At the annual option of the related supplier, the

overall profit percentage for the DISC’s taxable year for

all products and product lines may be determined by

aggregating the amounts described in subdivision (i) (a)

and (6) of this subparagraph of the DISC, and all do-

mestic members of the controlled group (as defined in

§ 1.993-1(k)) of which the DISC is a member, for the

DISC’s taxable year and for taxable years of such mem-

bers ending with or within tiie DISC’s taxable year.

(iii) For purposes of determining the amounts in sub-

divisions (i) (b) and (ii) of this subparagraph, a sale of

property between a DISC and its related supplier or be-

tween domestic members of the controlled group shall be

taken into account only during the DISC’s taxable year

(or taxable year of the member ending within the DISC’s

taxable year) during which the property is ultimately

sold to a person which is neither the DISC nor such a

domestic member.

(3) Grouping of transactions. (i) In general, for pur-

poses of this section, an item, product, or product line is

the item or group consisting of the product or product

line pursuant to § 1.994-1(c) (7) used by the taxpayer

for purposes of applying the intercompany pricing rules

of § 1.994-1.

(ii) However, for purposes of determining the overall

profit percentage under subparagraph (2) of this para-

graph, any product or product line grouping permissible

under § 1.994-1(c) (7) may be used at the annual choice

of the taxpayer, even though it may not be the same item

63a

or grouping referred to in subdivision (i) of this sub-

paragraph, as long as the grouping chosen for determin-

ing the overall profit percentage is at least as broad as the

grouping referred to in such subdivision (i).

(4) Full costing method. For purposes of this section,

the term “full costing method” is the method for deter-

mining combined taxable income set forth in § 1.994-1

(ce) (6).

(d) Application of limitation on DISC income (“no

loss” rule). If the marginal costing rules of this section

are applied, the combined taxable income method of

$ 1.994-1(¢e) (3} may not be applied to cause in any tax-

able year a loss to the related supplier, but such method

may be applied to the extent it does not cause a loss. For

purposes of the preceding sentence, a loss to a related

supplier would result if the taxable income of the DISC

would exceed the combined taxable income of the related

supplier and the DISC determined in accordance with

paragraph (b) of this section. If, however, there is no

combined taxable income (so determined), see the last

sentence of § 1.994-1(e) (1) (i).

(e) Examples. The provisions of this section may be

illustrated by the following examples:

Example (1). X and Y are calendar year taxpayers.

X, a domestic manufacturing company, owns all the stock

of Y, a DISC for the taxable year. During 1973, X manu-

factures a product line which is eligible to be export prop-

erty (as defined in § 1.993-3). X enters into a written

agreement with Y whereby Y is granted a sales franchise

with respect to exporting such product line from which

qualified export receipts will be derived and Y will receive

commissions with respect to such exports equal to the

maximum amount permitted to be received under the in-

tercompany pricing rules of section 994. Commissions are

computed using the combined taxable income method un-

der § 1.994-1(c) (3). For purposes of applying the com-

64a

bined taxable income method, X and Y compute their

combined taxable income attributable to the product line

of export under the marginal costing rules in accordance

with the additional facts assumed in the table below:

(1) Maximum combined taxable income (determined un-

der paragraph (b) (2) of this section) :

(a) Y’s gross receipts from export sales ................ $95.00

(b) Less:

Ci) SARRUS MI i a K.. 40.00

Cily Se i ea Bee a 20.00

(iii) Y’s export promotion expenses claimed

in determining Y’s DISC taxable in-

CO sai hiciiiensiisibnaphcdicitintd itbsibitnt is tiecainds $ 5.00

CEG FE IOI acre pepe rcederweeensccnsace silee 65.00

(c) Maximum combined taxable income ................ 30.00

(2) Overall profit percentage limitation (determined un-

der paragraph (b) (3) of this section) :

(a) Gross receipts of X and Y from all domestic

ir Dee Ge hii ee 400.00

(tk, Less deductions:

(i): SI I: atid 160.00

BR Py a ee 80.00

(iii) Other costs (of which $8 are costs of the

DISC including $5 of export promotion

expenses claimed in determining Y’s

COED UND ein 40.00

Cae). UI 280.00

(d) Total taxable income from all sales computed

on a full costing method —.....0.. ee. 120.00

(e) Overall profit perceniage (line (d) ($120) pea

divided by line (a) ($400)) (percent) —.......... 30

(f) Multiply by gross receipts from Y’s export ,

wee ae Cre Ge dee a nis $95.00

(g) Overall profit percentage limitation ............. 28.50

LL

65a

Since the overall profit percentage limitation under line

(2)(g) ($28.50) is less than the maximum combined

taxable income under line (1) (¢) ($30), combined tax-

able income under marginal costing is limited to $28.50.

Since under the franchise agreement Y is to earn the

maximum commission permitted under the interecompany

[sic] pricing rules of section 994, combined taxable income

on the transactions is $28.50. Accordingly, the costs at-

tributable to export sales (other than for direct material,

direct labor, and export promotion expenses) are $1.50,

1.e., line (1) (ce) ($30) minus line (2)(g) ($28.50). Un-

der the combined taxable income method of § 1.994-1

(c) (3), Y will have taxable income attributable to the

Sales of $14.75, i.e., the sum of 1/2 of combined taxable

income (1/2 of $28.50) and 10 percent of Y’s export pro-

motion expenses claimed in determining Y’s taxable in-

come (10 percent of $5). Accordingly, the commissions

Y receives from X are $22.75, ‘i.e., Y’s costs ($8, see line

(2) (b) (iii) plus Y’s profit ($14.75).

Example (2). (1) Assume the same facts as in ex-

ample (1), except that gross receipts from export sales

are only $85 and gross receipts from all sales remain at

$400. For purposes of applying the combined taxable

income method, X and Y may compute their combined

taxable income attributable to the product line of export

property under the marginal costing rules as follows:

(1) Maximum combined taxable income (determined under

paragraph (b) (2) of this section) :

(a) Y’s gross receipts from export sales...

(b) Less:

$85.00

(i) Direct materials 00 $40.00

2. 20.00

5.00

65.00

20.00

:

i

:

:

66a

(2) Overall profit percentage limitation (deterruined under

paragraph (b) (3) of this section) :

(a) Gross receipts from Y’s export sales (line

(iL |» eRe aOR Lae ance rasauiees 85.00

(b) Multiply by overall profit percentage (as de-

termined in example (1)) (percent) -.............. 30

(c) Overall profit percentage limitations -.............. 25.50

Since maximum combined taxable income under line

(1) (ce) ($20) is less than the overall profit percentage

limitation under line (2) (c) ($25.50), combined taxable

income under marginal costing is limited to $20. Since

under the franchise agreement Y is to earn the maximum

commission permitted under the intercompany pricing

rules of section 994, combined taxable income on the trans-

actions is $20. Accordingly, no costs (other than for

direct material, direct labor, and export promotion ex-

penses) will be attributed to export sales. Under the

combined taxable income method of § 1.994-1(c) (3), Y

will have taxable income attributable to the sales of $10.50,

i.e, the sum of % of combined taxable income (% of

$20) and 10 percent of Y’s export promotion expenses

claimed in determining Y’s-taxable income (10 percent

of $5). Accordingly, the Commissions Y receives from

X are $18.50, i.e., Y’s costs ($8, see line (2) (b) (iii) of

example (1) ) plus Y’s profit ($10.50).

(2) If export promotion expenses are not claimed in

determining taxable income of Y under the combined

taxable income method, the taxable income of Y would be

increased to $12.50 and commissions payable to Y would

be increased to $20.50, computed as follows:

(3) Maximum combined taxable income (determined

under paragraph (b) (2) of this section) :

(a) Y’s gross receipts from export sales _..... doa $85.00

67a

(b) Less:

(i) Direct materials 00 40.00

se Mestad netnlncnscse, Ro 20.00

(ili) Total deductions 00 60.00

(c) Maximum combined taxable income... 25.00

(4) Overall profit percentage limitation (line (2) (¢)).. 25.50

Since maximum combined taxable income under line

(3) (ce) ($25) is less than the overall profit percentage

under line (4) ( $25.50), combined taxable income under

marginal costing is limited to $25. Since under the fran-

chise agreement Y is to earn the maximum commission

permitted under the intercompany pricing rules of section

994, combined taxabie income on the transactions is $25.

Accordingly, no costs (other than for direct materia] and

direct labor) will be attributed to export sales. Under the

combined taxable income method of § 1.994-1(¢) (3), Y

will have taxable income attributable to the sales of

$12.50, i.e., 1/2 of combined taxable income (1/2 of $25).

Accordingly, the commissions Y receives from X are

$20.50, i.e., Y’s costs ($8, see line (2) (b) (iii) of example

(1)) plus Y’s profit ($12.50).

Example (3). (1) Assume the same facts as in example

(1), except that gross receipts from export sales are only

$85, gross receipts from all sales remain at $400, and Y

has costs of $40 consisting of Y’s export promotion ex-

penses of $35 and costs of $5 other than for direct ma-

terial, direct labor, or export promotion expenses, For

purposes of applying the combined taxable income method,

X and Y may compute their combined taxable income

attributable to the product line of export property under

the marginal costing rules as follows:

(1) Maximum combined taxable income (determined

under paragraph (b) (2) of this section) :

(a) Y’s gross receipts from export sales... $85.00

|

+ eae, taal

68a

(b) Less:

CRF BO TN, didetcttinttaenicecteatinnntbtbareincs 40.00

CO TN a 20.00

(iii) Y’s export promotion expenses claimed

in determining Y’s taxable income .......... 35.00

Ciw) ‘Tietend GROCUOUND uss ckivn ci cciececneeciscciniceesnoce 95.00

(c) Maximum combined taxable income (loss) ....(10.00)

(2) Overall profit percentage limitation (as deter-

Ee, pha ere NaN lta er at 25.50

Since maximum combined taxable income under line

(1) (c) (which is a loss of $10) is less than the overall

profit percentage limitation under line (2) (c) ($25.50),

combined taxable income under marginal costing is a loss

of $10 and under the combined taxable income method of

§ 1.994-1(c) (3), Y witl have no taxable income or loss

attributable to the saies. Accordingly, the commissions Y

receives from X are $40, i.e., Y’s costs ($40).

(2) If export promotion expenses are not claimed in

determining Y’s taxable income under the combined tax-

able income method, the taxable income of Y would be in-

creased to $12.50 and commissions payable to Y would be

increased to $52.50 computed as follows:

(3) Maximum combined taxable income (determined

under paragraph (b)(2) of this section) (line

(3) (c) of example (2)) ......... eavteeaceseaceseessnesteensnneneee $25.00

(4) Overall profit percentage limitation (as determined

ET Te ee ye Ny CE 25.50

The results would be the same as in part (2) of example

(2), except that the commissions Y receives from X are

$52.50, i.e., Y’s cost ($40) plus Y’s profit ($12.50).