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

> Briefs, arguments, decisions, and more.

URL: https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40386013_0090%3A1

## Record

- **Collection:** Supreme Court brief
- **Document type:** Petition for Writ of Certiorari
- **Published:** January 1, 1997
- **Citation:** 520 U.S. 1185

## Text

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
TINIE sihiah iad vadinnseciihnaiobtebasninebionssusadsavennceveerees 1
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

---

Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40386013_0090%3A1. Public record. Not legal advice.