No. 96-1107

IN THE SUPREME COURT OF THE UNITED STATES

OCTOBER TERM, 1996

COMMISSIONER OF INTERNAL REVENUE, PETITIONER

v.

TEXACO, INC. AND SUBSIDIARIES

ON PETITION FOR A WRIT OF CERTIORARI
TO THE  UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT

REPLY BRIEF FOR THE PETITIONER

WALTER DELLINGER
Acting Solicitor General
Department of Justice
Washington, D.C. 20530-0001
(202)514-2217

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TABLE OF AUTHORITIES

Cases                   Page

Argentina  v. Weltover,  504 U. S. 607 (1997) . . . . 4, 6
Commissioner v. Culbertson, 337 U.S.733 (1949) . . . . 3, 6
Commissioner v. First  Security  Bank,  405 U.S. 394
(1972) . . . . 1, 2, 5, 6
L.E. Shunk Latex Products, Inc. v. Commissioner,
18 T. C. 940(1952) . . . . 4, 5
United States  v. Basye, 410 U.S.441 (1973) . . . . 1, 2, 5, 6

Statute and regulation

Internal Revenue  Code, 26 U.S.C. 482 . . . . 5, 6, 7
26 C. F.R.  1.482.1 (b)  (1981) . . . . 6

Miscellaneous:

B. Bittker & J. Eustice, Federal Income Taxation of
Corporations and Shareholders (1987 cd.) . . . . 5-6

(I)

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In the Supreme Court
 
OCTOBER TERM, 1996

No. 96-1107

COMMISSIONER OF INTERNAL REVENUE, PETITIONER

v.

TEXACO, INC. AND SUBSIDIARIES

ON PETITION FOR A WRIT OF CERTIORARI
TO THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT

REPLY BRIEF FOR THE PETITIONER

Respondent errs in asserting that its purchases of
Saudi crude oil did not stem from "a consensual
agreement" but were instead dictated by foreign law
(Br. in Opp. 15).  Building upon that flawed foundation,
respondent mistakenly asserts that this Court's deci-
sion in Commissioner v. First Security Bank, 405
U.S. 394 (1972), rather than its decision in United
States  v. Basye, 410 U.S. 441 (1973), governs this case.
Review by this Court is warranted because of the
fundamental misapplication by the courts below of the
decisions of this Court and the extraordinary impor-
tance of the question presented.
1. The mere fact that Texaco was unusually depen-
dent upon supplies of Saudi crude oil in 1979 and 1980
(see Pet. 7-8 & n. 7) does not exempt Texaco from the

(1)

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2

operation of the internal revenue laws of the United
States. As the Chairman of Exxon has straightfor-
wardly acknowledged, the Saudi resale condition was
nothing more than a "condition[] of sale" (Tr. 154-
155). Texaco, Exxon and the other Aramco partici 
pants "always had the choice of not buying Mr.
Yamani's oil" (ibid.). The fact that Texaco had a
great need for supplies in 1979 and 1930 does not mean
that Texaco had a legal obligation to purchase Saudi
oil or to purchase such oil under any specific set of
contractual terms. For the reasons described in the
petition (Pet. 16-19), the fact that the seller had
sufficient market power to dictate the terms of sale
does not make those terms a "law." 1
Respondent does not dispute that, in determining
whether the reasoning of First Security or Basye
controls, the critical focus should be on whether the
conduct of the taxpayer was restrained by law or was
instead consensual.  See Br. in Opp. 17 ([b]oth courts
below  agreed with this proposition").  Respondent and
the courts below err, however, in assuming that a
consensual agreement cannnot exist within the mean-
ing of  Basye unless the taxpayer could have success-
fully negotiated a different result. The Tax Court,
for example, did not conclude that Texaco's purchases

___________________(footnotes)
                               
1 If, for example, any private supplier had imposed a resale
price condition on sales to Texaco, the fact that Texaco `[really
needed" those supplies would not exempt Texaco from the con-
sequences that attach to such "a consensual agreement" under
the laws of the United States-whether those consequences
stem from antitrust laws or internal revenue laws.  Respondent
and the courts below erred precisely in concluding that the
mere fact that the seller in this case was the Saudi government
somehow converts a consensual commercial arrangement into a
"law" that removed all freedom of action from Texaco.

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3

of crude oil were not the product of "a consensual
agreement"; it concluded only that Texaco had insuf-
ficient market power to avoid the "non-negotiable"
resale price demand of the seller (Pet. App. 149a; see
Br. in Opp. 18).  The fact that the seller's demand was
"non-negotiable,"  however, does not mean that Texaco
had to agree to it.  It means only that Texaco did
agree to it in order to purchase the crude oil.
By agreeing to this term of sale, Texaco voluntar-
ily surrendered its power to allocate the associated
income among its subsidiaries.  Texaco's voluntary
decision to accept the terms demanded by the seller
does not prevent the Commissioner from applying
"the first principle of income taxation that income
must be taxed to him who earns it." Commissioner v.
Culbertson, 337 U.S. 733, 739-740 (1949). As this
Court held in Basye-in language that applies di-
rectly to this case-''[t]he entity earning the income
* * * cannot avoid taxation by entering into a con-
tractual arrangement whereby that income is di-
verted to some other person or entity." 410 U.S. at
449.2 2.  The question of recurring importance that is
presented in this case is whether a foreign govern-
ment can enter the marketplace and, in dealings with
private parties, establish terms of sale that displace
the provisions of United States law that govern the
taxation of United States corporations. In the pre-

___________________(footnotes)

2 Respondent does not dispute that, for the reasons de-
scribed in the petition, the allocation of this income to respon-
dent does not violate the terms of the Saudi restriction. See
Pet. 14-15 & n.9.  In being required to pay tax on the income it
has earned, Texaco is merely being required to comply with
United States law; it is not being required to violate any
foreign law.

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4

sent case, the foreign government was selling sup-
plies of a commodity that was temporarily in short
supply, and it was imposing restrictions only for the
supplies that it sold.3   The "restriction"  thus  imposed

was purely contractual in character and in effect, for
it did not purport to bind or in any other fashion
regulate anyone other than those who consented to
the restriction by purchasing the supply.
The facts of L.E. Shunk Latex Products, Inc. v.
Commissioner, 18 T.C. 940 (1952), on which respon-
dent relies (Br. in Opp. 24), are therefore markedly
different.  In  Shunk Latex, the United States govern-
ment was not in the business of selling either raw
rubber or condoms.  The United States also did not

seek to impose any contractual resale price re-
straints as a condition of sale of such materials. In-
stead, the government established price ceilings on
those products and made it unlawful for any  taxpayer
to conduct business at prices in excess of those
established ceilings.  On these facts, the court held in

___________________(footnotes)

3 The cases cited by respondent (Br. in opp. 22 n. 21) that
involve situations in which a foreign government is acting as a
"regulator of a market" (Argentina v. Weltover, Inc., 504 U.S.
607, 614 (1992)) are thus inapposite.  The Saudi terms of sale
were not provisions of general application that "regulated" a
market; they were contractual terms of sale that bound only its
customers-those who purchased oil directly from the govern-
ment.  See Pet. 21-24.

4 Moreover, when those parties converted the crude oil into
refined products (or when their affiliates did so), the contrac-
tual resale "restriction" utterly disappeared. Pet. App. 4a. As
the Saudi Oil Minister emphasized (Pet. App. 48a):

[T]he oil companies are definitely making much higher pro-
fits in the downstream by refining Saudi crude and selling
the products at higher prices. This we cannot control.

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5

Shunk Latex that the Commissioner could not allo-
cate profits to sellers based upon theoretical-prices
that exceeded the ceilings established by federal law.
18 T.C. at 961. 5
The difference between a law that requires univer-
sal obedience and a contractual term that is binding
only on those who have agreed to it is the core dis-
tinction between First Security and Basye.  The
decision in First Security precludes the allocation of
income to a taxpayer who, under a generally applica-
ble law, is precluded from conducting the commerce
being taxed. 405 U.S. at 405.  The decision  in Basye,
by contrast, permits the allocation of income to a
taxpayer who, under a consensual commercial ar-
rangement, has agreed to terms that cause a deflec-
tion of the income it has earned to an untaxed affili-
ate. 410 U.S. at 449.
3. The courts below misunderstood and misapplied
this critical, controlling distinction between First
Security  and  Basye.   As the petition explains (Pet. 25-
26 &n. 14), the decision of the court of appeals there-
by creates favorable tax consequences for commercial
restrictions imposed on commercial sales made to
United States corporations by foreign Nations. The
reasoning applied by the courts below would create an
enduring opportunity for substantial abuse, for it ob-
structs the plain objective of Section 482 of the Inter-
nal Revenue Code to "prevent[] artificial shifting,
milking, or distorting of the true taxable incomes of

___________________(footnotes)

5 In the course of holding that income could not be allocated
to a corporation that could not lawfully participate in the
business that generated the income, this Court cited Shunk
Latex with approval in Commissioner v. First Security Bank,
405 U.S. at 406.

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6

commonly controlled enterprises" (B. Bittker & J.
Eustice, Federal Income Taxation of Corporations
and Shareholder  15.03, at 15-14 (1987 cd.)). See
Pet. 25-26 & n.14.
Respondent misses the point of the statute in con-
tending that there is no opportunity for abuse if
courts apply "heightened scrutiny" to ensure that a
foreign sales restriction was adopted by the foreign
government without the collusion of the United
States taxpayer (Br. in Opp. 25, quoting Pet. App.
113a).  The function of  Section  482  is  to determine the
"true taxable income" of a United States taxpayer
(26 C.F.R. 1.482-1(b) [1981)) and " to correct artificial
intragroup pricing policies" that shift income "to
affiliated foreign corporations that are not generally
subject to U.S. tax." B. Bittker & J. Eustice, supra,
at 15-16.  The taxpayer's "motivation or purpose"  in
entering into the arrangement is not relevant (id. at
15-14).  A reallocation is necessary clearly to reflect
the taxpayer's income when, as here, the taxpayer's
activities have earned the income that has been
realized instead by foreign affiliates that the taxpayer
controls-for income is to be taxed "to him who earns
it" (Commissioner  v. Culbertson, 337 U.S. at 739-
740). 4.  This case-along with the companion case in-
volving amicus Exxon-involves more than five bil-
lion dollars of taxes and interest.  The issue pre-
sented in this case arises at the interstices of this
Court's decisions in Basye and First Security, and it
implicates principles that the Court has applied in the
governmental immunity context in decisions such as
Argentina v. Weltover, Inc., 504 U.S. 607 (1992).  See
Pet. 19-23.  Its resolution thus requires an ex-
planation of this Court's jurisprudence that only this

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7

Court can authoritatively provide.  Review by this
Court is warranted by the extraordinary importance
of this case for the public fisc, by the broad scope of
its potential future applications, and by the evident
need for guidance in the lower courts on the proper
application of Section 482 to commercial transactions
involving foreign governments.
For the reasons stated above and in the petition, the
petition for a writ of certiorari should be granted.
Respectfully submitted.

WALTER DELLINGER
Acting Solicitor General

MARCH 1997