The opinion of the court was delivered by: Baker, District Judge.
Archer-Daniels-Midland Company (ADM) brought this action
against the United States of America on behalf of itself and as
the common parent of an affiliated group of corporations. ADM
is seeking a refund of federal taxes along with interest paid
to the United States for the tax years 1975 through 1978. The
parties have filed cross motions for partial summary judgment.
(docket # 17 and 19) The only issue involved in these motions
is whether Treas. Reg. § 1.994-1(e)(1)(i), 26 C.F.R. §
1.994-1(e)(1)(i), which limits the use of two methods for
determining the taxable income of a domestic international
sales corporation (DISC), is valid.*fn1 For the reasons set
forth below, the court agrees with the plaintiffs that
Treas. Reg. § 1.994-1(e)(1)(i) is invalid.
I. INTERNAL REVENUE CODE SECTION AND TREASURY REGULATION
Congress enacted the DISC provisions,
26 U.S.C. § 991-997,*fn2 as a part of the Revenue Act of 1971. The purpose
of the provisions "was to provide tax incentives for United
States firms to increase their exports and to remove the
previous tax disadvantage of firms engaged in export activities
through domestic corporations instead of through foreign
subsidiaries." Thomas International, Ltd. v. United States,
773 F.2d 300, 301 (Fed. Cir. 1985), cert. denied, 475 U.S. 1045,
106 S.Ct. 1261, 89 L.Ed.2d 571 (1986); LeCroy Research Sys.
Corp. v. Commissioner, 751 F.2d 123, 124 (2d Cir. 1984). These
provisions authorize the exporters to establish DISCs as
separate subsidiaries to handle foreign sales and leases. The
basic function of a DISC, under section 993, "is the selling or
leasing of export property which has been created by someone
else in the United States for ultimate use outside the United
States." Gehl Co. v. Commissioner, 795 F.2d 1324, 1326 (7th
Cir. 1986) (quoting Bittker & Eustice, Federal Income Taxation
of Corporations and Shareholders ¶ 17.14.2 (4th ed. 1979)). In
essence, a DISC may be only a shell corporation whose sole
function is to receive income from foreign sales by the parent
corporation. Thomas International, 773 F.2d at 301; see Dresser
Indus. v. Commissioner, 911 F.2d 1128, 1131 (5th Cir. 1990)
("Typically, a DISC is a paper company without facilities,
employees, or inventory of its own.").
The tax advantages of the DISC provisions stem from the fact
that a DISC is not subject to federal income tax on its income
from export sales. Durbin Paper Stock Co. v. Commissioner,
80 T.C. 252, 254 (1983). Instead, approximately one-half of the
DISC's earnings is taxed to its shareholders as constructive
dividends. The remainder of the earnings is not taxed until
actually distributed to the shareholders. See Gehl, 795 F.2d at
1327; Thomas International, 773 F.2d at 301; LeCroy, 751 F.2d
at 124. However, the statute provides that the exempted
earnings must be used in export activities and not diverted to
production for the domestic market or to production overseas.
To fulfill the purposes of the DISC provisions, the DISC scheme
includes strict requirements for qualification as a DISC and
provisions regulating "transactions and transfers involving the
flow of the DISC's tax-deferred profits to related entities."
Gehl, 795 F.2d at 1326.
The DISC can participate in export transactions in two
different ways. In each type of transaction, the DISC deals
with a "related supplier"*fn3 in the sale of export
property*fn4 to a third party. In the first type of
transaction, the DISC operates as a principal in the resale of
export property that the DISC purchased from the related
supplier. Here the DISC earns income on the resale which the
related supplier would otherwise have earned. In the second
type of transaction, the DISC acts as a commission agent
facilitating the sale of export property directly from the
related supplier to the third party. The DISC's earnings in
this transaction include commissions which the related supplier
can deduct as commission expenses to reduce taxable income.
One provision that regulates the flow of the DISC's profits
to related entities is section 994. This section sets forth
inter-company pricing rules used to determine the DISC's
taxable income. As established in this section, DISC taxable
income is "based on a . . . `deemed' transfer price for export
goods provided to the DISC by its parent or related supplier."
Dresser, 911 F.2d at 1131. The statute includes three
alternative formulas for determining the "deemed transfer
price." Id. Section 994(a) states:
In the case of a sale of export property to a DISC
by a [related supplier], the taxable income of
such DISC and such person shall be based upon a
transfer price which would allow such DISC to
derive taxable income attributable to such sale
(regardless of the sales price actually charged)
in an amount which does not exceed the greatest of
(1) 4 percent of the qualified export receipts
on the sale of such property by the DISC plus 10
percent of the export promotion expenses of such
DISC attributable to such receipts,
(3) taxable income based upon the sale price
actually charged (but subject to the rules
provided in section 482).
26 U.S.C. § 994(a). The three alternative inter-company pricing
methods for computing the taxable income from the export sales
are known as the 4 percent gross receipts method, the combined
taxable income method, and the section 482 method.*fn5
Although section 994(a) specifically applies only to
transactions in which the DISC acts as a principal, section
994(b) directs the Secretary to prescribe rules to apply when
the DISC acts as a commission agent.*fn6 The rules are found
in inter-company pricing rules for DISCs, 26 C.F.R. §
1.994-1(d) (1991). These rules apply the 4 percent gross
receipts method (called simply the "gross receipts method" in
the regulations) and the combined taxable income method in
sections 994(a)(1) and (2) to commissions.
The Secretary also has issued regulations concerning the
application of the three pricing methods. Treasury Reg.
1.994-1(e)(1)(i) limits the situations in which the 4 percent
gross receipts method and the combined ...