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June 11, 1969


The opinion of the court was delivered by: Campbell, Chief Judge.


This is a consolidated action and involves three suits brought by the United States Gypsum Company ("USG") and its wholly owned subsidiary, the United States Gypsum Export Company ("Export") for refunds for federal income taxes paid by plaintiffs. The cases involve the tax liability of USG for the years 1954 and 1955 and again for 1957 and 1958, and the taxes of Export for the years 1957 and 1958. The defendant, ("government") not only denied all grounds for refund, but also claimed certain offsets as affirmative defenses. The basis for the alleged offsets is that USG paid one of its wholly owned subsidiaries excessive amounts for transporting its products and that it paid another subsidiary, Export, excessive amounts for crude gypsum rock, and undercharged it for finished products intended for resale by Export.

The issues are numerous and complex. After consolidation of the cases and extensive pre-trial discussions between the court and counsel, it was determined and agreed that this was what is traditionally referred to as the "Protracted Case", a case which should be tried under the special procedure recommended by the Judicial Conference of the United States as set forth in the Handbook of Recommended Procedures For Protracted Cases (currently titled Manual for Complex and Multidistrict Litigation). Following the recommended procedures as set forth in the Manual, counsel for both parties prepared and agreed to a rather extensive stipulation of facts thus enabling all of us to define just wherein genuine disagreement existed. I commend all counsel for their efforts in this regard and for the cooperative spirit in which they labored. These many and extended conferences, some with the court but many between counsel and their principals, have resulted in the settlement of possibly the most complex and difficult issue in this litigation. That issue, generally referred to as the "depletion issue", involved USG's deductions during all the years in question for depletion of its mineral deposits. Again, I compliment counsel for their cooperation and efforts in reaching a fair and just settlement on that issue and removing that most difficult question from the court's consideration.

On the remaining issues, extensive stipulations were filed by the parties and where no agreement could be reached the court heard the testimony and received various exhibits into evidence. This testimony and the many exhibits shall be referred to in some detail herein. With the elimination of the depletion issue there remained and is now before me basically four broad and generally unrelated issues. I shall briefly summarize them.

The first issue concerns the reasonableness of charges paid by USG to Panama Gypsum Inc. ("Panama"), a wholly owned subsidiary of USG organized under the laws of the Republic of Panama, for transporting by ship crude gypsum rock from gypsum mines in Nova Scotia and Jamaica to USG's plants in the United States. The Nova Scotia mines are owned and operated by Little Narrows Gypsum Co. Ltd. ("Narrows") a Canadian Company wholly owned by USG. The Jamaica mines are owned and operated by Jamaica Gypsum Ltd. ("Jamaica") also a subsidiary of USG, organized under the laws of Jamaica, British West Indies. The question presented is basically whether the charges were excessive, and if so, was the excess properly reallocated to USG pursuant to the provisions of section 482 of the Internal Revenue Code (26 U.S.C. § 482) in order clearly to reflect its income for federal income tax purposes.

The second issue involves the operations and earnings of United States Gypsum Export Co. Export purchased rock from Canadian Gypsum ("Canadian") another wholly owned subsidiary, organized under the laws of the Dominion of Canada, and from Narrows and Jamaica which it in turn sold to USG. It also sold finished gypsum products which it purchased from USG. This issue has generally been referred to as the "Export issue" and presents the questions: (a) Whether Export was a Western Hemisphere Trade Corporation under the Internal Revenue Code (26 U.S.C. § 921-922); and (b) Whether the income of Export earned from the sale of rock to USG and the sale of manufactured products purchased from USG should properly be reallocated to USG again under section 482 (26 U.S.C. § 482) in order to clearly reflect the income of USG for federal income tax purposes.

Less complicated factually, if not legally, are the two remaining issues which counsel and the court have come to refer to as the "stock split issue" and the "patent infringement issue". The first relates to the deductibility as ordinary and necessary business expense of certain amounts paid for legal and registration fees and for stock certificates pursuant to a stock split and whether certain of the said amounts paid in connection with an earlier reorganization and subsequent stock dividends are deductible by USG in 1955 as an ordinary loss deduction (26 U.S.C. § 165). The patent infringement issue involves the tax consequences of an amount received by USG as a result of certain patent litigation.

Resolution of all of the above issues requires detailed discussion of the far reaching and complex operations of the United States Gypsum domain. Additional facts, where necessary, will be set forth in the discussion of the individual issues.


This issue involves USG and the tax years 1954, 1955, 1957 and 1958. USG's tax returns for these years were audited by the Internal Revenue Service and certain deficiencies were assessed. USG paid these deficiencies and then made a claim and subsequently filed suit for refund. At this point no questions had been raised by the Internal Revenue Service with regard to the amounts paid by USG for shipping services to Panama and none of the deficiencies which were assessed involved payments to Panama for shipping services. Panama's returns for the years 1954, 1955, 1957 and 1958 were likewise audited by the Internal Revenue Service (Office of International Operations). In these audits neither the Secretary of the Treasury nor his delegate undertook under Section 482 to distribute a portion or allocate any gross income, deductions, credits or allowances between Panama and USG. In its amended answers to the refund suits filed by USG for the years 1954, 1955, 1957 and 1958, the government first raised the "shipping issue" by then claiming that the amounts paid by USG to Panama for shipping services during the years in question were excessive and that any amounts due in the refund suits should be offset by the amounts of the excessive shipment payments. Authority for the offsets was claimed under sections 61, 162 and 482. (26 U.S.C. § 61, 162 and 482). The government now limits its claimed authority to section 482.*fn1

During the trial of the shipping issue the government's trial counsel introduced into evidence a letter dated October 27, 1967 from the Chief Counsel of the Internal Revenue Service to the Assistant Attorney General, Tax Division, Department of Justice, purporting to allocate under section 482, Panama's income, or at least a substantial part thereof, to USG.

The issue, stated simply is whether the shipping charges paid to Panama by USG were unreasonably high or excessive thus authorizing the application of section 482 of the Internal Revenue Code which permits the Secretary to allocate income and deductions where it is necessary to do so clearly to reflect the income of the actual earner. It is basically a codification of the long established principle expressed in Helvering v. Horst, 311 U.S. 112, 61 S.Ct. 144, 85 L.Ed. 75 (1940), that income should be taxed to the party who earned it. Or, as recently stated by our Seventh Circuit Court of Appeals: "The goal of the statutory allocation procedure is to insure that controlled taxpayers are placed on a parity with uncontrolled taxpayers." Local Finance Corporation v. Commissioner of Internal Revenue, 407 F.2d 629, 632 (1969). Parenthetically, I should note that USG also questions the authority of the government to invoke the provisions of section 482 at this time and in the manner of following the procedure it owned subsidiary incorporated under the has in this case. Section 482 of the Internal Revenue Code provides as follows:

    "In any case of two or more organizations, trades,
  or businesses (whether or not incorporated, 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 or
  his delegate may distribute, apportion, or allocate
  gross income, deductions, credits, or allowances
  between or among such organizations, 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

Thus the question here is whether it is necessary to allocate Panama's income to USG to prevent evasion of taxes or clearly to reflect the income of USG and Panama. The resolution of this question involves a rather detailed analysis of the USG shipping operation and its history, and the dealings of USG with its subsidiary, Panama. The record before me on this issue includes a partial stipulation of facts including some 119 exhibits; extensive testimony of five witnesses heard over four days of trial and resulting in seven volumes of transcript; and a number of other exhibits in addition to those offered with the stipulation which were offered and admitted during the course of the oral testimony. Counsel for both parties have also devoted large portions of their very excellent briefs, both pretrial and post trial, to this most difficult and complex dispute.

The history of USG's shipping.

As briefly related above, the largest part of USG's transportation needs, by way of ocean shipping, are supplied by Panama Gypsum Company, a wholly laws of the Republic of Panama. These shipping services involve transportation of raw gypsum rock from gypsum deposits owned by USG or other of its subsidiaries at Nova Scotia and Jamaica to various sea coast plants of USG in the United States. Shipments are made primarily on five ships, the King, Prince, Queen, Duchess and Empress. All but the King are owned and were built and designed by Panama. The King was owned by Gypsum Packet Company, ("Packet"), a Nova Scotia corporation wholly owned by USG, and was leased by Packet to Panama.

USG began transporting raw gypsum from Nova Scotia in 1924. The rock was then carried in vessels owned and operated by Packet. As business expanded and until World War II, four vessels owned by Packet were being used to carry rock for USG. Immediately following World War II, demands for gypsum products greatly increased and thus, of course, USG's demands for raw materials greatly increased. However, most of Packet's fleet had been destroyed in the war. Only the King remained operational. The need for new means of shipment prompted a number of important and far reaching decisions by USG. It was decided that two new ships would be constructed and specifically designed to meet the difficult port conditions existing at the deposit sites at Nova Scotia. It was also decided the vessels should be self-unloading. To handle its shipping needs USG decided to form a new subsidiary under the laws of the Republic of Panama and to place its ships under Panama register. The Republic of Panama was selected for incorporation and registration because of what USG felt were favorable tax considerations and labor factors. The new company was organized in 1946. Two new ships, the Queen and the Prince, were delivered to Panama in 1947. To help pay for the ships Panama borrowed 4.5 million dollars from its parent USG, which loan has since been repaid at the then prime rate of interest. In 1954 Panama chartered the King from Packet and also ordered two new additional self-unloading ships, the Duchess and the Empress, which were delivered in 1956.

Any additional transportation needs of USG were arranged through Gypsum Transportation Co., Inc., ("Transportation") another wholly owned subsidiary incorporated under the laws of Delaware. Transportation operated a barge fleet in New York harbor and the surrounding areas but also arranged charters for USG when its plants required more crude gypsum than Panama could carry on its ships.

The shipping rates paid to Panama by USG.

The shipping rates paid to Panama by USG were set by a contract of affreightment. (Ex. 3). There was a 1948 contract, renewed year to year, and a superseding 1955 contract, effective July 1, 1955. (Ex. 18). It is the position of USG that the 1948 contract is based on what USG would have to pay Panama if Panama had to charter suitable and available ships on the market and operate those ships. (The government does not accept the relevance of this criteria.) The formula relied on, in the main, was based on operating costs of a 5,600 ton ship which USG considered the most suitable and available on the market but which by no means was a perfect comparison for the ships to be built by Panama. A 25¢ per ton service charge was added to the rate as payment for the benefit of the self-unloading features of the Panama ships.*fn2

The 1955 contract of affreightment, effective July 1, 1955 (Ex. 18), agreed basically with the rate formula established in the 1948 contract except that the parties agreed to a ten year contract. Rates would not be renegotiated each year but would be adjusted based on the variances of the "World Wide Tramp Ship Rate Index" which originates in Oslo, Norway and is published once a month in the New York Journal of Commerce.

Under the 1955 contract USG was to receive a 10% discount on the rate formula in consideration for entering the long term agreement. The service charge for self-unloaders was also reduced from 25¢ to 15¢ per ton. The terms of the contract also assured Panama that it would transport between 800,000 and 1,500,000 tons of crude gypsum for USG each year and an additional 400,000 to 750,000 for each vessel as the Duchess and the Empress came into service. However, USG's obligation was limited in that it was excused from these requirements during such times as USG or its source of supply might not be able to provide or load crude rock at the ports due to causes beyond the control of USG or its source of supply and also during such times as USG may not be able to receive or use gypsum at a particular plant due to causes reasonably beyond its control (Ex. 18, pars. 1 and 9.).

Under the contracts of affreightment USG paid the following amounts to Panama for shipping services for the shipment of crude rock.*fn3

YEAR                          AMOUNT PAID
        1954                          $3,519,916
        1955                            3,446,042
        1957                            6,199,847
        1958                            4,519,018
                  TOTAL               $17,684,823

The government argues that the payments to Panama reduced USG's net taxable income*fn4 and accordingly increased Panama's gross income which was not taxed by either the United States or the Republic of Panama and that, to the extent that the above payments by USG to Panama exceed the amounts that would have been paid in an arm's length transaction, the income should be reallocated pursuant to the provisions of section 482. To establish the essential premise, i.e. that the rates paid did exceed amounts that would have been paid in an arm's length transaction, the government relies on the testimony and analysis of its expert, Mr. Matthew Kerwin, who testified before the court. Mr. Kerwin determined, by reconstruction, what in his opinion would be a reasonable shipping rate for the years in question. His determination was primarily based on probable time charter charges, rather than a long term contract of affreightment, though I am not sure the form of the transaction would substantially affect the price paid. The government's main challenge to the rates as established is that those rates were established for a 5,600 ton vessel and the vessels being used by Panama were larger and faster than the 5,600 ton vessel and therefore would operate much more economically.

USG's expert, Mr. William E. Bardelmeier, an experienced shipping consultant likewise reconstructed and determined what in his opinion would be a reasonable rate negotiated at arm's length. Mr. Bardelmeier prepared six hypothetical cases (Exs. 123, 124a, 124b, 125, 126 and 127). After this detailed analysis, Mr. Bardelmeier concluded that the rates charged were fair and reasonable.

Internal Revenue Code, section 482 authorizes allocation of income between a parent and its subsidiary when such allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of the parent or subsidiary. The pertinent Internal Revenue Regulation, (§ 1.482-2(b)), provides in essence that when a controlled entity, i.e. a subsidiary, performs services on behalf of its parent or another member of the controlled group at a charge which is not equal to an arm's length charge, the district director may make appropriate allocations to reflect an arm's length charge for such services. An arm's length charge is further defined to mean:

  "The amount which was charged or would have been
  charged for the same or similar services in
  independent transactions with or between unrelated
  parties under similar circumstances considering all
  relevant facts." (Reg. § 1.482(b)(3)).

USG strenuously argues that the dealings and negotiations between USG and Panama, its wholly owned subsidiary, were at arm's-length and adversary in nature. The evidence indicated otherwise. Surely it would be naive to suggest that the dealings here were, as USG alleges, at arm's-length. Panama, a wholly owned subsidiary, was dealing with its parent corporation and the tenure of the executives of Panama who were dealing for the subsidiary was completely at the will of the parent. This was not an arm's-length transaction.

Rather, it is obvious that the rates, details and contents of the contracts of affreightment were arbitrarily set by USG through its vice-president, Edward Rembret, who was its negotiator. But no negotiations between controlled companies are genuinely at arm's-length. This is why section 482 was enacted. Section 482 and the regulations promulgated thereunder do not require arm's-length bargaining, but only that the amounts charged as a result of the bargaining are equal to what would have been charged in an arm's length transaction. It is also obvious in this case that although tax considerations were important in this action they were not entirely or even primarily the motive. It is significant that the rate arrived at seems to be comparable with the market in general so far as this can now be ascertained. On the over all scheme of the foreign corporation's management, costs of operation thereof and dividends declared thereby, and taxable as straight income to plaintiff, I find no evidence of any attempt illegally to avoid tax. (Though I appreciate the fact that section 482 may apply even in the absence of fraud or deliberate tax avoidance, 7 Mertens, Law of Federal Income Taxation C. 38, p. 166). More importantly, I further find on the basis of the entire record before me, that the amounts paid were fair and reasonable and are equal to an arm's length charge for the services rendered. The facts clearly indicated that the companies would have entered into this same arrangement had they been uncontrolled corporations and bargained at arm's length. Thus, I conclude that the taxpayer's decision here challenged by the government is a legitimate exercise of the business discretion vested in the taxpayer and not open to the challenge or later second guessing of the tax gatherer seeking additional tax revenue by the use of some different method suggested by his substituted latter day and partisan discretion.

As stated by the court in A.P. Green Export Company v. United States, 284 F.2d 383 at 390, 151 Ct.Cl. 628 (1960):

  "Plaintiff was faced with a choice of two legitimate
  courses of conduct, either of which would be

  sound and justifiable. We are not prepared to say
  that in this situation plaintiff was bound to choose
  that course which would best pay the Treasury."

I do not reject or in any way diminish the authority of the tax gatherer to carefully scrutinize business operations of the taxpayer. However, if in the end the object of the procedure in question is not for venal purposes, i.e. to evade and defeat taxes, and if it still clearly reflects its income, business decisions should be within the discretion of the taxpayer. Here, two expert witnesses differed as to what a reasonable and proper rate would have been. That is, the rate that would have been produced from an arm's length transaction. The expert testifying on behalf of USG showed extensive preparation and concluded that the rate charged by Panama and paid by USG was close to what he would have negotiated for in an arm's length transaction at that time. The government's expert, Kerwin, came up with what he thought would have been proper rates, but the variances between his suggested rates and those actually in effect were certainly understandable and acceptable in so volatile a market as ocean-going freight — particularly here where the government's expert has the benefit of enlightened hindsight.

I should emphasize also that the income of Panama resulting from the shipping charges and here sought to be allocated to USG did not escape the tax gatherer. Eventually dividends are paid by Panama and USG receives these dividends as ordinary income. Thus taxes were merely delayed — not defeated.

In summary, after hearing and observing the thorough testimony of the expert witnesses, and having carefully reviewed all of the exhibits in connection therewith and as offered by counsel, and having heard and read the extensive arguments of counsel for the taxpayer and the government, I find that the rates set, though they may have been relatively high and were not actually negotiated at arm's length but arbitrarily set, were reasonably within the range of what would have been charged for similar services in an independent transaction between unrelated parties under similar circumstances. Even with its well informed hindsight, the government has presented no persuasive evidence that the rates were unreasonable.

Accordingly, I find that the income of Panama earned from the shipping charges paid by USG should not be reallocated pursuant to the provisions of section 482.

I should here also observe that the Treasury Department has recently issued further regulations which are consistent with this finding. (Reg. § 1.482-2(b)(3) and (7), 34 Fed.Reg. 933, Jan. 22, 1969). These regulations essentially restate the proposition that when a related company performs services for its sister company, the value of those services and not the cost of performance, should be paid by the recipient company. This appears to be merely a further definition of the arm's length or reasonable price test I have applied here. The government has not taken the position that Panama's costs should be the basis of the payments for the shipping services performed for USG. The amounts the government would allow, however, are much closer to actual costs than to what I have found to be a fair and reasonable or "arm's length" charge.

In view of these findings and ruling it is unnecessary to determine the further argument of USG, that the right of allocation of income between a parent and its subsidiary is exclusively within the power of the Secretary of the Treasury or his delegate and that said allocation was never properly attempted in this case. Since it has been reargued here and again in the "Export issue", I shall repeat my view of the government's authority as stated early in this litigation.

  "The Government, by way of equitable setoff can place
  in issue all of the plaintiff tax refund suitor's
  deductions and credits for the years brought in
  question by the plaintiff, notwithstanding the
  Commissioner having already reviewed and made prior

  determinations thereon." (Order, August 4, 1965).

USG, in this issue and again in the Export issue, strenuously argues that under the statute only the Secretary of the Treasury or his delegate has the power of allocation, and that no similar power has been bestowed on the Department of Justice. United States v. First Security Bank, 334 F.2d 120 (9th Cir. 1964); Maxwell Hardware Co. v. Commissioner of Internal Revenue, 343 F.2d 713 (9th Cir., 1965); Peter Pan Seafoods Inc. v. United States, 272 F. Supp. 888 (W.D.Wash., 1967). I do not believe that the position here taken by USG is inconsistent with my prior ruling. If the taxpayer elects to sue for refund on the theory that he has overpaid his tax, he puts his deductions and credits into issue. The government is not precluded from arguing nor the court from finding that deductions of amounts paid to related companies for services were unreasonable and that income must be reallocated clearly to reflect the taxpayer's income or to prevent the evasion of taxes. Upon such a finding, however, only the Secretary or his delegate may make the necessary allocation.


These issues involve the operations of United States Gypsum Export Company, ("Export"), which, as previously stated, is a wholly owned subsidiary of USG. USG purchased gypsum rock from and sold manufactured products to its wholly owned Canadian subsidiary, Canadian Gypsum Company ("Canadian"), through its subsidiary Export. Specifically, the questions presented are: (1) Whether Export qualified as a Western Hemisphere Trade Corporation and was entitled to the special deduction accorded such corporations; and (2) Whether a portion of Export's income should be allocated to USG under section 482.

Like the shipping issue, the record before the court is voluminous and complete. Much of the evidence was submitted by stipulation. The court also heard the testimony of certain witnesses in open court. Depositions, further stipulations of facts and answers to interrogatories were also introduced into evidence in open court.

The operations of Export Company.

Export was incorporated in 1954 as a result of a study USG conducted of its export-import operations. USG allegedly planned to explore and develop an export-import business through Export Company. Prior to that time USG had made substantial sales to Canadian, which operated a manufacturing plant and sales organization in Canada and also made some sales in Mexico, the Caribbean, South America and Europe. Sales were apparently also made to unrelated and independent purchasers when the purchasers initiated inquiry. USG in its evidence and in its briefs relates a number of business reasons for establishing the Export Company. It is quite clear, however, that a primary purpose was the tax advantage it could obtain as a Western Hemisphere Trade Corporation.

Through 1955 Export had only two employees, both "salesmen", in the Caribbean and Latin America. For about a year and one half Export also employed a geologist working in the Dominican Republic analyzing gypsum deposits. USG personnel furnished accounting, billing and secretarial services for Export and also handled all of the details of credit, bills of lading, and made out customs papers and tax returns. All of these services were performed on "service contracts" entered into between USG and Export.

The purchase of crude gypsum rock by USG from its mining subsidiaries and through Export was facilitated by contracts entered into between USG and Export and between Export and the mining subsidiaries. Under the terms of the contract between Export and Canadian, Canadian agreed to produce, sell and deliver in Canada one million net tons of gypsum rock each year and whatever additional tonnage as Export might order. Export agreed to purchase the same amounts. Export agreed to pay Canadian its average costs per ton of producing the rock plus 25ยข per ton. This price incidentally was the same price which USG had been paying Canadian for crude gypsum. Very similar contracts were later negotiated between Export and Little Narrows and Jamaican, the other mining ...

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