Reply Brief — Commissioner v. Texaco Inc.

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No. 96-1107

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Jn the Supreme Court of the Gnited States

OCTOBER TERM, 1996

COMMISSIONER OF INTERNAL REVENUE, PETITIONER

TEXACO, INC. AND SUBSIDIARIES

ON PETITION FOR A WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

WALTER DELLINGER

Acting Solicitor General

Depa rtment Of Justice

Washington, D.C. 20530-0001

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(202) 514-2217

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TABLE OF AUTHORITIES

Cases: Page

Argentina v. Weltover, 504 U.S. 607 (1997) ............. 4,6

Commissioner v. Culbertson, 337 U.S. 733 (1949) .... 3,6

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

CORNET isn taniiesnnseiennlinaiialtsheonuinaliplatisnasisttiiine hieecseiilchaaiain 1, 2, 5, 6

L.E. Shunk Latex Products, Inc. v. Commissioner,

EC ae EE LEED. skacsinstassnbereverciaeisianickstanbatgneseidenine 4,5

United States v. Basye, 410 U.S. 441 (1973) .... §=1,2,5,6

Statute and regulation:

Internal Revenue Code, 26 U.S.C. 482 .................. 5, 6, 7

Fe es, SE CED siidnrkiiciinvienicietnsdtetatbtenidecies 6

Miscellaneous:

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

Corporations and Shareholders (1987 ed.) .............. 5-6

(I)

Jn the Supreme Court of the United States

OCTOBER TERM, 1996

No. 96-1107

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

REPLY BRIEF FOR THE PETITIONER

Respondent errs in asserting that its purchases of

Saudi crude oil did not stem from “a consensual

agreement” but were instead dictated by foreign law

(Br. in Opp. 15). Building upon that flawed foundation,

respondent mistakenly asserts that this Court’s deci-

sion in Commissioner v. First Security Bank, 405

U.S. 394 (1972), rather than its decision in United

States v. Basye, 410 U.S. 441 (1973), governs this case.

Review by this Court is warranted because of the

fundamental misapplication by the courts below of the

decisions of this Court and the extraordinary impor-

tance of the question presented.

1. The mere fact that Texaco was unusually depen-

dent upon supplies of Saudi crude oil in 1979 and 1980

(see Pet. 7-8 & n. 7) does not exempt Texaco from the

(1)

2

operation of the internal revenue laws of the United

States. As the Chairman of Exxon has straightfor-

wardly acknowledged, the Saudi resale condition was

nothing more than a “condition[] of sale” (Tr. 154-

155). Texaco, Exxon and the other Aramco partici-

pants “always had the choice of not buying Mr.

Yamani’s oil” (ibid.). The fact that Texaco had a

great need for supplies in 1979 and 1980 does not mean

that Texaco had a legal obligation to purchase Saudi

oil or to purchase such oil under any specific set of

contractual terms. For the reasons described in the

petition (Pet. 16-19), the fact that the seller had

sufficient market power to dictate the terms of sale

does not make those terms a “law.”

Respondent does not dispute that, in determining

whether the reasoning of First Security or Basye

controls, the critical focus should be on whether the

conduct of the taxpayer was restrained by law or was

instead consensual. See Br. in Opp. 17 (“[bJoth courts

below agreed with this proposition”). Respondent and

the courts below err, however, in assuming that a

consensual agreement cannnot exist within the mean-

ing of Basye unless the taxpayer could have success-

fully negotiated a different result. The Tax Court,

for example, did not conclude that Texaco’s purchases

1 If, for example, any private supplier had imposed a resale

price condition on sales to Texaco, the fact that Texaco “really

needed” those supplies would not exempt Texaco from the con-

sequences that attach to such “a consensual agreement” under

the laws of the United States—whether those consequences

stem from antitrust laws or internal revenue laws. Respondent

and the courts below erred precisely in concluding that the

mere fact that the seller in this case was the Saudi government

somehow converts a consensual commercial arrangement into a

“law” that removed all freedom of action from Texaco.

3

of crude oil were not the product of “a consensual

agreement”; it concluded only that Texaco had insuf-

ficient market power to avoid the “non-negotiable”

resale price demand of the seller (Pet. App. 149a; see

Br. in Opp. 18). The fact that the seller’s demand was

“non-negotiable,” however, does not mean that Texaco

had to agree to it. It means only that Texaco did

agree to it in order to purchase the crude oil.

By agreeing to this term of sale, Texaco voluntar-

ily surrendered its power to allocate the associated

income among its subsidiaries. Texaco’s voluntary

decision to accept the terms demanded by the seller

does not prevent the Commissioner from applying

“the first principle of income taxation: that income

must be taxed to him who earns it.” Commissioner v.

Culbertson, 337 U.S. 738, 739-740 (1949). As this

Court held in Basye—in language that applies di-

rectly to this case—“[t]he entity earning the income

* * * cannot avoid taxation by entering into a con-

tractual arrangement whereby that income is di-

verted to some other person or entity.” 410 U.S. at

449,”

2. The question of recurring importance that is

presented in this case is whether a foreign govern-

ment can enter the marketplace and, in dealings with

private parties, establish terms of sale that displace

the provisions of United States law that govern the

taxation of United States corporations. In the pre-

2 Respondent does not dispute that, for the reasons de-

scribed in the petition, the allocation of this income to respon-

dent does not violate the terms of the Saudi restriction. See

Pet. 14-15 & n.9. In being required to pay tax on the income it

has earned, Texaco is merely being required to comply with

United States law; it is not being required to violate any

foreign law.

sent case, the foreign government was selling sur-

plies of a commodity that was temporarily in short

supply, and it was imposing restrictions only for the

supplies that it sold.2 The “restriction” thus imposed

was purely contractual in character and in effect, for

it did not purport to bind or in any other fashion

regulate anyone other than those who consented to

the restriction by purchasing the supply.‘

The facts of L.E. Shunk Latex Products, Inc. v.

Commissioner, 18 T.C. 940 (1952), on which respon-

dent relies (Br. in Opp. 24), are therefore markedly

different. In Shunk Latex, the United States govern-

ment was not in the business of selling either raw

rubber or condoms. The United States also did not

seek to impose any contractual resale price re-

straints as a condition of sale of such materials. In-

stead, the government established price ceilings on

those products and made it unlawful for any taxpayer

to conduct business at prices in excess of those

established ceilings. On these facts, the court held in

3 The cases cited by respondent (Br. in Opp. 22 n. 21) that

involve situations in which a foreign government is acting as a

“regulator of a market” (Argentina v. Weltover, Inc., 504 U.S.

607, 614 (1992)) are thus inapposite. The Saudi terms of sale

were not vrovisicns of general application that “regulated” a

market; they were contractual terms of sale that bound only its

customers—those who purchased oil directly from the govern-

ment. See Pet. 21-24.

4 Moreover, when those parties converted the crude oil into

refined products (or when their affiliates did so), the contrac-

tual resale “restriction” utterly disappeared. Pet. App. 4a. As

the Saudi Oil Minister emphasized (Pet. App. 48a):

[Tjhe oil companies are definitely making much higher pro-

fits in the downstream by refining Saudi crude and selling

the products at higher prices. This we cannot contrc!.

eed

es?

Shunk Latex that the Commissioner could not allo-

cate profits to sellers based upon theoretical prices

that exceeded the ceilings established by federal law.

18 T.C. at 961.°

The difference between a law that requires univer-

sal obedience and a contractual term that is binding

only on those who have agreed to it is the core dis-

tinction between First Security and Basye. The

decision in First Security precludes the allocation of

income to a taxpayer who, under a generally applica-

ble law, is precluded from conducting the commerce

being taxed. 405 U.S. at 405. The decision in Basye,

by contrast, permits the allocation of income to a

taxpayer who, under a consensual commercial ar-

rangement, has agreed to terms that cause a deflec-

tion of the income it has earned to an untaxed affili-

ate. 410 U.S. at 449.

3. The courts below misunderstood and misapplied

this critical, controlling distinction between First

Security and Basye. As the petition explains (Pet. 25-

26 & n. 14), the decision of the court of appeals there-

by creates favorable tax consequences for commercial

restrictions imposed on commercial sales made to

United States corporations by foreign Nations. The

reasoning applied by the courts below would create an

enduring opportunity for substantial abuse, for it ob-

structs the plain objective of Section 482 of the Inter-

nal Revenue Code to “prevent[] artificial shifting,

milking, or cistorting of the true taxable incomes of

5 In the course of holding that income could not be allocated

to a corporation that could not lawfully participate in the

business that generated the income, this Court cited Shunk

Latex with approval in Commissioner v. First Security Bank,

405 U.S. at 406.

commonly controlled enterprises” (B. Bittker & J.

Eustice, Federal Income Taxation of Corporations

and Shareholders { 15.08, at 15-14 (1987 ed.)). See

Pet. 25-26 & n.14.

Respondent misses the point of the statute in con-

tending that there is no opportunity for abuse if

courts apply “heightened scrutiny” to ensure that a

foreign sales restriction was adopted by the foreign

government without the collusion of the United

States taxpayer (Br. in Opp. 25, quoting Pet. App.

113a). The function of Section 482 is to determine the

“true taxable income” of a United States taxpayer

(26 C.F.R. 1.482-1(b) (1981)) and “to correct artificial

intragroup pricing policies” that shift income “to

affiliated foreign corporations that are not generally

subject to U.S. tax.” B. Bittker & J. Eustice, supra,

at 15-16. The taxpayer’s “motivation or purpose” in

entering into the arrangement is not relevant (7d. at

15-14). A reallocation is necessary clearly to reflect

the taxpayer’s income when, as here, the taxpayer’s

activities have earned the income that has been

realized instead by foreign affiliates that the taxpayer

controls—for income is to be taxed “to him who earns

it” (Commissioner v. Culbertson, 337 U.S. at 7389-

740).

4. This case—along with the companion case in-

volving amicus Exxon—involves more than five bil-

lion dollars of taxes and interest. The issue pre-

sented in this case arises at the interstices of this

Court’s decisions in Basye and First Security, and it

implicates principles that the Court has applied in the

governmental immunity context in decisions such as

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

Pet. 19-23. Its resolution thus requires an ex-

planation of this Court’s jurisprudence that only this

Qeeees neues

Court can authoritatively provide. Review by this

Court is warranted by the extraordinary importance

of this case for the public fisc, by the broad scope of

its potential future applications, and by the evident

need for guidance in the lower courts on the proper

application of Section 482 to commercial transactions

involving foreign governments.

For the reasons stated above and in the petition, the

petition for a writ of certiorari should be granted.

Respectfully submitted.

WALTER DELLINGER

Acting Solicitor General

MARCH 1997