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

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## Record

- **Collection:** Supreme Court brief
- **Document type:** Petition for Writ of Certiorari
- **Published:** January 1, 1992
- **Citation:** 506 U.S. 827

## Text

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

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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

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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. :

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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.

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| 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

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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.

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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

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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

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40386011_0822%3A1. Public record. Not legal advice.