Petition for Writ of Certiorari — Commissioner v. Texaco Inc.

Supreme Court, U.S.

- ,ti 8 D

Y 961107 vAN 101997,

OF JHE CLERK

Jn the Supreme Court of the Gited States

OCTOBER TERM, 1996

COMMISSIONER OF INTERNAL REVENUE, PETITIONER

Vv.

TEXACO, INC. AND SUBSIDIARIES

ON PETITION FOR A WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

PETITION FOR A WRIT OF CERTIORARI

WALTER DELLINGER

Acting Solicitor General

LORETTA C. ARGRETT

Assistant Attorney General

LAWRENCE G. WALLACE

Deputy Solicitor General

KENT L. JONES

Assistant to the Solicitor

General

JONATHAN 8S. COHEN

THOMAS J. CLARK

Attorneys

Department of Justice

Washington, D.C. 20530-0001

(202) 514-2217

QUESTION PRESENTED

Whether a directive of a foreign government that

has the ancillary consequence of distorting the in-

come of a United States taxpayer—by causing profits

earned by the activities of that taxpayer to be realized

instead by its foreign affiliates—prohibits the

Commissioner of Internal Revenue from exercising

the power vested in her by statute to apportion or

allocate gross income among the affiliates of United

States taxpayers “in order to prevent evasion of taxes

or clearly to reflect the[ir] income” (26 U.S.C. 482).

(I)

TABLE OF CONTENTS

Page

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DAE Et hic ncuhiicghndasnyahanbsaxbuantnsescsnnvvesdetessccins 1

Statute and regulations involved .............ccccccceesessseeeeees 2

EE te Miatha ie aig da bbhotiiaes stbdedavidsahsivowedsokiedheesieoesss 3

Reasons for granting the petition ................ccceeeeeseeeeeees 12

a a ie saniwundiinasensanee 26

TABLE OF AUTHORITIES

Cases:

Bamberger v. Clark, 390 F.2d 485 (D.C. Cir.

EM tai ishdlis ha ates didi cubdshendneieabopeandoahinhinineaenssvacessen 20

Bank of the United States v. Planters Bank of

Georgia, 22 U.S. (9 Wheat.) 904 (1824) ................08 20

Bassis v. Universal Line, S.A., 436 F.2d 64 (2d Cir.

MT Cid ila ail dslil olathe sondcesudphpanendurinéueuiadanenibeete 20

Commissioner v. Culbertson, 337 U.S. 733 (1949)... 12, 14

Commissioner v. First Security Bank, 405 U.S. 394

I Lh thd td Clash bnh dea tinsaseecibiiedennncontneumes 11, 12, 14, 16

Kalmich v. Bruno, 553 F.2d 549 (7th Cir.), cert.

SI I SI OP CRETE) conesccenconcnecnsconcnscesncsesccens 20

Ohio v. Helvering, 292 U.S. 360 (1934) ...............00668 20-21

Procter & Gamble Co. v. Commissioner, 961 F.2d

iar emnbesbapndeneenbene 17

Republic of Argentina v. Weltover, Inc., 504 U.S.

eas cea dak eicl ak ninaiaredaaneonsiions 21, 22. 23

Saudi Arabia v. Arabian American Oil Co., 27

I eee spumundiononis 22

South Carolina v. United States, 199 U.S. 437

a aaa acd setae ad a tiniepdcliiiamisasitulianss 21, 23

United States v. Basye, 410 U.S. 441 (1978) .......... st, 25.

14, 17, 18, 19, 24

(IIT)

IV

Statutes, regulations and rule: Page

Foreign Sovereign Immunities Act of 1976, 28 U.S.C.

PE WG DOU, . exrcicinssicvcasesevinsieduadinnhineduniadecineviateantle 21

Internal Revenue Code, 26 U.S.C. 482 ......... 2. 6 9 i.

13, 15, 19, 26

Revenue Act of 1928, ch. 852, § 45, 45 Stat. 791:

Op Ses Se in peninctsbsactinseacsdesssubkatanend teers 13

26 C.F.R.:

© SRT acdsee dansivcaseneutavecaccenicesecdaxcadeeasancieveaee 2

DD ED cs ickcckass siccanesciasescnnceaseueannts 2-3

Be EE scovctscccutcib cavdvksuenammiensatdadcaeumiceeintee 13

BREED COUPES cdkactaccassicdsdsannecivanceckdlatereeies 16

FROM EEE" nidsndvnintacsede<sencadédsusocoloiankecaccceucaiiance’ 2

BR TINE avescbanccteuaces sic binecaibasinaibeses deomoaam since: 2

Pr eet ee Seitenende 20

Miscellaneous:

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

Corporations and Shareho!lders (1987 ed.) ............ 13,

14, 19, 26

Black’s Law Dictionary (6th ed. 1990) ...............eceeee 21

Rev. Rul. 82-80, 1962-1 C.B. 80 .........ccccccsssercssssescoosees 17

In the Supreme Court of the Gnited States

OCTOBER TERM, 1996

No.

COMMISSIONER OF INTERNAL REVENUE, PETITIONER

Vv.

TEXACO, INC. AND SUBSIDIARIES

ON PETITION FOR A WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

PETITION FOR A WRIT OF CERTIORARI

The Solicitor General, on behalf of the Commis-

ioner of Internal Revenue, petitions for a writ of cer-

tiorari to review the judgment of the United States

Court of Appeals for the Fifth Circuit in this case.

OPINIONS BELOW

The opinion of the court of appeals (App. Ja-13a) is

reported at 98 F.3d 825. The opinion of the Tax Court

(App. 14a-187a) is reported at 66 T.C.M. (CCH) 1707.

JURISDICTION

The judgment of the court of appeals was entered on

October 17, 1996. The jurisdiction of this Court is

invoked under 28 U.S.C. 1254(1).

(1)

STATUTE AND REGULATIONS INVOLVED

1. Section 482 of the Internal Revenue Code, 26

U.S.C. 482, provides in relevant part:

In any case of two or more organizations,

trades, or businesses (whether or not incorpo-

rated, whether or not organized in the United

States, and whether or not affiliated) owned or

controlled directly or indirectly by the same

interests, the Secretary may distribute, appor-

tion, or allocate gross income, deductions, credits,

or allowances between or among such organiza-

tions, trades, or businesses, if he determines that

such distribution, apportionment, or allocation is

necessary in order to prevent evasion of taxes or

clearly to reflect the income of any of such

organizations, trades, or businesses. * * *

2. During the years relevant to this litigation,

Section 1.482-1A(b)(1) of the Treasury Regulations on

Income Tax, 26 C.F.R. 1.482-1A(b)(1) (1981), provided:’

The purpose of section 482 [of the Intcrnal

Revenue Code] is to place a controlled taxpayer on

a tax parity with an uncontrolled taxpayer, by

determining, according to the standard of an

uncontrolled taxpayer, the true taxable income

from the property and business of a controlled

taxpayer. The interests controlling a group of

controlled taxpayers are assumed to have com-

plete power to cause each controlled taxpayer so

1 The provisions of this regulation have been placed in a

different format in the regulation that replaced it for tax years

beginning after April 21, 1993. Compare 26 C.F.R. 1.482-1T(a)

and (b), with 26 C.F.R. 1.482-1A(b). The newer regulation does

not alter the provisions of relevance to this case.

3

to conduct its affairs that its transactions and

accounting records truly reflect the taxable

income from tne property and business of each of

the controlled taxpayers. If, however, this has not

been done, and the taxable incomes are thereby

understated, the district director shall intervene,

and, by making such distributions, apportion-

ments, or allocations as he may deem necessary of

gross income, deductions, credits or allowances,

or of any item or element affecting taxable in-

come, between or among the controlled taxpayers

constituting the group, shall determine the true

taxable income of each controlled taxpayer. The

standard to be applied in every case is that of an

uncontrolled taxpayer dealing at arm’s length

with another uncontrolled taxpayer.

STATEMENT

l.a. In 1933, the government of Saudi Arabia

granted a concession to Standard Oil of California to

explore for, extract and export Saudi Arabian oil (App.

18a). A corporation known as Aramco (the Arabian

American Oil Company) was formed to exercise the

rights granted under that concession. Since 1948,

that corporation has had the same four share-

holders—Standard Oil of California (now Chevron),

Standard Oil of New Jersey (now Exxon Corporation),

Socony-Vacuum Oil Company (now Mobil Corpora-

tion) and Texaco (id. at 19a). Texaco (along with its

consolidated subsidiaries) is the respondent in this

case.

Under the terms of the Saudi concession, the right

of Aramco to extract oil was subject to the payment of

taxes and royalties to Saudi Arahia (App. 18a-19a).

Until 1960, the Aramco participants had effective

control over the production and pricing of Saudi crude

oil (id. at 28a). Between the time that the Organiza-

tion of Petroleum Exporting Countries (OPEC) was

formed in 1960 and the onset of what has been called

the “first oil crisis” in 1978, however, the balance of

economic power in this relationship shifted (id. at

29a-33a). Saudi Arabia and other oil producing coun-

tries gained significant power in establishing produc-

tion rates and in setting the price for oil in world

markets (ibid.).

One of the consequences of this evolution in market

power was the ability of Saudi Arabia to negotiate

concessions from the Aramco participants. One of

those concessions was an agreement made in late 1976

that allowed Saudi Arabia to assume 100 percent

ownership of the oil producing properties and assets

of Arameo. Under this agreement, the four Aramco

participants thereafter provided services to Saudi

Arabia’s oil operations in return for stated fees (App.

33a).” In addition, Aramco (along with a Saudi com-

pany named Petromin) continued to conduct the

world-wide marketing of Saudi crude (id. at 32a-33a).

What has been called the “second oil crisis” began

in late 1978 when, as a consequence of the Iranian

revolution, various oil supplies were removed from

the world market. A perceived oil shortage resulted

(App. 40a). Dramatic price increases were adopted by

OPEC, but not all of its members agreed on the new,

2 Although this agreement was not signed (App. 33a), the

parties have operated under the terms of the agreement since

its negotiation. In particular, Saudi Arabia has assumed owner-

ship of the oi! producing assets of Aramco and Aramco has

performed service functions under the provisions of the

agreement (ibid.).

a |

radically higher price structure. In particular, Saudi

Arabia sought somewhat smaller price increases than

OPEC and declined to adhere to the higher OPEC

price. By early 1979, a tiered price structure existed

on world oil markets in which Saudi Arabia priced its

crude oil somewhat below the price demanded by other

OPEC countries (id. at 41a).°

The principal, initial beneficiaries of this price

differential were the Aramco participants, through

which the Saudi government continued to market its

crude oil supplies. Between 1979 and 1981, Saudi

Arabia sold crude oil to these companies—including

respondent—at prices below those generally available

in the world market (id. at 3a). See note 6, infra.

This price differential became widely known as the

“Aramco advantage” (App. 67a).

b. In an effort to allow the oil consuming nations—

rather than the Aramco participants alone—to benefit

from the below-market Saudi crude oil price, Saudi

Oil Minister Ahmed Zaki Yamani wrote a letter in

1979 to the Chairman of the Board of Aramco. This

letter, which is referred to in the opinions below as

“Letter 103/Z,” informed the Chairman that any

future sales of Saudi crude to Aramco were to be

conditioned upon a “pledge” by the Aramco partici-

pants “that they will not sell [Saudi crude oil] to a

third party at prices in excess of’ the Saudi official

selling price (App. 3a n.2).* This resale price restric-

3 Saudi crude oil price increases lagged somewhat behind

the OPEC price increases during this period, but the Saudi

price increases were_nonetheless substantial. The price of

Saudi crude, which was $13.34 per barrel in January 1979, rose

to $34.00 per barrel by October 1981. App. 66a.

4 Although the letter by its plain language applied only to

sales to “third parties,” thereby implying that it applied only to

tion remained in effect from January 1979 through

October 1981 (7d. at 67a).

The restriction described in Letter 103/Z, however,

“applied only to Saudi crude, not to the sale of

products refined from Saudi crude” (App. 4a). As a

result, the Aramco participants—including respon-

dent—“earned large profits from the sale of refined

products” (ibid.). The Saudi Oil Minister who wrote

Letter 103/Z stated publicly that “I cannot do

anything after [the Saudi crude is purchased] if

Exxon, Mobil or any ot the four [Aramco participants]

sell their refined products in the market at the

market price which enables them to realize a higher

rate of profit than is usually realized by other

refiners. That is in their pocket; I cannot interfere.”

App. 46a (emphasis added).°

Part of the profits thus placed in the “pocket” of the

Aramco participants during the 1979-1981 period was

the profit earned by their foreign and domestic affili-

ates who refined the crude oil purchased at the low

Saudi price and sold the refined products at the

market price for those products—thus earning “a

higher rate of profit than is usually realized by other

refiners” (App. 46a). In this manner, the foreign and

domestic refining affiliates of respondent (and the

other Aramco participants) reaped the economic value

of the “Aramco advantage.” The vast majority of the

Saudi crude oil purchased by respondent during this

sales to unrelated entities, the Tax Court found that the

restriction applied also to sales to affiliated entities. App. 133a.

5 The Saudi Oil Minister further stated that “the oil

companies are definitely making much higher profits in the

downstream by refining Saudi crude and selling the products

at higher prices. This we cannot control.” App. 48a (emphasis

added).

7

period was transferred to its affiliated foreign and

domestic refiners at the below-market Aramco price.

Only approximately 20 percent was sold to non-

affiliated customers (id. at 23a-24a).°

Throughout the period following 1976, when the

Saudi government assumed ownership of the produc-

ing assets of Aramco, the Aramco participants had no

obligation to purchase Saudi crude oil. As the Chair-

man of Exxon testified, the resale price condition

imposed by Letter 103/Z was simply a “condition[] of

sale” and Exxon “always had the choice of not buying

Mr. Yamani’s oil” (Tr. 154-155). As he testified,

“Cajny purchaser has a right to take it or not, if [he]

doesn’t want to meet the conditions” (Tr. 155). The

Aramco participants continued to purchase the Saudi

production during 1979-1981 because of their obvious

economic interest in obtaining crude oil supplies for

their world-wide refining and distributing operations.

However, when the price of Saudi crude increased

above the world market price in 1982—and the

“Aramco advantage” turned into an “Aramco disad-

vantage”—the Aramco participants drastically cur-

6 Texaco International Trader, Inc. (Textrad) was the

domestic subsidiary through which respondent made interna-

tional purchases and sales of crude oil. Between January 1979

and June 1981, Textrad purchased 1.9 billion barrels of Saudi

crude oil through Aramco. Textrad sold 34.2 percent of this

Saudi crude oil to other affiliates of respondent and 21.7

percent of the oil to Caltex Petroleum Company, a corporation

owned jointly by respondent and Chevron. Textrad sold less

than 20 percent of its Saudi crude oil during this period

through direct sales to unaffiliated third parties (App. 23a-24a).

tailed their purchases of crude oil from Saudi Arabia

(App. 67a).’

2. Under Section 482 of the Internal Revenue

Code, when two or more organizations are “owned or

controlled directly or indirectly by the same inter-

ests,” the Commissioner of Internal Revenue may

“distribute, apportion, or allocate gross income,

deductions, credits, or allowances between or among

such organizations * * * if he determines that such

* * * is necessary in order to prevent evasion of

taxes or clearly to reflect the income of any such

organizations.” 26 U.S.C. 482. The Commissioner

determined in this case that, in order clearly to

reflect the income of respondent for the years 1979-

1981, it was necessary to allocate approximately $1.8

billion of income to respondent that had been realized

through the sale of refined products by its foreign

affiliated refineries. This is the amount of additional

income that respondent would have received if it had

sold the Saudi crude oil to its foreign affiliated refin-

eries at its true economic value, rather than at the

stipulated Saudi price (App. 98a).

The Commissioner’s reallocation of this income in-

creased respondent’s federal income tax liability

because the income of the foreign affiliates of

respondent is not directly subject to United States

tax. Without this reallocation, the income earned by

7 For example, as the Saudi price increased above the

world market price after 1981, the purchases of Saudi crude by

Exxon fell from 2,000,000 barrels per day in 1981 to 600,000

barrels per day in 1983. The purchases by respondent declined

from 2,000,000 barrels per day in 1981 to 1,000,000 barrels per

day in 1982. App. 67a. The Chairman of Exxon testified that,

when the Saudi price rose above the world price in 1982, the oil

companies simply “decided not to take it” (Tr. 155).

the activities of respondent that was diverted to

respondent’s foreign affiliates through favorable

pricing arrangements would escape direct United

States taxation. It was the marketing activities of

respondent, not the refining activities of its affiliates,

that earned that income. And, as the Saudi govern-

ment contemplated, that income ended up in respon-

dent’s “pocket” (App. 46a) in the “downstream” ac-

counts of its controlled foreign affiliates (id. at 48a).

The Commissioner determined that it was necessary

to reallocate such income to respondent from its

foreign affiliates in order more “clearly to reflect”

respondent’s income under Section 482.

3. Respondent challenged the Commissioner’s

determination in Tax Court. Respondent’s suit was

consolidated with a similar case involving Exxon.

Following an evidentiary hearing, the Tax Court held

in favor of respondent and Exxon.*

The Tax Court reasoned that the resale price re-

striction contained in Letter 103/Z from the Saudi Oil

Minister was the “virtual equivalent” of a law prohib-

8 The Commissioner had issued a similar notice of defi-

ciency to Exxon based upon a reallocation of approximately

$4.5 billion of income to Exxon from its foreign affiliated

refining companies for the years 1979-1981 (App. 99a-100a). As

in respondent’s case, this income was realized by Exxon’s

foreign affiliates through their reaping of the economic benefit

of the “Aramco advantage” that had been passed to them by

Exxon’s domestic marketing subsidiary (ibid.).

The decision of the Tax Court in this case was favorable to

Exxon as well as to Texaco (App. 187a). Because other, unre-

lated tax issues remain pending in the Exxon case, however, a

final decision has not been entered in that case. Any appeal

from a final order in the Exxon case would lie to the Second

Circuit.

10

iting respondent from selling Saudi crude oil at a

price greater than the Saudi price (App. da). Al-

though the Saudi government contemplated that re-

spondent would pocket the associated income through

its “downstream” uses of the oil, the court concluded

that the “virtual” Saudi law barred respondent from

receiving the “Aramco advantage” profits that the

Commissioner sought to allocate to it (id. at 99a).

Relying on this Court’s decision in Commissioner v.

First Security Bank, 405 U.S. 394 (1972), the Tax

Court held that, when any law prohibits a taxpayer

from receiving a particular item of income, the Com-

missioner is precluded from allocating such income to

the taxpayer under Section 482. According to the Tax

Court, it did not matter (i) that respondent had

consented to the Saudi condition by purchasing crude

oil subject to the price restriction, (ii) that respon-

dent had directly realized much of the “Armaco advan-

tage” profits through the activities of its domestic

refinining affiliates or (iii) that neither criminal nor

civil penalties had been established by the Saudi

government for any violation of the resale price

restriction. The court held that it was enough that, if

the restriction had not been adhered to by respondent,

the “dire consequences of reduced [oil] supplies or

worse” would have occurred (405 U.S. at 100-101).

4. The court of appeals affirmed (App. la-13a). The

court agreed with the Tax Court that Letter 103/Z

“had the effect of a legal restriction in Saudi Arabia”

(id. at 6a). The court of appeals similarly agreed with

the Tax Court that, “[b]ecause the sales price of the

crude is governed by Letter 103/z, Texaco did not

have the power to control the sales price of the oil”

(ibid.). The court of appeals stated that, under this

Court’s decision in First Security Bank, the Com-

Oe

11

missioner could reallocate the Aramco- advantage

profits under Section 482 only if respondent had

““complete power’ to shift income among its subsidi-

aries” (App. 8a, quoting Commissioner v. First Secu-

rity Bank, 405 U.S. at 404-405). The court stated that

respondent lacked “precisely this ability to control

the flow of its income” because “Letter 103/z had the

force and effect of law” and respondent “was obligated

to comply with its requirements, and * * * did so”

(App. 10a).

The court of appeals rejected the Commissioner’s

argument that this case differed from First Security

Bank because the “law” involved in this case did not

preclude respondent from receiving the income that is

the subject of the tax; instead, the foreign “law” only

required respondent to realize these profits in its

“downstream” operations. The Saudi government had

no objection to the actions taken by respondent to put

(and keep) the profits in its “pocket” (App. 46a). The

Commissioner contended that these differences

brought this case within the scope of United States v.

Basye, 410 U.S. 441 (1973), in which this Court held

that First Security Bank did not apply in the case of a

distortion of income resulting from a “consensual

agreement of two parties acting at arm’s length.” Jd.

at 453 n.13. The court of appeals stated, however, that

the analysis of Basye does not apply to this case

because, in light of “the severe economic reprisal that

would have flowed from * * * a violation” of Letter

103/Z, respondent was deprived “of the power to sell

Saudi crude to its foreign refining affiliates for a

price that exceeded” the Saudi price (App. 12a, 13a).

12

REASONS FOR GRANTING THE PETITION

This case presents an issue of exceptional fiscal

and administrative importance. The decision of the

court of appeals ignores “the first principle of income

taxation: that income must be taxed to him who earns

it.” Commissioner v. Culbertson, 337 U.S. 733, 739-

740 (1949). By ignoring this “foundational rule” of

income taxation (United States v. Basye, 410 U.S. 441,

449 (1973)), the decision of the court of appeals misap-

plies this Court’s decision in Commissioner v. First

Security Bank, 405 U.S. 394 (1972), and fails to adhere

to the holding of this Court in United States v. Basye,

410 U.S. at 453 n.13, that a “consensual agreement”

cannot prevent a reallocation by the Commissioner

more “clearly to reflect” a taxpayer’s income under

_ Section 482.

More than $1,000,000,000 of taxes are at stake in

this case. More than twice as much is involved in the

companion case involving Exxon. See note 8, supra.

The decision of the court of appeals threatens simi-

larly broad and recurring consequences for other tax-

payers, for it offers a blueprint for the evasion of

United States taxes through the application of “legal

restrictions” that channel the profits earned by

United States taxpayers into the accounts of their

foreign affiliates.

Review by this Court of the decision in this case is

warranted by the exceptional fiscal and administra-

tive importance of the question presented and by the

serious misapplication by the court of appeals of the

decisions of this Court.

1. a. Section 482 of the Internal Revenue Code

authorizes the Commissioner to allocate income or

deductions among commonly controlled businesses “if

13

he determines that such * * * allocation is neces-

sary in order to prevent evasion of taxes or clearly to

reflect the income of any such * * * businesses.” 26

U.S.C. 482. This statute was first enacted as Section

45 of the Revenue Act of 1928, ch. 852, 45 Stat. 806. It

has long served as “one of the Service’s principal

weapons for policing the fairness of transactions

between related enterprises * * * that cannot or do

not file consolidated returns.” 8B. Bittker & J.

Eustice, Federal Income Taxation of Corporations

and Shareholders ¥ 15.03, at 15-14 (1987 ed.). As

Professors Bittker and Eustice have noted (ibid.)

(emphasis supplied):

The major function of §482 is the prevention of

artificial shifting, milking, or distorting of the

true taxable incomes of commonly controlled

enterprises, but its concern is with economic

reality rather than the taxpayer’s motivation or

purpose.

The Treasury regulations promulgated under this

statute have long explained that “[t]he purpose of

section 482 is to place a controlled taxpayer on a tax

parity with an uncontrolled taxpayer, by determining,

according to the standard of an uncontrolled taxpayer,

the true taxable income from the property and busi-

ness of a controlled taxpayer.” 26 C.F.R. 1.482-1(b)

(1981). See also note 1, supra.

In this case, in an effort to detemine “the true tax-

able income from the property and business” of

respondent, the Commissioner concluded that it was

necessary to allocate to respondent the income earned

through its marketing of Saudi crude when the eco-

nomic value of that income had been realized by

respondent’s affiliates—by their enjoyment of the

14

below-market-price inventories of crude oil obtained

from respondent. The Commissioner’s determination

did not “create” any income; nor did it attribute

income to respondent that respondent had not already

enjoyed, for respondent has complete control over its

foreign affiliates. The Commissioner’s determination

simply placed this income in the “pocket” of the tax-

payer whose economic activities earned it. By doing

so, the Commissioner followed “the first principle of

taxation: that income must be taxed to him who earns

it.” United States v. Basye, 410 U.S. at 449, quoting

Commissioner v. Culbertson, 337 U.S. at 739-740.

2. The court of appeals held, however, that the

Commissioner’s determination was invalid. The court

did not doubt that, as a matter of “economic reality”

(B. Bittker & J. Eustice, supra, at 15-14), the income

at issue in this case was attributable to the activities

of respondent. Instead, the court reasoned (i) that the

resale price restriction on Saudi crude oil contained

in Letter 103/Z was the “equivalent” of a foreign law

that prohibited respondent from receiving this income

(App. 5a) and (ii) that such income therefore could not

be allocated to respondent because, in Commissioner

v. First Security Bank, supra, “the Court held that

§ 482 did not authorize the Commissioner to allocate

income to a party prohibited by law from receiving it”

(App. 7a). Neither leg of the court’s reasoning with-

stands scrutiny.

a. The Saudi price “restriction” did not purport to

deprive respondent of the right to receive this income.

To the contrary, the Saudi Oil Minister expressly

contemplated that this income would be received in

the “downstream” operations of respondent’s refining

affiliates (whether foreign or domestic) and would

thus remain in respondent’s “pocket” (App. 46a). The

15

Saudi “restriction” was not a restriction against

receiving income; it was a restriction on the method

by which respondent was to receive this income. As

the Saudi Oil Minister stated, it was fully anticipated

that the Aramco participants would be “making

higher profits in the downstream by refining Saudi

crude and selling the products at higher prices” and

“[t]his we cannot control” (id. at 48a) (emphasis

added). Because the Saudi government had no ob-

jection to the actions taken by respondent to obtain

and retain these profits (ibid.), the court of appeals

manifestly misapplied the holding of First Security

Bank in stating that respondent was “prohibited by

law from receiving” this income (App. 7a).

b. Moreover, the court of appeals fundamentally

erred in its intepretation of the holdings of this Court

in First Security Bank and Bayse. The court of

appeals broadly reasoned that, under First Security

Bank, any legal restriction that deprives the tax-

payer of the “‘complete power’ to shift income among

its subsidiaries” prevents the Commissioner from

reallocating such income to the taxpayer (App. 8a,

9 For example, in respondent’s federal income tax returns

for 1979-1981, it consolidated with its own income the income

that its domestic refining affiliates enjoyed from their receipt

of the fruits of the “Aramco advantage.” No suggestion has

been made that such a consolidation of respondent’s domestic

income for domestic tax purposes violated the Saudi “law.”

Respondent could not realistically contend that a similar

allocation to respondent—for purposes of United States taxa-

tion under Section 482 of the Internal Revenue Code—of this

same “Aramco advantage” income received by respondent’s

foreign refining affiliates would place respondent in violation of

any Saudi “law” or bring down upon it any “severe economic

reprisal” (App. 13a) from the Saudi government.

16

quoting Commissioner v. First Security Bank, 405

U.S. at 404-405, quoting 26 C.F.R. 1.482-1(b)(1) (1971)).

That description of the holding of First Security

Bank ignores the factual context and the reasoning of

the decision in that case; it also fails to give account

to the subsequent decision of this Court in Basye,

which distinguished First Security Bank on grounds

that are controlling in this case.

Commissioner v. First Security Bank involved a

rare factual situation. In that case, the Commis-

sioner sought to allocate income to a bank from an

insurance affiliate even though the bank was not

lawfully able to engage in the type of business (insur-

ance) from which the income at issue was earned. 405

U.S. at 401-402. The Court noted that federai law

prohibited the bank from engaging in the enterprise

that generated the income and that “(t]he penalties

for violation of the banking laws include possible

forfeiture of a bank’s franchise and personal liability

of directors.” Jbid. It was in this narrow factual

context—where the taxpayer could not lawfully

engage in the commerce that produced the income—

that the Court stated that the Commissioner could

not allocate income to the taxpayer because the

taxpayer lacked “‘complete power’ to shift income

among its subsidiaries.” Jd. at 404.

In the present case, by contrast, respondent was

lawfully engaged in the business of buying and selling

crude oil. Moreover, the price “restriction” that was

imposed on the supplies that respondent purchased

from Saudi Arabia in 1979-1981 did not prohibit

respondent from receiving the income attributable to

those advantageous purachases. The Saudi Oil Minis-

ter publicly stated that the Saudi government had no

concern about the fact that respondent would ulti-

17

mately “pocket” these profits from its refining opera-

tions (App. 46a). No legal or practical disability

prevented respondent from earning—or from receiv-

ing into the accounts of its family of controlled

affiliates—the income involved in this case.” See

note 9, supra.

As this Court explained in United States v. Basye,

410 U.S. 441 (1973), the holding in First Security

Bank does not apply when the deflection of income

from the taxpayer to one of its controlled affiliates is

pursuant to a consensual arrangement rather than

necessitated by a legal disability to engage in such

commerce. In Basye, the Court explained that “(t]he

entity earning the income * * * cannot avoid

taxation by entering into a contractual arrangment

whereby that income is diverted to some other person

or entity.” 410 U.S. at 449. That holding applies

directly to the present case for, as the Exxon Chair-

man acknowledged, the Aramco participants had no

obligation to purchase Saudi crude; the purchases

were consensual. See page 7 & note 7, supra.

The distinction between First Security Bank and

Basye is that, (i) in the former case, the taxpayer

10 In Procter & Gamble Co. v. Commissioner, 961 F.2d

1255 (6th Cir. 1992), the court of appeals held that First

Security Bank applies where the law prohibiting the receipt of

income is that of a foreign country. See id. at 1259 (“[w]e see

no reason to alter [the analysis of First Security Bank] because

foreign law, as opposed to federal law, prevented payment of

royalties”). The Commissioner disagrees with that aspect of

the holding in Proctor & Gamble. See Rev. Rul. 82-80, 1982-1

C.B. 89 (“when the prohibition on the receipt of income is based

not on the laws of the United States * * * , the decision in

First Security Bank of Utah does not foreclose the Service

from applying Section 482 in order to clearly reflect income”).

18

inherently lacked the “power” to allocate income

among its subsidiaries because one of them could not

lawfully conduct the relevant business whereas, (ii) in

the latter case, the taxpayer merely surrendered the

“power” directly to receive the income under the

terms of a consensual commercial arrangement. In

the present case, however, the court of appeals fo-

cussed only on the fact that, after respondent agreed

to purchase the Saudi oil, it was bound by the Saudi

restriction. The court neglected to consider the dis-

positive point under Bayse that respondent, as a

United States taxpayer, “cannot avoid [United

States] taxation” by consenting to purchases of oil

subject to the Saudi restriction and thereby “divert

[such income] to some other person or entity.”

United States v. Bayse, 410 U.S. at 449.

ce. It bears emphasis that, by conforming to the

Saudi price “restriction,” respondent reaped enor-

mous profits. The Saudi government had no obliga-

tion to sell its crude oil to respondent at below-

market prices. The “Aramco advantage” was a com-

mercial windfall that permitted respondent to realize

billions of dollars of extra profit by marketing this oil

through its controlled affilliates. It is those profits,

and nothing else, that are at issue in this case. It is,

moreover, simply fanciful for respondent to contend

that it was coerced by economic necessity into the

Saudi price restriction. Respondent profited enor-

mously from the Saudi price advantage and, as the

Saudi government anticipated, was allowed to pocket

these profits in the accounts of its controlled refining

subsidiaries.

The Commissioner’s determination seeks only to

tax to respondent the economic values that it earned

19

from the economic activity that it conducted." Under

Section 482, the Commissioner properly allocated the

income involved in this case to the entity whose

activities “earn[ed] it” (United States v. Bayse, 410

U.S. at 449). The guiding principle in adjustments

made under Section 482 “clearly to reflect income” is

“economic reality” (B. Bittker & J. Eustice, supra, at

15-14). It is a fundamental objective of the statute “to

correct artificial intragroup pricing policies” that

shift income “to affiliated foreign corporations that

are not generally subject to U.S. tax” (id. at 15-16).

The taxpayer’s “motivation or purpose” in entering

into the arrangment is not relevant (id. at 15-14). A

reallocation is necessary clearly to reflect the tax-

payer’s income when, as here, the taxpayer’s activi-

ties have earned income that kas been realized by a

foreign affiliate that the taxpayer controls—for in-

come is to be taxed “to him who earns it.”

3. That the Saudi resale price restriction repre-

sents a consensual, commercial arrangement, as op-

posed to a “law” enacted by a foreign “sovereign,”

finds support not only in the facts of this case (pages

7-8, supra) but also in a long and consistent line of

decisions of this Court concerning governmental

'! Section 482 authorizes reallocation of the income earned

by the commercial activities of a United States corporation

solely for the purposes of the tax laws of the United States.

Application of Section 482 in this case does not interfere with

the Saudi price restriction. Respondent resold the Saudi crude

to its affiliates at the price it purchased it; that was its only

undertaking. The Saudi government did not seek to control

the ultimate profit realized by respondent in its sale of refined

products (App. 48a) (“This we cannot control.”),

20

immunity.” The Court has repeatedly held that,

when a government undertakes a commercial activity,

it acts in a commercial, not sovereign, capacity. In

Bank of the United States v. Planters’ Bank of

Georgia, 22 U.S. (9 Wheat.) 904, 997 (1824), the Court

explained:

It is, we think, a sound principle that when a

government becomes a partner in any trading

company, it divests itself, so far as concerns the

transactions of that company, of its sovereign

character, and takes that of a private citizen.

Instead of communicating to the company its

privileges and its prerogatives, it descends to a

level with those with whom it associates itself,

and takes the character which belongs to its

associates, and to the business which is to be

transacted.

This principle is equally applicable to domestic and

foreign governments that elect to act in a commercial

capacity. See, e.g., Ohio v. Helvering, 292 U.S. 360,

369 (1934) (“If a state chooses to go into the business

of buying and selling commodities, its right to do so

may be conceded so far as the Federal Constitution is

concerned; but the exercise of the right is not the

performance of a governmental function * * *. When

2 The court of appeals erred in implying that whether the

resale price restriction in Letter 103/Z was a Saudi “law” was a

question of fact to be reviewed under the clearly erroneous

standard (App. 6a). It has long been settled that a trial court’s

determination of foreign law “shall be treated as a ruling on a

question of law.” Fed. R. Civ. P. 44.1. See Kalmich v. Bruno,

553 F.2d 549, 552 (7th Cir.), cert. denied, 434 U.S. 940 (1977);

Bassis v. Universal Line, S.A., 436 F.2d 64, 68 (2d Cir. 1970);

Bamberger v. Clark, 390 F.2d 485, 488 (D.C. Cir. 1968).

21

a state enters the market place seeking customers it

divests itself of its quasi sovereignty pro tanto, and

takes on the character of a trader.”); South Carolina

v. United States, 199 U.S. 437, 463 (1905) (same).

The Court has recently applied this principle in a

case interpreting the proper scope of the immunity of

a foreign government from suit. In Republic of

Argentina v. Weltover, Inc., 504 U.S. 607 (1992), the

Argentine government had issued bonds as part of a

plan to stabilize its currency. Bondholders were enti-

tled to repayment in U.S. dollars. The Argentine

government, however, lacked sufficient foreign ex-

change to retire the bonds as they came due. The

government therefore unilaterally extended the time

for payment. When the bondholders brought suit in a

federal district court, Argentina sought to have the

suit dismissed on the ground that it was immune from

suit in the courts of the United States.

The threshold issue was whether the issuance of

the bonds by Argentina was a “commercial activity”

within the meaning of the Foreign Sovereign Immu-

nities Act of 1976 (FSIA), 28 U.S.C. 1602 et seg. In

holding that it was, the Court adhered to the analysis

it has applied since its decision in Planters’ Bank in

1824. The Court held that, “when a foreign govern-

ment acts, not as regulator of a market, but in the

manner of a private player within it, the foreign

sovereign’s actions are ‘commercial’ within the

meaning of the FSIA.” 504 U.S. at 614. The Court

explained that in such cases “the issue is whether the

particular actions that the foreign state performs

(whatever the motive behind them) are the type of

actions by which a private party engages in ‘trade and

traffic or commerce.’” Jbid., quoting Black’s Law

Dictionary 270 (6th ed. 1990). The Court noted that a

22

“sales contract” is an example of the situation in

which a foreign Nation acts in a commercial, rather

than sovereign, capacity (504 U.S. at 614-615):

Thus, a foreign government’s issuance of regula-

tions limiting foreign currency exchange is a

sovereign activity, because such authoritative

control of commerce cannot be exercised by a

private party; whereas a contract to buy army

boots or even bullets is a “commercial” activity,

because private companies can similarly use sales

contracts to acquire goods.

The principle articulated by the Court in these

decisions applies directly to the commercial sales

arrangements under which Saudi crude oil was sold to

respondent and the other Aramco participants during

the period relevant to the present case.” The court of

appeals erred in reasoning (App. 6a) that the resale

price component of this commercial arrangement

3 The fact that the Saudi government acts in a com-

mercial, rather than sovereign, capacity in effecting sales of

crude oil has been recognized in arbitration proceedings

involving Saudi Arabia and Aramco. Saudi Arabia v. Arabian

American Oil Co., 27 I.L.R. 117 (1958). In that case, Saudi

Arabia had granted to Aristotle Onassis, in an agreement

ratified by royal decree, the exclusive right to ship crude oil

from Saudi Arabia. The Saudi government contended that the

grant to Onassis constituted a law that Aramco was obligated to

obey by delivering to Onassis, in Saudi Arabia, all the Saudi

crude oil that Aramco lifted. Jd. at 140. The arbitration tribu-

nal found, however, that the Onassis agreement was “neither a

Law of the State of Saudi Arabia nor a Governmental regula-

tion.” Jd. at 228. Critical to the tribunal’s finding was that the

agreement had “a purely contractual nature” and did not “lay

down the norms of a general and impersonal nature.” Id.

at 204.

23

nonetheless became a sovereign “law” because it was

announced with the implicit approval of the Saudi

King. In Republic of Argentina v. Weltover, Inc., 504

U.S. at 616, the Argentine government had changed

the payment terms of its bonds to protect its foreign

exchange program and to avert a domestic credit

crisis. These obviously were legitimate governmen-

tal concerns. But the underlying activity in that

case, as here, was an inherently commercial one. See

ibid. The Court held in Weltover that, even if the

underlying concerns were governmental in nature,

that would not convert a commercial act into a

sovereign one. /d. at 614 (“whatever the motive be-

hind them”). See also South Carolina v. United

States, 199 U.S. at 463 (a State’s activity in selling

liquor is a commercial act even though undertaken

pursuant to validly enacted law).

The court of appeals also erred in concluding that

the Saudi condition of sale was the “virtual equiva-

lent” of a “law” simply because respondent could have

faced “severe” economic repercussions if it failed to

adhere to the resale price restriction (App. 13a). The

fact that the Aramco participants, during the period

from 1979 to 1981, had little leverage in their pur-

chases of Saudi crude stemmed from the substantial

market power that large sellers of crude oil had in

those years. It does not differentiate this case from

any other commercial relationship in which a buyer

becomes dependent largely on one source of supply.

Indeed, when the market relationship evolved again in

1982—and the “Aramco advantage” became an

“Aramco disadvantage”—respondent and the other

Aramco participants severely reduced their pur-

chases of oil from Saudi Arabia. See pages 7-8 & note

7, supra. The fact that market conditions temporar-

24

ily allowed Saudi Arabia to “dictate” the terms of the

commercial sale of its product does not make those

terms a “law.” Nor does it distinguish this case from

any other in which the ordinary ebb and flow of

market conditions alters the balance of power in com-

mercial relationships.

Furthermore, in concluding that the Saudi condi-

tion was a “law” because the threat of “severe eco-

nomic reprisal” left respondent with no real choice

(App. 13a), the court of appeals plainly misperceived

the economic forces at work. There is no plausible

reason why respondent should have desired to stem

the flow of Saudi largess, which showered billions of

dollars of extra profits on it through the benefits of

the “Aramco advantage.” Respondent stood to real-

ize, and did realize, an enormous windfall from the

terms under which the Saudi Oil Minister sold crude

oil during that era. It is unrealistic to think that a

corporation that stood to benefit so enormously would

object merely because those profits were to be real-

ized by its domestic and foreign refining affiliates,

rather than by its marketing subsidiary. In either

event, the profits ended up, as planned, in respondent’s

corporate “pocket.”

The Commissioner’s determination to allocate

those profits, and tax them, to the entity that earned

them is directly supported by this Court’s decision in

United States v. Basye, 410 U.S. at 449. The decision

of the courts below fundamentally misinterprets and

misapplies Basye and First Security Bank by permit-

ting a consensual, foreign directive to control—and

distort—the application of United States tax law.

6. The decision in this case has enormous impor-

tance to the public fisc, both immediately and prospec-

tively. Including the interest that has accumulated

25

on the unpaid taxes, more than $5,000,000,000 is at

Stake in this case and the similar case involving

Exxon. The Exxon case remains pending in the Tax

Court and ultimately will be appealable to the Second

Circuit. See note 8, swpra. If that court were here-

after to rule in the Commissioner's favor on this is-

sue, and thereby create a direct conflict on the pre-

cise question presented, the United States would not

then be able to recover the taxes in excess of

$1,000,000,000 involved in this case. The massive

revenue impact of the two cases combined reflects the

inherent importance of the question presented.

The analysis applied by the court of appeals in this

case threatens a serious and recurring prospective

injury to the public fisc. In the modern business envi-

ronment, with most large United States corporations

conducting business internationally, and with many

foreign governments participating directly in com-

mercial activities with multi-national corporations, it

is not difficult to perceive the consequences of the

reasoning applied in this case. The decision of the

court of appeals creates substantial tax incentives for

United States corporations to encourage or endure

the adoption of profitable foreign “legal restrictions”

that “require” such corporations to avoid United

States taxation on income earned by their activities

by diverting those profits to their controlled foreign

subsidiaries.“

‘4 This case presents a textbook example of the advantages that

a United States corporation can derive from being “thrown

into the briar bush” by a foreign “legal restriction.” The Saudi

“legal restriction” poured extensive profits into respondent’s

accounts and also gave it a basis for contending that a portion

of those profits is immune from United States tax. The deci-

sion of the courts below offers taxpayers (and foreign Nations)

26

In the Commissioner’s view, it is “economic real-

ity” (B. Bittker & J. Eustice, swpra, at 15-14), not the

commercial preferences of foreign Nations, that

controls the United States tax liability of United

States taxpayers under Section 482 of the Internal

Revenue Code. The question whether a foreign gov-

ernment can, in a commercial arrangement, dictate

the United States tax consequences of income earned

abroad by a United States taxpayer is a question of

substantial, recurring importance that this Court

should resolve.

CONCLUSION

The petition for a writ of certiorari should be

granted.

Respectfully submitted.

WALTER DELLINGER

Acting Solicitor General

LORETTA C. ARGRETT

Assistant Attorney General

LAWRENCE G. WALLACE

Deputy Solicitor General

KENT L. JONES

Assistant to the Solicitor

General

JONATHAN S. COHEN

THOMAS J. CLARK

Attorneys

JANUARY 1997

a substantial incentive to consent to “legal restrictions” that

“require” the earnings of United States corporations to be

retained (and thus sheltered) in the accounts of controlled

foreign affiliates.

LS lrllttt—ti‘_S