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ARCHER-DANIELS-MIDLAND CO. v. U.S.

September 8, 1992

ARCHER-DANIELS-MIDLAND COMPANY, ET AL., PLAINTIFFS,
v.
UNITED STATES OF AMERICA, DEFENDANT.



The opinion of the court was delivered by: Baker, District Judge.

ORDER

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,
    (2) 50 percent of the combined taxable income of
  such DISC and [the related supplier] which is
  attributable to the qualified export receipts on
  such property derived as the result of a sale by
  the DISC plus 10 percent of the export promotion

  motion expenses of such DISC attributable to such
  receipts, or
    (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 ...


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