UNITED STATES COURT OF APPEALS
For the Fifth Circuit
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No. 95-60696
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TEXACO, INC. and SUBSIDIARIES,
Petitioner-Appellee,
VERSUS
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellant.
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Appeal from the United States Tax Court
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October 17, 1996
Before DAVIS, JONES and EMILIO M. GARZA, Circuit Judges.
DAVIS, Circuit Judge:
The Commissioner of Internal Revenue challenges the Tax Court's
legal conclusion that Letter 103/z, a 1979 pronouncement of Saudi
Arabian oil policy by the Saudi Arabian Oil Minister, prohibits the
Commissioner from exercising her authority to reallocate income under
26 U.S.C. §§ 482 and 61 (1994). We affirm.
I.
Texaco, Inc. is the parent corporation of a group of entities
engaged in the production, refining, transportation, and marketing of
crude oil and refined products in the United States and abroad. Texaco
has a number of subsidiary/affiliate corporations under its umbrella.
One of those affiliates is Texaco International Trader, Inc. (Textrad),
which acted as the international trading company for the worldwide
Texaco refining and marketing system during the period in question.
As the trading company, Textrad purchased Saudi crude oil from the
Saudi government by way of the Arabian American Oil Company (Aramco)
and resold that crude to both affiliates and unrelated customers.
The Commissioner contends that Textrad unduly shifted profits to
its foreign affiliates during taxable years 1979-81, and she increased
Textrad’s U.S. taxable income for those years under §§ 4821 and 61 of
the Internal Revenue Code to reflect those profits. Texaco argues that
it had no power to control the allocation of profits on Saudi Oil
during those years because of the restrictions imposed by Letter 103/z,
which required Texaco and the other Aramco members to re-sell Saudi
Arabian crude at specified below market prices. The Tax Court
conducted a lengthy trial and entered detailed findings of fact, which
we need not repeat here. We state only those facts necessary to
understand our opinion.
A.
From early 1979 through late 1981, Saudi Arabia permitted Texaco
and the other Aramco participants to buy Saudi Arabian crude oil at
below market prices. The Saudi government also established the
1
26 U.S.C. § 482 (1994) states:
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 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 such organizations,
trades, or businesses.
2
official selling price (the OSP) for Saudi Arabian crude below the
market price. The Saudi government took these actions in response to
requests by the United States and other consuming countries to moderate
the price of crude oil. To ensure its price regulation had its
intended effect, the Saudi government prohibited Texaco and other
participants in Aramco from re-selling Saudi crude at prices higher
than the OSP. As the Tax Court found, these restrictions were
authorized by the King and communicated to Aramco by Minister Yamani
in Letter 103/z, dated January 23, 1979.2 Except in instances where it
was excused from doing so, Textrad complied with Letter 103/z and
resold the Saudi crude at the OSP.
During the period in question, Textrad sold approximately 34
percent of its Saudi crude or about 780,000,000 barrels to its refining
affiliates. Of these, approximately 275,000,000 barrels were sold to
Texaco's domestic refining company and 505,000,000 barrels to Texaco's
foreign refining affiliates.3 Textrad also sold 15-20 percent of its
Saudi oil at the below market OSP to customers that were completely
unrelated to Texaco. This was consistent with the pattern and volume
of Textrad's sales to unrelated customers in earlier years. Moreover,
the Tax Court specifically found that any changes in Textrad’s sales
to both its affiliates and its unrelated customers during this period
were not related to the Saudi price restrictions.
2
Paragraph 5 of Letter 103/z required Texaco and the other Aramco
participants “to pledge that they will not sell to a third party at
prices in excess of what we have specified herein.”
3
Any profits made by Texaco's domestic affiliates from the sale
of products refined from this oil were included in Texaco's United
States taxable income.
3
The restrictions in Letter 103/z, however, applied only to Saudi
crude, not to the sale of products refined from Saudi crude. As a
result, the companies that bought Saudi crude from Textrad at the below
market OSP, including Texaco’s refining affiliates, earned large
profits from the sale of refined products. Unlike its domestic
affiliates, Texaco's foreign refining affiliates reported no taxable
income in the United States.
B.
The commissioner alleges that Textrad shifted profits attributable
to the lower cost of Saudi crude out of Texaco's U.S. taxable income
when it sold Saudi crude at the OSP to its foreign refining affiliates.
The Commissioner reallocated over $1.7 billion in income to Textrad for
taxable years 1979, 1980, and 1981. Following a five-week trial, the
Tax Court issued a detailed opinion. The Tax Court held that the
Commissioner was precluded from allocating income to Texaco under §§
482 and 61 because the price restrictions in Letter 103/z were the
"virtual equivalent of law," which Texaco was required to obey.
The Tax Court supported this conclusion with a number of factual
findings, including the following:
1. The Saudi government, with the approval of the King, issued
Letter 103/z prohibiting the resale of Saudi crude at amounts exceeding
the OSP.
2. Texaco was subject to that restriction and faced severe
economic repercussions, including loss of its supply of Saudi crude and
confiscation of its assets, if it violated Letter 103/z.
3. This mandatory price restriction applied to all sales of Saudi
4
crude, including sales to affiliated entities.
4. Neither Texaco nor any other Aramco participant had any power
to negotiate or alter the terms of this restriction.
Based on its findings that Texaco was obligated to comply, and did
comply, with the Saudi government’s price restrictions, the Tax Court
concluded that Texaco's pricing policy to its foreign affiliates as
well as its unrelated customers was due to these restrictions and not
to any attempt to distort its true income for tax purposes. The
Commissioner has appealed the order disallowing the allocation.
II.
A.
Based on the Tax Court’s factual findings, which are not clearly
erroneous, we agree that Letter 103/z had the effect of a legal
restriction in Saudi Arabia. The 1979 pricing requirements were
authorized by the King and issued by Minister Yamani on behalf of the
Saudi government as mandatory restrictions. These restrictions applied
to all sales of Saudi crude by the Aramco participants and others. The
restrictions were in effect during the period at issue and were
followed by Texaco. The Tax Court's findings of fact fully support its
conclusion that Letter 103/z should be given the effect of law for
purposes of §§ 482 and 61.
We also agree with the Tax Court's legal conclusion that the
teaching of Commissioner v. First Security Bank, 405 U.S. 394 (1972),
bars the Commissioner from allocating income to Textrad on its sales
of Saudi crude under § 482. Because the sales price of the crude is
governed by Letter 103/z, Texaco did not have the power to control the
5
sales price of the oil.
Section 482 of the Internal Revenue Code authorizes the Secretary
to apportion or allocate income between organizations controlled by the
same interests “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 such organizations . . . .” 26
U.S.C. § 482. The relevant IRS regulation explains that the purpose
of § 482 is “to place a controlled taxpayer on a tax parity with an
uncontrolled taxpayer” and to ensure that controlling entities conduct
their subsidiaries’ transactions in such a way as to reflect the “true
taxable income” of each controlled taxpayer. 26 C.F.R. § 1.482-1(b)(1)
(1996).4 The regulation further explains that “[t]he standard to be
applied in every case is that of an uncontrolled taxpayer dealing at
arm’s length with another uncontrolled taxpayer.” Id.
4
26 C.F.R. § 1.482-1(b)(1) reads in full:
The purpose of section 482 is to place a controlled taxpayer
on a tax parity with an uncontrolled taxpayer, by
determining, according to the standard of an uncontrolled
taxpayer, the true taxable income from the property and
business of a controlled taxpayer. The interests
controlling a group of controlled taxpayers are assumed to
have complete power to cause each controlled taxpayer so to
conduct its affairs that its transactions and accounting
records truly reflect the taxable income from the property
and business of each of the controlled taxpayers. If,
however, this has not been done, and the taxable incomes are
thereby understated, the district director shall intervene,
and, by making such distributions, apportionments, or
allocations as he may deem necessary of gross income,
deductions, credits, or allowances, or of any item or
element affecting taxable income, between or among the
controlled taxpayers constituting the group, shall determine
the true taxable income of each controlled taxpayer. the
standard to be applied in every case is that of an
uncontrolled taxpayer dealing at arm's length with another
uncontrolled taxpayer.
6
In First Security, the Court held that § 482 did not authorize the
Commissioner to allocate income to a party prohibited by law from
receiving it. 405 U.S. at 404. In that case, two related banks
offered credit life insurance to their customers. Federal law
prohibited the banks from acting as insurance agents and receiving
premiums or commissions on the sale of insurance. The banks referred
their customers to an unrelated insurance company to purchase this
insurance. The insurance company retained a small percent of the
premiums for administrative services and transferred the bulk of the
premiums through a reinsurance agreement to an insurance company
affiliated with the banks, which reported all of the reinsurance
premiums it received as income. The Commissioner reallocated 40% of
the related insurance company’s income from these reinsurance premiums
to the banks as compensation for originating and referring the
insurance business. Id. at 396-99.
The Court concluded that due to the restrictions of federal
banking law, the holding company that controlled the banks and the
insurance affiliate did not have the power to shift income among its
subsidiaries. In so holding, the Court emphasized that the
Commissioner’s authority to allocate income under § 482 presupposes
that the taxpayer has the power to control its income: “The underlying
assumption always has been that in order to be taxed for income, a
taxpayer must have complete dominion over it.” Id. at 403. Indeed,
as the Court noted, the Commissioner’s own regulations for implementing
§ 482 contemplate that the controlling interest “must have ‘complete
power’ to shift income among its subsidiaries.” Id. at 404-05 (quoting
7
26 C.F.R. § 1.482-1(b)(1) (1971)).
Moreover, the regulations and First Security make clear that this
standard is not limited to cases where the government contends the
taxpayer attempted to evade taxes. Rather, the Court explicitly
extends its reasoning to circumstances where the government contends
that the organization's “true taxable income” has not been reflected.5
After explaining that the right to control the allocation of income is
critical, the Court stated: "It is only where this power exists, and
has been exercised in such a way that the ‘true, taxable income’ of a
subsidiary has been understated, that the Commissioner is authorized
to reallocate under § 482. . . . The ‘complete power’ referred to in
the regulations hardly includes the power to force a subsidiary to
violate the law." Id. (emphasis added). Because the holding company
in First Security could not have allocated the income to the banks
unless it acted in violation of the law, the Court concluded that the
banks’ true income was not understated and the Commissioner’s
allocation under § 482 was improper.
5
We find no indication from the facts and contentions of the
parties in First Security that the government contended that the banks
or the holding company sought to evade taxes. Rather, First Security
explains in general terms the type case § 482 is designed to reach
without distinguishing between claims of evasion and other claims that
the true income of the taxpayer has not been reflected: "The question
we must answer is whether there was a shifting or distorting of the
[taxpayers] true net income." Id. at 400-401 (emphasis added); see also
id. at 407 (concluding that because the holding company “did not
utilize its control over the [banks and the affiliated insurance
company] to distort their true net incomes,” the Commissioner could not
exercise his § 482 authority) (emphasis added). This is consistent
with the approach and structure of the regulation, which also does not
distinguish between evasion and other conduct that fails to reflect the
true taxable income of the taxpayer. See 26 C.F.R. § 1.482(b)(1)
(1996).
8
The Sixth Circuit decision in Procter & Gamble Co. v.
Commissioner, 961 F.2d 1255 (6th Cir 1992) also supports the Tax
Court's conclusion. In that case, the court held that a Spanish law
prohibiting a foreign affiliate from paying royalties for the use of
patents was sufficient to preclude the Commissioner from reallocating
income to account for a reasonable royalty. The court stated that “the
purpose of § 482 is to prevent artificial shifting of income between
related taxpayers.” Id. at 1259 (emphasis added). Again the deciding
issue was one of control: “Because Spanish law prohibited royalty
payments, [the controlling company] could not exercise the control that
§ 482 contemplates, and allocation under § 482 is inappropriate.” Id.
at 1259. See also L.E. Shunk Latex Products, Inc. v. Commissioner, 18
T.C. 940 (1952) (holding that Commissioner could not allocate
additional income to condom manufacturer where manufacturer sold
condoms to its affiliate at price set by Office of Price
Administration, even though affiliate made substantial profits on the
transactions).
It is precisely this ability to control the flow of its income
that Texaco lacked. The Tax Court found, and we agree, that Letter
103/z had the force and effect of law, that Textrad was obligated to
comply with its requirements, and that it did so comply. Because
Textrad lacked the power to sell Saudi crude above the OSP,
reallocation under § 482 is inappropriate.
B.
The Commissioner tries to justify the allocation by analogizing
Texaco’s conduct to an “assignment of income” and places much reliance
9
on the Supreme Court’s decision in United States v. Basye, 410 U.S. 441
(1973). However, nothing in Basye is contrary to the principles
discussed above, and the Commissioner’s reliance on this case is
misplaced.
In Basye, the Court relied on familiar principles “that income is
taxed to the party who earns it and that liability may not be avoided
through an anticipatory assignment of that income” to hold that a group
of doctors’ failure to actually receive a portion of their compensation
that was instead placed in a retirement trust did not preclude the
Commissioner from allocating that income to them. Id. at 457. The
Court found that the sole reason the doctors could not receive the
challenged portion of their income was because their medical
partnership had agreed with a health plan foundation to service the
foundation’s members for free in exchange for contributions to a
retirement trust. Id. at 449.
The Court’s holding in Basye turned on the consensual nature of
the agreement and is entirely consistent with the principles of control
expressed in the regulations adopted under § 482 and in First Security.
As the regulations make clear, the goal of inquiring into the
transactions of controlled taxpayers under § 482 is “to ascertain
whether the common control is being used to reduce, avoid or escape
taxes.” 26 C.F.R. § 1.482-1(c) (1996). The Court in Basye agreed with
the Commissioner that the doctors’ compensation scheme was entirely
voluntary -- that the medical partnership possessed common control and
used it to reduce, avoid, or escape taxes. That the doctors exercised
that control prior to their actual possession of the income was
10
irrelevant.
But where, as here, the taxpayer lacks the power to control the
allocation of the profits, reallocation under § 482 is inappropriate.
As stated above, we fully agree with the Tax Court that Letter 103/z
deprived Textrad of the power to sell Saudi crude to its foreign
refining affiliates for a price that exceeded the OSP. Because Texaco
lacked the ability to control the allocation of the income in question,
it follows that it could not have used its control to evade taxes or
artificially shift its income to its foreign affiliates so that its
true taxable income was not reflected.
C.
Nor would the Commissioner’s proposed allocation be consistent
with § 482's goal of achieving tax parity between controlled and
uncontrolled taxpayers. As the First Security Court and the
regulations make clear, the “‘purpose of § 482 is to place a controlled
taxpayer on a tax parity with an uncontrolled taxpayer.’” 405 U.S. at
407 (citing 26 C.F.R. § 1.482-1(b)(1) (1971)). Thus, “[t]he standard
to be applied in every case is that of an uncontrolled taxpayer dealing
at arm’s length with another uncontrolled taxpayer.” 26 C.F.R. §
1.482-1(b)(1) (1996).
The record evidence fully supports the Tax Court’s findings that
Textrad sold significant amounts of Saudi crude to unrelated customers
at the same OSP it sold to its affiliates, that the volume of Textrad’s
sales of Saudi crude to unrelated customers during this period remained
generally consistent with historic levels, and that any changes in
Textrad’s sales to its affiliates and its unrelated customers during
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this period had no nexus with the restrictions imposed by Letter 103/z.
Therefore, the Tax Court did not err in concluding that the
Commissioner failed to demonstrate any disparity between Texaco’s
treatment of its affiliates and its unrelated customers as a result of
the Saudi price restrictions. Thus, under the regulation’s tax parity
standard, the Commissioner’s allocation of Texaco’s income under § 482
is improper.
In sum, the Tax Court did not err in concluding that Textrad sold
the Saudi crude to both its affiliates and its unrelated customers at
the below market OSP to avoid violating Letter 103/z and the severe
economic reprisal that would have flowed from such a violation.
Accordingly, the Commissioner had no authority to allocate the income
under § 482.
For the reasons stated above, the Tax Court properly concluded
that the Commissioner was without authority to reallocate Texaco's
income under § 482.
AFFIRMED.
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