Duffy and Knoch, Senior Circuit Judges, and Kerner, Circuit Judge.
Baldwin-Lima-Hamilton Corporation (Taxpayer), as transferee of the Austin-Western Company (AW), brought this refund suit in the district court to recover income taxes in the amount of $108,271.50 for 1953, 1954 and 1955. The Commissioner had determined under § 482 of the Internal Revenue Code, 26 U.S.C. § 482 (1954) (formerly § 45 of the 1939 Internal Revenue Code), that all of the income for those years of the Austin-Western Hemisphere Company (AWH) a subsidiary of AW, be reflected as the income of its parent, AW, for federal tax purposes. The district court found that the Commissioner's total reallocation of income was unreasonable, arbitrary and erroneous, and held that no part of AWH's income be allocated to AW. While we agree with the district court that the Commissioner's total re-allocation of income was erroneous, we believe some re-allocation is necessary. We remand this case to the district court to determine what part of AWH's income should be allocated to AW.
From 1953 to 1955, AW manufactured heavy machinery and equipment (such as road graders, road rollers, hydraulic cranes and street sweepers), which it sold to distributors in the United States and foreign countries. The machines, valued from $16,000 to $20,000, were made to the specific order of the distributors, who in turn sold them to the ultimate users. The distributors developed the market and maintained contact with the customers by providing instructions, parts and service and demonstrating the machines.
In 1952, AWH was incorporated as a wholly owned subsidiary of AW. The initial capitalization was $5,000, and nothing more was invested in AWH. AWH was to act as a distributor of AW's products in the Western Hemisphere outside of the United States. The stated purpose of AWH's incorporation was to expand foreign trade for AW and to take advantage of tax benefits under § 921 and § 922 of the Internal Revenue Code, 26 U.S.C. §§ 921, 922 (1954) (formerly §§ 109 and 26(i) of the 1939 Internal Revenue Code), which imposes reduced tax rates on a corporation which qualifies as a Western Hemisphere Trade Corporation. In order to qualify as a Western Hemisphere Trade Corporation, a corporation must derive 95% of its gross income from sources outside of the United States and within the Western Hemisphere.
AWH sold AW's machinery to the same 25 to 30 foreign distributors who, prior to AWH's creation, had bought directly from AW. AWH became responsible for filling orders and shipping the goods to the distributors. At the time of AWH's incorporation, AW notified its distributors that they would be dealing with AWH in the future, but that there would be no other change in the terms and conditions of their sales relationship. AWH made no effort to seek additional distributors in its designated market, although it employed a Spanish speaking salesman who kept in contact with the distributors. AWH also sent some printed catalogues, circulars and other advertising material written in the Spanish language to the distributors, but the distributors themselves were primarily responsible for the advertising to their customers.
AWH was officed in AW's building in Aurora, Illinois, and had no other office space or warehouse, and paid AW rent for the offices. AWH had no inventory of machines or parts other than those which were ordered by the distributors and in transit to them. Some AWH employees worked in its export department performing supervisory, clerical and sales duties, but this was the extent of AWH's separate work force. A number of employees worked jointly for AW and AWH in arranging for shipment and insurance, and in managing AWH's office in Aurora. AW paid the salaries of AWH's employees and did other administrative work for AWH.
On October 8, 1952, AWH's Board of Directors passed a resolution in which it agreed to pay AW for the cost of the machinery plus "an amount equal to fifteen per cent (15%) of the cost price of products purchased by this corporation from Austin-Western Company * * * in payment for the furnishing of general administrative services by officers and employees of Austin-Western Company to this corporation." The 15% cost figure, which sought to represent the services performed by AW, was justified at trial on the basis of the average of AW's cost from 1948 to 1952. A study introduced at trial indicated that this 15% figure, which was AW's sole remuneration from AWH other than for AW's bare manufacturing costs, included 10% for general administrative services and 5% for profit to AW. The cost figure, against which the 15% was applied, represented AW's manufacturing costs only, and did not include the additional costs of marketing which AW charged to its other distributors.
From 1953 to 1955, AWH's net profit percentage (to cost) exceeded AW's net profit percentage and the consolidated net profit percentage for both AW and AWH. In 1953, AWH's net profit percentage was 12.9%, AW's percentage was 11.9%, and the consolidated net profit percentage was 12.1%; for 1954 and 1955 respectively, 9.5% and 9.8% represented the net profit percentage for AWH, 8.5% and 2.5% for AW, and 8.6% and 3.2% for both AW and AWH in the consolidated net figure.
The Commissioner, under § 482, ruled that all of AWH's net income should be allocated to AW. Section 482 provides:
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 businesses.
The district court decided that the net income of AW on its sales to AWH, was clearly reflected on AW's returns and that the Commissioner had acted unreasonably and arbitrarily in allocating all of AWH's net income to AW. It also held that no apportionment between AW and AWH was necessary under § 482.
The practical advantage of inflating AWH's income is obvious. Since it was a Western Hemisphere Trade Corporation, its income was taxed at a rate substantially lower than that of AW. The corporations between them, would pay less taxes if more income were attributed to AWH.
Taxpayer argues that since AWH was a valid Western Hemisphere Trade Corporation and entitled to take advantage of the tax benefits under § 922, the Commissioner cannot use § 482 to strip it of its favored tax treatment. The creation of a corporation in order to obtain tax benefits is a valid business purpose and cannot constitute evasion ...