106 T.C. No. 1

UNITED STATES TAX COURT

THE COCA-COLA COMPANY, AND INCLUDIBLE SUBSIDIARIES, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 299-94. Filed January 4, 1996.

P filed a motion for partial summary judgment

relating to the computation of combined taxable income

under sec. 936(h)(5)(C)(ii), I.R.C., with respect to

syrup and soft-drink concentrate produced by P's sec.

936, I.R.C., subsidiary, Caribbean Refrescos, Inc. 

1. Held: Sec. 1.936-6(b)(1), Q&A-12, Income Tax 

Regs., governs the computation of combined taxable

income with respect to sales of component concentrate

to unrelated third parties.

2. Held, further, sec. 1.936-6(b)(1), Q&A-12,

Income Tax Regs., requires U.S. affiliate expenses to

be allocated and apportioned to the component

concentrate by applying the production cost ratio to
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1Unless otherwise indicated, all Rule references are to the

Tax Court Rules of Practice and Procedure, and all section

references are to the Internal Revenue Code in effect during the

years in issue.

all expenses allocable and apportionable to the

integrated product; i.e., bottle and can soft drink. 

3. Held further, sec. 1.936-6(b)(1), Q&A-12,

Income Tax Regs., requires U.S. affiliate expenses

allocable and apportionable to the integrated product,

i.e., bottle and can soft drink, to be determined under

sec. 1.861-8, Income Tax Regs., as described in sec.

1.936-(6)(b)(1), Q&A-1, Income Tax Regs.

4. Held, further, P may net interest income against 

interest expense in determining the amount of the

interest deduction to be allocated and apportioned in

computing combined taxable income under sec. 936,

I.R.C., and sec. 1.861-8(e)(2), Income Tax Regs. 

Bowater Inc. v. Commissioner, 101 T.C. 207 (1993).

Charles W. Hall, William S. Lee, Nancy T. Bowen, William

P. McClure, Herman B. Bouma, and Gregory J. Ossi, for 

petitioner.

Beth Williams, H. Steven New, and David P. Fuller, for 

respondent.

OPINION

WRIGHT, Judge: This matter is before the Court on

petitioner's motion for partial summary judgment filed under Rule

121.1 This case was heard at a motions session held on February
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2In addition, the Court considered an amicus curiae brief

filed by PepsiCo.

23, 1995, at Washington, D.C.2 Petitioner's motion was taken

under advisement.

Summary judgment is intended to expedite litigation and

avoid unnecessary and expensive trials. Florida Peach Corp. v.

Commissioner, 90 T.C. 678, 681 (1988). Summary judgment may be

granted with respect to all or any part of the legal issues in

controversy "if the pleadings, answers to interrogatories,

depositions, admissions, and any other acceptable materials,

together with the affidavits, if any, show that there is no

genuine issue as to any material fact and that a decision may be

rendered as a matter of law." Rule 121(b); Sundstrand Corp. v.

Commissioner, 98 T.C. 518, 520 (1992), affd. 17 F.3d 965 (7th

Cir. 1994); Zaentz v. Commissioner, 90 T.C. 753, 754 (1988). The

moving party bears the burden of proving that there is no genuine

issue of material fact, and factual inferences will be read in a

manner most favorable to the party opposing summary judgment. 

Dahlstrom v. Commissioner, 85 T.C. 812, 821 (1985). The facts

presented below do not appear to be in dispute, are stated solely

for purposes of deciding the motion, and are not findings of fact

for this case. Fed. R. Civ. P. 52(a); Sundstrand Corp v.

Commissioner, supra at 520. 

I. Background
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Petitioner owns bottling companies known as company bottling

operations (CBO's), each of which is a domestic corporation owned

or controlled directly or indirectly by petitioner. Petitioner's

principal place of business is Atlanta, Georgia. Caribbean

Refrescos, Inc. (CRI), is a wholly owned subsidiary of

petitioner. 

CRI produces soft-drink concentrate in Puerto Rico and

transfers all of the concentrate for the U.S. market to Coca-Cola

USA (sometimes referred to as USA), an unincorporated division of

petitioner. Coca-Cola USA sells concentrate, in unchanged form,

to CBO's and to unrelated independent bottling companies engaged

in producing syrup and selling such syrup to wholesalers. CocaCola USA converts the remainder of the concentrate into fountain

syrup and sells the syrup to unrelated bottlers and CBO's. 

Fountain syrup is a combination of concentrate, high fructose

corn syrup, and water. Syrup is mixed with carbonated water at

retail outlets to produce the fountain soft drink sold to

consumers. During the years at issue, the dilution ratio for

Coke, Diet Coke, Caffeine Free Diet Coke, Cherry Coke, and Diet

Cherry Coke was 1:79.26:515. Thus, one unit of concentrate is

processed into 79.26 gallons of syrup, which is further processed

into 515 gallons of soft drink. Regardless of the form of the

product sold, each sale involves exactly one unit of concentrate. 

The CBO's that purchase concentrate from Coca-Cola USA

convert the concentrate into fountain syrup and sell the syrup to
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unrelated retailers. The CBO's that purchase fountain syrup sell

the fountain syrup to unrelated retailers. 

CRI is both the possessions corporation and the electing

corporation within the meaning of section 936. Under section

1504(b), a section 936 possessions corporation is required to

file a separate U.S. corporate return and is therefore ineligible

to join in the parent corporation's consolidated return. 

The issues before us for partial summary judgment arise out

of the section 936 tax credit, which is designed to encourage

investment and employment in Puerto Rico and other possessions of

the United States. The amount of the credit is derived from the

amount of the "combined taxable income" (sometimes referred to as

CTI) derived from the "possession product". The primary dispute

in the instant case involves the dividing of income and expenses

between related parties. More specifically, the dispute involves

whether the use of a formulaic calculation, or rather a

calculation based upon factual relationships, is mandated in

order to obtain the proper allocation and apportionment of

expenses to the gross income derived from the sale of a component

possession product by a U.S. affiliate. 

Petitioner filed its Federal income tax returns for taxable

years 1983 through 1986 relying in part on section 1.936-6(b)(1),

Q&A-12, Income Tax Regs. (Q&A-12). Respondent issued a

deficiency notice to petitioner in 1991 for taxable years 1983

and 1984. Petitioner filed a motion for partial summary judgment
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in that prior case, docket No. 17171-91, similar to the one filed

in the instant case. Respondent thereafter conceded the prior

case in November 1992. On November 10, 1992, the Commissioner

opened a regulation project with respect to the computation of

combined taxable income under section 936(h). In October 1993,

respondent issued the notice of deficiency in the instant case,

determining deficiencies in petitioner's Federal income taxes for

1985 and 1986 in the amounts of $30,504,383 and $42,640,008,

respectively. Respondent determined that petitioner was not

entitled to the amount of the section 936 tax credit claimed on

its returns for the years at issue. The petition in the instant

case was filed January 4, 1994. On January 12, 1994,

respondent's proposed amendment to Q&A-12 was published in the

Federal Register. See infra note 5.

A secondary dispute in the instant case involves the

treatment of interest expense with respect to computing combined

taxable income under section 936. We are asked to decide whether

petitioner may net interest income against interest expense in

determining the amount of interest deduction to be allocated and

apportioned in computing combined taxable income. Respondent

contends that interest netting violates section 1.861-8(e)(2),

Income Tax Regs., and petitioner must allocate and apportion the

amount of its gross interest expense in determining combined

taxable income. As a preliminary matter, we summarily reject

respondent's argument and find, without further analysis, on the
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basis of Bowater Inc. v. Commissioner, 101 T.C. 207 (1993), that

petitioner may net interest income against interest expense in

determining the amount of interest deduction to be allocated and

apportioned in computing combined taxable income under section

936 and section 1.861-8(e)(2), Income Tax Regs. See also General

Portland Cement Co. v. United States, 628 F.2d 321 (5th Cir.

1980). 

II. Discussion

A. Section 936 and Section 1.936-6(b)(1) Q&A 1 & 12, Income

Tax Regs.

Under the statutory scheme of section 936, a U.S.

corporation, such as CRI, which elects the application of section

936 and meets certain requirements with respect to operating in a

possession, is entitled to a credit against the U.S. tax on

certain possession-related income. Section 936 provides the

following:

SEC. 936(a). Allowance of Credit.--

(1) In General.-- * * * if a domestic corporation

elects the application of this section * * * there

shall be allowed as a credit against the tax imposed by

this chapter an amount equal to the portion of the tax

which is attributable to the sum of--

(A) the taxable income, from sources without

the United States, from--

(i) the active conduct of a trade or 

business within a possession of the United

States, or

(ii) the sale or exchange of

substantially all of the assets used by the
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taxpayer in the active conduct of such trade

or business, and

(B) the qualified possession source

investment income. 

* * * * * * *

(d) Definitions and Special Rules.--For purposes of

this section--

* * * * * * *

(2) Qualified Possession Source Investment

Income.--The term "qualified possession source

investment income" means gross income which--

(A) is from sources within a possession of

the United States in which a trade or business is

actively conducted, and

(B) the taxpayer establishes to the

satisfaction of the Secretary is attributable to

the investment in such possession (for use

therein) of funds derived from the active conduct

of a trade or business in such possession, or from

such investment,

less the deductions properly apportioned or allocated

thereto. [Emphasis added.]

Section 936(h) provides the following:

SEC. 936(h). Tax Treatment of Intangible Property

Income.--

* * * * * * *

(3) Intangible property income.--For purposes of 

this subsection--

(A) In general.--The term "intangible 

property income" means the gross income of a 

corporation attributable to any intangible 

property * * *

(B) Intangible property.--The term 

"intangible property" means any--
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(i) patent, invention, formula, 

 process, design, pattern, or knowhow;

* * * * * * *

(iii) trademark, trade name, or brand 

name;

(iv) franchise, license, or contract;

(v) method, program, system, 

procedure, campaign, survey, study, forecast,

estimate, customer list, or technical data; 

 * * * 

* * * * * * *

which has substantial value independent of the services

of any individual.

* * * * * * *

(5) Election out.--

* * * * * * *

(C) Methods of computation of taxable

income.--If an election of one of the following

methods is in effect pursuant to subparagraph (F)

with respect to a product or type of service, an

electing corporation shall compute its income

derived from the active conduct of a trade or

business in a possession with respect to such

product or type of service in accordance with the

method which is elected.

* * * * * * *

(ii) Profit split.--

(I) General rule.--If an election

of this method is in effect, the

electing corporation's taxable income

derived from the active conduct of a

trade or business in a possession with

respect to units of a product produced 

* * *, in whole or in part, by the

electing corporation shall be equal to

50 percent of the combined taxable
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income of the affiliated group (other

than foreign affiliates) derived from

covered sales of units of the product

produced * * *, in whole or in part, by

the electing corporation in a

possession.

(II) Computation of combined

taxable income.--Combined taxable income

shall be computed separately for each

product produced * * *, in whole or in

part, by the electing corporation in a

possession. Combined taxable income

shall be computed (notwithstanding any

provision to the contrary) for each such

product * * * by deducting from the

gross income of the affiliated group

(other than foreign affiliates) derived

from covered sales of such product * * *

all expenses, losses, and other

deductions properly apportioned or

allocated to gross income from such

sales * * * and a ratable part of all

expenses, losses, or other deductions

which cannot definitely be allocated to

some item or class of gross income,

which are incurred by the affiliated

group (other than foreign affiliates). 

* * * 

* * * * * * *

(7) Regulations.--The Secretary shall prescribe

such regulations as may be necessary or appropriate to

carry out the purposes of this subsection * * * 

[Emphasis added.] 

In the simplest terms, section 936(a) allows for a tax

credit. The amount of this credit is equal to the portion of tax

attributable to the "taxable income" derived from conducting

business in a possession. Section 936(h) determines the

treatment of intangible property income. Intangible property is

broadly defined in section 936(h) and includes, of relevance
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3The term "electing corporation" means a domestic

corporation for which an election under sec. 936 is in effect.

Sec. 936(h)(5)(E). The term "affiliated group" means the

electing corporation and all other 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 interest, within

(continued...)

here, formulas, processes, trademarks, trade names, brand names,

franchises, licenses and contracts, methods, programs, systems,

procedures, campaigns, surveys, studies, forecasts, customer

lists, and technical data. Sec. 936(h)(3)(B)(i),(iii), (iv),

(v). The formula for beverage bases or concentrates for various

soft drinks and syrups is considered intangible property under

section 936(h)(3)(B). See also sec. 1.936-5(a), A-6, Example

(1)(A), Income Tax Regs. 

In the absence of an election under section 936(h)(5),

intangible property income is taxed to the U.S. shareholders of

the possessions corporation. If a possessions corporation makes

a valid election, its active trade or business income with

respect to the product for which the election is made is computed

in accordance with the method elected. CRI elected the "profitsplit" method under section 936(h)(5)(C)(ii). 

Under the profit-split method, the taxable income of the

"electing corporation", with respect to a product produced in a

possession, is deemed to be 50 percent of the "combined taxable

income" of the "affiliated group" derived from sales of the

product to nonaffiliates or to foreign affiliates.3 The
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3(...continued)

the meaning of sec. 482. Sec. 936(h)(5)(C)(i)(I)(b).

remaining 50 percent of the combined taxable income is allocated

to, and treated as, the taxable income of the appropriate U.S.

affiliate or affiliates. Sec. 936(h)(5)(C)(ii)(I), (III). 

Combined taxable income equals the gross income of the section

936 corporation and its U.S. affiliates derived from sales of the

possession product to nonaffiliates or foreign affiliates less

the expenses of the section 936 corporation and the U.S.

affiliates allocated and apportioned to such gross income. Sec.

936(h)(5)(C)(ii)(II). Thus, the section 936 credit equals the

tax attributable to 50 percent of the combined taxable income

figure. 

Congress recognized in enacting section 936(h) that some

section 936 corporations produce products that are not sold as

such to unrelated parties, but rather are transferred to

affiliates and used as component parts in the production of other

products that are then sold by the affiliates to unrelated

parties. Congress directed the Secretary of the Treasury to

write the rules with respect to such component products. Section

936(h)(7) requires the Secretary to prescribe such regulations as

may be necessary and appropriate to carry out the purposes of

section 936(h). 

Section 1.936-6, Income Tax Regs., provides the following:
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(b) Profit split option--(1) Computation of

combined taxable income.

Question 1: In determining combined taxable

income from sales of a possession product, how are the

allocations and apportionments of expenses, losses, and

other deductions to be determined?

Answer 1: (i) Expenses, losses, and other

deductions are to be allocated and apportioned on a

"fully-loaded" basis under § 1.861-8 to the combined

gross income of the possessions corporation and other

members of the affiliated group * * * The amount of

research, development, and experimental expenses

allocated and apportioned to combined gross income is

to be determined under § 1.861-8(e)(3). * * * Other

expenses which are subject to § 1.861-8(e) are to be

allocated and apportioned in accordance with that

section. For example, interest expense * * * is to be

allocated and apportioned under § 1.861-8(e)(2). With

the exception of marketing and distribution expenses

discussed below, the other remaining expenses which are

definitely related to a class of gross income shall be

allocated to that class of gross income and shall be

apportioned on the basis of any reasonable method, as

described in § 1.861-8(b)(3) and (c)(1). Examples of

such methods may include, but are not limited to, those

specified in § 1.861-8(c)(1)(i) through (vi). 

* * * * * * *

Question 12: If the possession product is a

component product or an end-product form, how is the

combined taxable income for such product to be

determined?

Answer 12: (i) In computing combined taxable income, 

the sales price of the component product * * * is

determined as follows. With respect to a component

product, an independent sales price from comparable

uncontrolled transactions must be used if such price

can be determined in accordance with sec. 1.482-

2(e)(2). If an independent sales price of the

component product from comparable uncontrolled

transactions cannot be determined, then the possessions

corporation must treat the sales price for the

component product as equal to the same proportion of

the third party sales price of the integrated product

which the production costs attributable to the
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component product bear to the total production costs

for the integrated product. * * *

(ii) * * * The possessions corporation will determine

its costs * * * attributable to the possession product and

its expenses allocable and apportionable to the possession

product under sec. 1.861-8, as described in question and

answer 1 * * *

Each member of the affiliated group that is a

United States person, other than the possessions

corporation, shall determine its costs (other than

costs incurred for materials purchased from a U.S.

affiliate) attributable to the possession product, and

its expenses allocable and apportionable to the

integrated product under sec. 1.861-8, as described in

question and answer 1 of this paragraph (b)(1). Each

such United States person (other than the possessions

corporation) shall apportion to the possession product,

on the basis of the ratio of the production costs for

the possession product to the total production costs

for the integrated product, the expenses that such

affiliate allocated and apportioned to the integrated

product. * * * [Emphasis added.]

For purposes of computing combined taxable income, section

1.936-6(b)(1), Q&A-1, Income Tax Regs. (Q&A-1), governs the

computation of combined taxable income by prescribing rules for

the allocation and apportionment of expenses derived from the

sale of a possession product sold to unrelated third parties in

unchanged form. Q&A-12, on the other hand, appears to govern the

computation of combined taxable income by prescribing rules for

the allocation and apportionment of expenses derived from the

sale of a product sold to unrelated third parties which contains

a component possession product.
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B. Parties' Positions

Respondent first argues that Q&A-1 governs in the instant

case, requiring that all expenses USA incurs and those CBO

expenses that are factually related to gross income from the sale

of concentrate be apportioned in full to such income regardless

of the form in which the possession product is sold. Second,

respondent argues in the alternative that even were Q&A-12

controlling in the instant case, the application of the

production cost ratio contained in Q&A-12 produces absurd

results, and petitioner's motion should be denied on the basis of

Exxon Corp. v. Commissioner, 102 T.C. 721 (1994). Respondent

maintains that the question before this Court is whether Congress

intended the results that flow from petitioner's application of

the production cost ratio (PCR) to the U.S. affiliates' expenses

known to be factually related to the gross income derived from

CRI's component concentrate. 

Respondent argues further that the factual relationship test

found in section 1.861-8(b) and (c), Income Tax Regs., is adopted

in section 936(h)(5)(C)(ii)(II) through its overall incorporation

of the standards contained in section 861. Respondent claims

that Q&A-12 must be read in the context of the statute and is to

be applied only as a supplement to Q&A-1, which determines,

according to respondent, the expenses allocable and apportionable

to the possession product in all cases including those cases in

which the possession product is sold in a component form. 
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A possession product is an item of property which is the

result of a production process carried on in a possession. Sec.

1.936-5(a), A-1, Income Tax Regs. Possession products encompass

component products, integrated products, and end-product forms. 

Id. A component product is a product which is subject to further

processing before sale to an unrelated party. Id. An integrated

product is (1) a product not subject to any further processing

before sale to an unrelated party and (2) a product which

includes all component products from which it is produced. Id.

A possessions corporation may treat a component product or an

integrated product as its possession product even though the

final stage or stages of production occur outside the possession. 

Id. Further processing includes transformation, incorporation,

assembly, or packaging. Id. For our purposes, the integrated

product is syrup or soft drinks, the component product is

concentrate, and the possession product is the component

concentrate. Again, CRI is both the possessions corporation and

the electing corporation within the meaning of section 936.

CRI incurs costs in producing and shipping concentrate to

the United States. Production costs include direct labor costs

and overhead incident to and necessary for production but do not

include direct material costs and interest. Secs. 1.936-6(b)(1),

Q&A 12, 1.936-5(b)(4), 1.471-11(b), Income Tax Regs. USA and the

CBO's incur expenses in selling the syrup and soft drinks. U.S.

affiliate expenses allocable and apportionable to the integrated
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product, i.e., syrup and soft drink, are determined under section

1.861-8, Income Tax Regs., as described in section 1.936-6(b)(1),

Q&A-1, Income Tax Regs. These expenses include, inter alia,

research and development, experimental, interest, marketing,

distribution, and advertising expenses. Sec. 1.936-6(b)(1),

Income Tax Regs. 

We provide the following examples for illustration:

Example 1

When petitioner sells concentrate as concentrate, i.e., in

unchanged form, to unrelated third parties, CTI is determined as

follows:

Item Amount

Gross income from the sale

 of concentrate per unit1 $2.24

 Total USA expenses (1.48)

Combined taxable income .76

1Concentrate is sold in units; syrup and soft drinks are

sold in equivalent gallons.

In this example, the PCR is not applicable because the

concentrate is being sold in unchanged form and not as a

component of something larger. Here, Q&A-1 determines the

computation of CTI, requiring that all expenses factually related

to the concentrate be allocated and apportioned in full to the

income derived from the sale of the concentrate as concentrate. 

Thus, 50 percent of the CTI is 38 cents per unit, resulting in a
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tax credit equal to the tax attributable to 38 cents per unit of

concentrate sold. 

Example 2

When the concentrate is sold as a component of a beverage

product to unrelated third parties, CTI is determined as follows:

Item Amount

Gross income from the sale

 of concentrate as a component

 of syrup $2.24

Total USA expenses (1.48)

Production costs incurred per

 unit of possession product .10

Total production costs

 incurred per unit of

 integrated product .80 

PCR 12.5%

Expense allocation after

 applying the PCR (.19)

Combined taxable income 2.05

If the possession product is a component product, as here,

combined taxable income is determined under Q&A-12. The plain

language of Q&A-12 requires (1) the determination of five factors

relating to sales, costs, and expenses and (2) the application of

those factors when using the allocation and apportionment method

provided therein. The five factors to be determined under Q&A-12

are as follows: 

(1) The electing corporation must determine the sale price

of the component product. The sale price is derived from either
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an independent sale price from comparable uncontrolled

transactions, or if an independent sale price from comparable

uncontrolled transactions cannot be determined, then the sale

price is determined using a production cost ratio method. This

first requirement is not at issue for purposes of the instant

motion;

(2) the possessions corporation must determine its costs

attributable to the possession product under section 1.861-8,

Income Tax Regs.;

(3) the possessions corporation must determine its expenses

allocable and apportionable to the possession product under

section 1.861-8, Income Tax Regs.;

(4) each member of the affiliated group must determine its

costs attributable to the possession product under section 1.861-

8, Income Tax Regs; and

(5) each member of the affiliated group must determine its

expenses allocable and apportionable to the integrated product

under section 1.861-8, Income Tax Regs.

Finally, Q&A-12 requires that each affiliate apportion to

the possession product on the basis of the ratio of the

production costs for the possession product to the total

production costs for the integrated product, the expenses the

affiliate allocated and apportioned to the integrated product. 

In our second example, the total production costs associated

with the integrated product equal 80 cents per unit, and the
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production costs associated with the possession product equal 10

cents per unit, resulting in a PCR of 12.5 percent. The PCR is

then applied to the total expense amount of $1.48 per unit,

resulting in approximately 19 cents per unit expense allocation. 

The CTI equals $2.05 per unit, resulting in a tax credit equal to

the tax attributable to approximately $1.03 per unit of beverage

product sold.

In this example, only 12.5 percent of the expenses known to

be factually related to the sale of the integrated product are

allocated and apportioned to the income derived from the sale of

the possession product. This results in an increased CTI figure,

which in turn increases the amount of the section 936 possessions

tax credit. Thus, where production costs at the possession level

are small in relation to the total production costs, as in the

instant case, a low PCR is produced, resulting in the allocation

of a relatively small percentage of the total amount of expenses

to the income derived from the sale of the possession product. 

Respondent argues that the application of the PCR in the

instant case results in unapportioned USA expenses totaling

$227,213,515 in 1985, representing approximately 89.84 percent of

the total amount of expenses for that year, and unapportioned

expenses totaling $263,021,507 in 1986, representing 91.7 percent

of the total expenses for that year. 

Both parties acknowledge that regardless of the form in

which the concentrate is sold, i.e., one unit of concentrate,
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79.26 gallons of syrup, or 515 gallons of soft drink, petitioner

incurs approximately the same amount of expense with respect to

each product. Petitioner argues, however, that the regulations

under section 936 contain only one provision prescribing the

manner of calculating combined taxable income with respect to a

component product; i.e., Q&A-12. Under the plain meaning of this

regulation, Q&A-12 controls the computation of combined taxable

income with respect to possession products that are component

products, according to petitioner. The concentrate produced by

CRI, which is converted into syrup or into bottle and can soft

drinks before sale to unrelated parties, is a component product. 

According to petitioner, under the plain, unambiguous terms of

the regulation, Q&A-12 governs the computation of combined

taxable income with respect to such concentrate, mandating the

application of the production cost ratio. 

Petitioner further asserts that the application of Q&A-12 to

component concentrate is consistent with the regulatory scheme in

general. In petitioner’s view, the language in the question

portion of Q&A-12 is broad and unqualified, and nothing in the

regulations under section 936 indicates that any other rules may

apply with respect to component products, according to

petitioner.

Petitioner argues that the language in Q&A-12 clearly states

that the role of Q&A-1, with respect to component products, is to

determine U.S. affiliate expenses at the integrated product
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level; i.e., to determine the aggregate of U.S. affiliate

expenses allocable and apportionable to the gross income from the

integrated product containing the component product. Q&A-12 then

prescribes the PCR as the exclusive basis for allocating and

apportioning those expenses to the component possession product. 

Petitioner argues that under the plain meaning of the regulation,

the PCR applies to all U.S. affiliate expenses allocable and

apportionable to the integrated product; i.e., syrup and soft

drinks. 

Furthermore, argues petitioner, the example in Q&A-12

confirms this interpretation. In the example, expenses of the

U.S. affiliates are allocated and apportioned to the integrated

product, computers, and then apportioned to the component

product, central processing units, using the PCR. Thus,

petitioner argues, the example provided in Q&A-12 supports the

plain meaning of the regulation.

Respondent contends that on the facts before us, section

936(h)(5)(C)(ii)(II), as interpreted by Q&A-1, requires that all

expenses that USA incurs, and those CBO expenses that are

factually related to concentrate gross income, be apportioned in

full to such income. Respondent argues that Congress did not

intend the results that flow from petitioner's application of the

PCR to U.S. affiliates' expenses known to be factually related

to, and therefore allocable and apportionable solely to, the

gross income derived from CRI's component concentrate. With
- 23 -

4The term "covered sales" means sales by members of the

affiliated group (other than foreign affiliates) to persons who

are not members of the affiliated group or to foreign affiliates. 

Sec. 936(h)(5)(C)(ii)(IV).

respect to expenses incurred by petitioner's corporate and USA

divisions, the amount of expenses apportionable to CRI's

component concentrate gross income can be precisely quantified,

according to respondent. Petitioner concedes, for purposes of

the instant motion, that USA incurred approximately the same

amount of expense, on a per-gallon basis, regardless of whether

USA sold the concentrate to third parties in its integrated form

or in its unchanged form. Thus, respondent argues that USA

expenses factually attributable to the concentrate must be

allocated and apportioned in full to such concentrate regardless

of whether it is sold in an unchanged form or in a component

form. 

According to respondent, section 936(h)(5)(C)(ii)(II)

governs all computations of combined taxable income and adopts a

facts-and-circumstances test for apportioning U.S. affiliates'

expenses to the gross income derived from covered sales of a

possession product regardless of the form in which the possession

product is sold.4 Congress mandated this approach, argues

respondent, by enacting language borrowed directly from section

861. Respondent argues that the phrase "properly apportioned or

allocated" is a term of art borrowed verbatim from section

861(b), and enactment of this particular phrase should be
- 24 -

interpreted as a directive from Congress to apply the section

1.861-8, Income Tax Regs., expense allocation and apportionment

regime in performing CTI computations. 

The principles under section 1.861-8, Income Tax Regs.,

require that all deductions must be allocated to the class or

classes of gross income to which they are factually related. 

Deductions are incurred with respect to activities and properties

that generate particular classes of gross income, or which

generate all classes of gross income, and that are definitely

related to those classes of gross income. 

These principles, according to respondent, require that

deductions be apportioned between gross income derived from the

possession product (the statutory grouping) and other gross

income (the residual grouping) using a method that reasonably

reflects the factual relationship between the deductions and the

income assigned to the grouping. Respondent contends that

section 936(h)(5)(C)(ii)(II) adopts a method of apportioning

expenses to possession product gross income which turns upon

factual relationships. Petitioner's alleged misapplication of

the PCR causes gross misapportionments, according to respondent. 

Petitioner argues that the plain meaning of Q&A-12 is

consistent with the language and purpose of section

936(h)(5)(C)(ii)(II). Petitioner contends that section

936(h)(5)(C)(ii)(II) provides only general principles for

component products and does not provide specific guidance for
- 25 -

5Other procedures were recommended to the Treasury and IRS,

and another procedure has been proposed by the Commissioner for

taxable years beginning after 1993. Under the proposed

amendment, CTI for a component possession product is determined

by applying the PCR to the CTI for the integrated product

containing the component possession product. See Notice of

Proposed Rulemaking, 59 Fed. Reg. 1690 (Jan. 12, 1994).

determining the taxpayer's expense, losses, and other deductions

that are properly allocated and apportioned to the gross income

derived from sales of a component possession product. Indeed,

there is no specific reference anywhere in section 936(h) to

component possession products or the computation of CTI with

respect to component possession products, asserts petitioner. 

Section 936(h)(7) authorizes and directs the Secretary to

prescribe such regulations as may be necessary or appropriate to

carry out the purposes of section 936(h), and, according to

petitioner, Q&A-12 is the provision the Secretary chose to

prescribe to fill the statutory gap. Thus, petitioner argues,

respondent chose to (1) make Q&A-12 the exclusive procedure for

computing CTI with respect to component possession products and

(2) chose to use a formulary apportionment method in order to

make such computation. Undoubtedly, other procedures for

computing CTI for component possession products could have been

prescribed, and other procedures might be thought by some to 

produce "better" results, argues petitioner. The procedures

adopted in Q&A-12 were chosen, however, and are fully consistent

with the language and purpose of section 936(h)(5)(C)(ii)(II).5 
- 26 -

Petitioner argues that having prescribed an allocation and

apportionment procedure that could either favor or disfavor a

taxpayer, depending on the circumstances, respondent should not

be permitted to selectively enforce the provision by challenging

its application for particular taxpayers. Petitioner

acknowledges that it obtains favorable results by applying Q&A 12

as written. The results produced by applying Q&A-12, however, do

not justify overriding the plain language of the regulation. 

Petitioner contends that a plain and unambiguous provision may be

judicially overridden only if it produces grossly or patently

absurd results.

Respondent argues that petitioner's interpretation of Q&A-12

improperly limits the role of Q&A-1, contrary to clear

indications that Q&A-1 must be accorded a broad scope. 

Respondent contends that petitioner's interpretation of Q&A-12 is

plainly at odds, not only with the express broad terms of Q&A-1,

but also with section 936. Q&A-1 is intended to state the

standards by which all expenses attributable to the possession

product must be allocated and apportioned regardless of the form

in which the possession product is sold to the third parties,

asserts respondent. Q&A-1 must be given a broad scope of

application in making allocations and apportionments of expenses

directly to the possession products in all situations where

expenses can be so apportioned using the methods provided in

section 1.861-8, Income Tax Regs. Respondent argues that in
- 27 -

apportioning expenses to component possession product gross

income, the PCR of Q&A-12 plays a complementary and supportive

role, not an exclusive role.

Furthermore, respondent contends that the example in Q&A-12

is merely illustrative and does not authorize petitioner's

interpretation. Illustrative examples must be interpreted so as

to effectuate the statutory language and purpose, according to

respondent, and Q&A-12 must not be interpreted in a manner which

restricts or conflicts with the statute or with Q&A-1. 

Respondent contends that if an example in the regulations is

inconsistent with the text of the regulation, the example must

yield and the regulatory text is given effect. 

Petitioner argues that the plain meaning of Q&A-12 does not

unduly restrict the scope of Q&A-1. Q&A-12 complements Q&A-1 by

prescribing the method by which CTI is computed for possession

products sold in component form. Q&A-1 provides rules for

allocating and apportioning U.S. affiliate expenses with respect

to sales of possession products in general; Q&A-12 provides rules

prescribing the manner in which U.S. affiliate expenses are to be

allocated and apportioned with respect to component possession

products. 

C. Analysis: Legislative Regulations Generally

First, we must determine the roles that Q&A-1 and Q&A-12

play in the instant case. After determining which provision

plays the primary role, we must then determine, under section
- 28 -

936, the manner of computing combined taxable income and the

method by which expenses are to be allocated and apportioned

under the facts of the instant case. 

There is no specific reference anywhere in section 936(h) to

component products or the computation of combined taxable income

with respect to component products. The computation of combined

taxable income with respect to component possession products

under the profit-split method is prescribed in Q&A-12. The

formulary apportionment method prescribed in Q&A-12 determines

the manner in which U.S. affiliate expenses are apportioned to

the gross income derived from covered sales of the component

possession product. 

Section 1.936-6(b)(1), Income Tax Regs., was promulgated

pursuant to a specific statutory grant of authority under section

936(h)(7). Where the Commissioner acts under a specific grant of

authority, our primary inquiry is whether the regulation is not

contrary to the statute and is not arbitrary or capricious. 

Rowan Cos. v. United States, 452 U.S. 247 (1981); Florida

Manufactured Housing Association, Inc. v. Cisneros, 53 F.3d 1565,

1572 (11th Cir. 1995); CWT Farms, Inc. v. Commissioner, 755 F.2d

790, 800 (11th Cir. 1985), affg. 79 T.C. 86 (1982).

Congress' delegation of rulemaking power was expressed in S.

Rept. 960, 70th Cong., 1st Sess. (1928), 1939-1 C.B. (Part 2)

409, 419, as follows:
- 29 -

The Committee believes it to be impractical to attempt

by legislation to prescribe the various detailed and

complicated rules necessary to meet the many differing

and complicated situations. Accordingly, it has found

it necessary to delegate power to the Commissioner to

prescribe regulations legislative in character covering

them. * * * 

See also Tate & Lyle, Inc. & Subs. v. Commissioner, 103 T.C. 656 

(1994).

Section 1.936-6(b), Income Tax Regs., is a legislative

regulation containing substantive rules. As such, the regulation

is entitled to greater weight and deference than an interpretive

regulation issued pursuant to the Commissioner's general grant of

authority to prescribe needful rules and regulations under

section 7805(a). CWT Farms, Inc. v. Commissioner, supra at 800; 

Tate & Lyle, Inc. & Subs. v. Commissioner, supra at 666; PerkinElmer Corp. & Subs. v. Commissioner, 103 T.C. 464 (1994). 

A legislative regulation is made pursuant to a specific

grant of authority, often without precise congressional guidance,

to define a statutory term or prescribe a method of executing a

statutory provision. Chevron U.S.A., Inc. v. Natural Res. Def.

Council, Inc., 467 U.S. 837, 843-844 (1984); Anderson, Clayton &

Co. v. United States, 562 F.2d 972 (5th Cir. 1977). 

In section 936(h)(7), Congress has delegated to the

Commissioner authority to act in an essentially legislative

manner to fill in the gaps of the statute. If the Commissioner's

interpretation is reasonable, it will not be supplanted with our

own. Florida Manufactured Housing Association, Inc. v. Cisneros,
- 30 -

supra at 1571-1572; see United States v. Cartwright, 411 U.S.

546, 550 (1973); RJR Nabisco, Inc. v. United States, 955 F.2d

1457, 1464 (11th Cir. 1992). 

In Chevron U.S.A., Inc. v. Natural Res. Def. Council, Inc.,

supra at 842-843, the Supreme Court stated the following:

When a court reviews an agency's construction of

the statute which it administers, it is confronted with

two questions. First, always, is the question whether

Congress has directly spoken to the precise question at

issue. If the intent of Congress is clear, that is the

end of the matter; for the court, as well as the

agency, must give effect to the unambiguously expressed

intent of Congress. If, however, the court determines

Congress has not directly addressed the precise

question at issue, the court does not simply impose its

own construction on the statute, as would be necessary

in the absence of an administrative interpretation. 

Rather, if the statute is silent or ambiguous with

respect to the specific issue, the question for the

court is whether the agency's answer is based on a

permissible construction of the statute. [Emphasis

added; fn refs. omitted.] 

Our primary inquiry in the case of a legislative regulation

is whether the interpretation or method prescribed therein is

within the delegation of authority. Regardless of whether the

regulation at issue is legislative or interpretive, it is

appropriate to ascertain whether the regulation harmonizes with

the plain language of the statute, its origin, and its purpose in

order to determine whether the regulation carries out the

congressional mandate in a proper manner. United States v. Vogel

Fertilizer Co. 455 U.S. 16, 24-26 (1982); CWT Farms, Inc. v.

Commissioner, supra at 801.
- 31 -

As legislative regulations are essentially substantive rules

of law, the rules of interpretation applicable to statutes are

appropriate tools of analysis. KCMC, Inc. v. FCC, 600 F.2d 546,

549 (5th Cir. 1979); Intel Corp. & Consol. Subs. v. Commissioner,

100 T.C. 616, 630 (1993), affd. 67 F.3d 1445 (9th Cir. 1995);

Phillips Petroleum Co. v. Commissioner, 101 T.C. 78, 97 (1993),

affd. without published opinion ___F.3d___ (10th Cir., Nov. 28,

1995). Statutes are to be construed so as to give effect to

their plain and ordinary meaning unless to do so would produce an

absurd result. Green v. Bock Laundry Machine Co., 490 U.S. 504,

509 (1989); United States v. NEC Corp., 931 F.2d 1493, 1498 (11th

Cir. 1991); Blue Cross & Blue Shield v. Weitz, 913 F.2d 1544,

1548 (11th Cir. 1990); Exxon Corp. v. Commissioner, 102 T.C. 721

(1994). 

Where a statute is clear on its face, we require unequivocal

evidence of legislative purpose before construing the statute so

as to override the plain meaning of the words used therein. 

Halpern v. Commissioner, 96 T.C. 895 (1991). All parts of a

statute must be read together, and each part should be given its

full effect. D. Ginsberg & Sons, Inc. v. Popkin, 285 U.S. 204,

208 (1932); Estate of Dupree v. United States, 391 F.2d 753, 757

(5th Cir. 1968); McNutt-Boyce Co. v. Commissioner, 38 T.C. 462,

469 (1962), affd. per curiam 324 F.2d 957 (5th Cir. 1963). 

Unless exceptional circumstances dictate otherwise, when we find

the terms of a statute unambiguous, judicial inquiry is complete. 
- 32 -

Burlington N. R.R. v. Oklahoma Tax Commn., 481 U.S. 454, 461

(1987); United States v. NEC Corp., supra at 1498.

Thus, the party who seeks to convince a court to adopt a

reading of a statute which is at odds with its plain meaning

labors under a heavy burden. United States v. NEC Corp., supra

at 1499. 

Consistent with the foregoing, we examine the historical

development of section 936 and determine whether the regulation

implements the congressional mandate in a reasonable manner.

D. Analysis: Section 1.936-6(b)(1), Q&A-1 & -12, Income

Tax Regs.

Section 936 has its genesis in section 262 of the Revenue

Act of 1921, ch. 136, 42 Stat. 271, which exempted a U.S.

corporation from Federal taxes on foreign-source income if it

derived at least 80 percent of its income from sources within a

possession and satisfied certain other requirements. The

requirements for exemption from tax as a possessions corporation

were carried forward without material change into section 931 of

the Internal Revenue Code of 1954. In the Tax Reform Act of

1976, Congress eliminated the exemption and in its place enacted

the tax credit mechanism of section 436. Tax Reform Act of 1976,

Pub. L. 94-455, sec. 1051, 90 Stat. 1643.

Congressional intent for section 931 and its predecessors

consistently has been the encouragement of American business

investments in possessions of the United States. American
- 33 -

6Sec. 931 provided as follows:

SEC. 931. INCOME FROM SOURCES WITHIN POSSESSIONS 

 OF THE UNITED STATES.

 

(a) General Rule.--In the case of

citizens of the United States or domestic

corporations, gross income means only gross

income from sources within the United States

if the conditions of both paragraph (1) and

paragraph (2) are satisfied:

 (1) Three-year period.--If 80 percent or

more of the gross income of such citizen or

domestic corporation (computed without the

(continued...)

companies operating in the possessions originally were subjected

to double taxation by the imposition of both the Federal

corporate income tax and the taxes levied by the possessions

governments. Tariff Act of 1913, ch. 16, sec. II, 38 Stat. 166;

Revenue Act of 1918, ch. 18, 40 Stat. 1058.

Congress perceived that the tax burden so created placed

American businesses at a competitive disadvantage when compared

with their British and French counterparts not subject to

taxation upon the profits they earned abroad unless paid back to

the home company. Congress consequently enacted the original

version of section 931 to remove that competitive disadvantage. 

H. Rept. 350, 67th Cong., 1st Sess. 1 (1921), 1939-1 C.B. (Part

2) 168, 174.

Section 931 provided corporations an exclusion for

possession-source income if they met the "80-percent source" test

and the "50-percent active trade or business" test.6 Because of
- 34 -

6(...continued)

benefit of this section) for the 3-year

period immediately preceding the close of the

taxable year (or for such part of such

period immediately preceding the close of

such taxable year as may be applicable) was

derived from sources within a possession of

the United States; and

 

(2) Trade or business.--If--

(A) in the case of such

corporation, 50 percent or more of its

gross income (computed without the

benefit of this section) for such period

or such part thereof was derived from

the active conduct of a trade or

business within a possession of the

United States * * * 

the exclusion, and because dividends received by a domestic

corporation from its wholly owned possessions subsidiary were not

eligible for the intercorporate dividends received deductions

under section 246(a)(2)(B), possessions corporations amassed

large amounts of income not repatriated to the United States. 

To encourage investment of possessions-source earnings in

the United States, Congress, in 1976, enacted section 936. Tax

Reform Act of 1976, Pub. L. 94-455, sec. 1051, 90 Stat. 1643. 

The Tax Reform Act of 1976 revised prior law, providing for a

more efficient system for exemption of possessions corporations

in order to prevent the possessions from losing a significant

source of capital. In place of the exemption mechanism contained

in section 931, section 936 permits a U.S. corporation to elect a

tax credit to offset the U.S. tax on its possessions income. 
- 35 -

Thus, the current version of the investment incentive takes the

form of a tax credit rather than an exemption.

It is clear from the legislative record that Congress was

aware of the highly favorable tax benefits afforded U.S.

corporations operating in Puerto Rico. It is equally clear that

Congress intended to retain and reaffirm such tax benefits by

enacting section 936. The Senate Finance Committee and the House

of Representatives Committee on Ways and Means stated the

following, in virtually identical reports: 

The special exemption provided (under sec. 931) 

in conjunction with investment incentive programs

established by possessions of the United States,

especially the Commonwealth of Puerto Rico, have been

used as an inducement to U.S. corporate investment in

active trades and businesses in Puerto Rico and the

possessions. Under these investment programs little or

no tax is paid to the possessions for a period as long

as 10 to 15 years and no tax is paid to the United

States as long as no dividends are paid to the parent

corporation.

Because no current U.S. tax is imposed on the

earnings if they are not repatriated, the amount of

income which accumulates over the years from these

business activities can be substantial. The amounts

which may be allowed to accumulate are often beyond

what can be profitably invested within the possession

where the business is conducted. As a result,

corporations generally invest this income in other

possessions or in foreign countries either directly or

through possessions banks or other financial

institutions. In this way possessions corporations not

only avoid U.S. tax on their earnings from businesses

conducted in a possession, but also avoid U.S. tax on

the income obtained from reinvesting their business

earnings abroad.

 

The committee after studying the problem

concluded that it is inappropriate to disturb the

existing relationship between the possessions
- 36 -

7Sec. 936(h) was added to the Code in response to issues

raised in Eli Lilly & Co. v. Commissioner, 84 T.C. 996 (1985),

affd. in part, revd. in part and remanded 856 F.2d 855 (7th Cir.

1988). See H. Conf. Rept. 97-760, at 504 n.* (1982), 1982-2 C.B.

600, 617.

investment incentives and the U.S. tax laws because of

the important role it is believed they play in keeping

investment in the possessions competitive with

investment in neighboring countries. * * * [S. Rept.

94-938, at 277-278 (1976), 1976-3 C.B. (Vol. 3) 57,

315-316; H. Rept. 94-658 (1975), 1976-3 C.B. (Vol. 2)

945, 946-947; emphasis added.]

Thus, under both section 936 and its predecessor section

931, possessions corporations are and have been effectively

exempt from tax on income from possessions sources. This

exemption applied to income from intangibles created by such

corporation or acquired from an unrelated party. In 1982,

Congress added subsection (h) to section 936.7 Tax Equity and

Fiscal Responsibility Act of 1982, Pub. L. 97-248, sec. 213, 96

Stat. 452. Subsection (h) was added in order to lessen the abuse

caused by taxpayers claiming tax-free income generated by

intangibles developed outside of Puerto Rico. See H. Conf. Rept.

97-760, at 505 (1982), 1982-2 C.B. 600, 617. 

Section 936(h)(1) provides that any income of an electing

corporation attributable to intangible property is deemed to be

the income of, and is taxable to, the shareholders of the section

936 corporation. Where income is derived from the sale of an

intangible possessions product, taxable income generally is

computed under section 936(b)(1)-(4). A section 936 corporation
- 37 -

8Sec. 936(h)(7) was redesignated as sec. 936(h)(8) by the

Technical and Miscellaneous Revenue Act of 1988, Pub. L. 100-647,

sec. 1012(h)(2)(B), 102 Stat. 3502.

may, however, “elect out” under section 936(h)(5) and choose to

compute its taxable income under one of two methods: (1) The

cost-sharing method; or (2) the profit-split method. Pursuant to

either method, the stockholders of the section 936 corporation

are taxed on a share of the income generated from intangible

assets.

Congress recognized in enacting section 936(h) that some

section 936 corporations produce products that are not sold to

unrelated parties, but rather are transferred to affiliates and

used as component parts in the production of other products that

are then sold by the affiliates to unrelated parties. The

statute, however, does not provide any specific rules for the

computation of combined taxable income in such a case. Rather,

Congress directed the Treasury to write the rules with respect to

such component products. Sec. 936(h)(7). The conference report

accompanying the enactment of section 936(h) instructs the

Secretary to:

prescribe regulations providing for appropriate

treatment in cases where the island affiliate * * *

produces a component which it sells to an affiliate for

incorporation into a product sold to third parties. 

[H. Conf. Rept. 97-760, supra at 508, 1982-2 C.B. at

619.8]

We conclude that section 1.936-6(b)(1) Q&A-12, Income Tax

Regs., establishes a permissible method for computing CTI where
- 38 -

9As is customary, the IRS invited interested members of the

public to submit written comments with respect to proposed

regulations interpreting sec. 936 as amended by the Tax Equity

and Fiscal Responsibility Act of 1982. Numerous comments were

received and considered. See 47 Fed. Reg. 53746 (Nov. 29, 1982).

the possession product is a component product. In evaluating the

regulations under section 936, we are mindful of the Supreme

Court's admonition: "The choice among reasonable interpretations

is for the Commissioner, not the courts." National Muffler

Dealers Association, Inc. v. United States, 440 U.S. 472, 488

(1979). Provided that Q&A-12 is neither unreasonable nor plainly

inconsistent with the statute, it will be upheld. Bingler v.

Johnson, 394 U.S. 741, 750 (1969); RJR Nabisco, Inc. v. United

States, 955 F.2d at 1464.

The legislative history of section 936, as a whole, is

silent on the precise issue before us. The legislative history

does, however, make clear Congress' consistent intention to

maintain the favorable tax benefit of operating in a U.S.

possession, and we find that the application of the PCR in Q&A-12

in the instant case is fully consistent with that intention.

The regulatory scheme under section 936 is technical and

complex, and we find that the Commissioner considered the

treatment of possession products in a detailed and reasoned

fashion before making a final decision.9 Section 936 does not

specifically define the term “CTI”, nor does the statute provide

a clear method for allocating and apportioning expenditures in
- 39 -

computing CTI under the facts before us. The term CTI, and the

method for computing such, for purposes relevant here, however,

is defined in Q&A-12. General language of a statutory provision

will not be held to apply to a matter specifically dealt with in

another part of the same enactment; specific terms prevail over

the general. D. Ginsberg & Sons, Inc. v. Popkin, 285 U.S. at

208; Dupree v. United States, 391 F.2d 753, 758 (5th Cir. 1968).

Under the profit-split method, the electing corporation's

taxable income derived from products produced in a possession

equals 50 percent of the combined taxable income of the

affiliated group derived from covered sales of these products. 

Sec. 936(h)(5)(C)(ii)(II). Combined taxable income is the gross

income of the affiliated group derived from covered sales of the

possession product less all expenses properly apportioned and

allocated to such income. 

Q&A-1 describes the proper allocation and apportionment of

expenses in computing CTI with respect to soft-drink concentrate

produced by CRI and sold by U.S. affiliates in unchanged form to

unrelated bottlers. If, however, the possession product is

simply a component of a final product, then Q&A-12 prescribes the

manner of computing CTI. 

Q&A-12 prescribes the method for determining CTI with

respect to component products. Under that method, the expenses

which the affiliated group allocated and apportioned to the

integrated product, i.e., syrup and soft drink, must be further
- 40 -

apportioned to the possession product, i.e., the soft-drink

concentrate. The latter apportionment is based on the ratio of

the production costs for the possession product to the total

production costs for the integrated product. 

In using this formulaic method to arrive at CTI, it becomes

clear that the greater the expense allocation to the concentrate,

the lower the CTI, and, thus, the smaller the credit. 

Conversely, the lesser the expense allocation to the concentrate,

the higher the CTI, and, thus, the greater the credit. In the

example in Q&A 12, the taxpayer's PCR is 80 percent. This is

because the production costs incurred at the possessions level

are high relative to total production costs. Petitioner,

however, has relatively low PCR's with respect to its component

product, which, as stated earlier, results in a quite favorable

tax benefit. The use of a formula will cut both ways; it will be

beneficial to some and not so beneficial to others. That is the

intrinsic nature of formulas. 

Essentially, respondent is arguing that, at each level, the

application of the PCR impermissibly misapportions away from the

component concentrate expenses that are known and admitted to be

factually related to the concentrate, which in turn inflates the

CTI figure, causing the sheltering of post-allocation income. We

find that the focus of respondent's argument appears to center on

the wisdom of the choice between two alternatives; i.e., a

formulaic versus a fact-based approach, rather than on whether
- 41 -

the choice made was a reasonable choice within a gap left open by

Congress. 

Q&A-12 contains no mention of "factual relationships" or

"economic consequences". It merely provides a formula used in

calculating CTI in order to determine the amount of credit under

section 936. There is no doubt and no dispute that (1)

petitioner qualifies for the section 936 credit, and (2) CRI made

a valid election to use the profit-split method under section

936. 

Currently, in response to the instant case, the Commissioner

has opened a new regulation project regarding the computation of

CTI under section 936(h). The proposed regulation contains,

again, a formulary rather than a factual approach attacking the

issue from the income side as opposed to the expense side. The

proposed regulation makes no mention of factual relationships or

economic reality.

We find that Q&A-12 is clear on its face, and respondent's

strained interpretation of the relationship between Q&A-1 and

Q&A-12 is merely an attempt to persuade this Court to

retroactively revise the regulation. Until the regulation is

changed, reflecting the Commissioner's proposed amendments to

Q&A-12, taxpayers are entitled to the tax benefit generated under

Q&A-12.

 Additionally, we find that the formulaic method prescribed

in Q&A-12 is consistent with Congress' intent to encourage
- 42 -

investment in U.S. possessions, and consequently, we find that

Q&A-12 is not inconsistent with any stated congressional intent. 

Q&A-12 could have been written to require simply that

expenditures be allocated and apportioned in a manner consistent

with the rules set forth in section 1.861-6, Income Tax Regs.,

but it was not. 

The fact that other methods might also be reasonable, or

even preferable, however, does not warrant our overturning a

regulation which itself has a reasonable basis. Brown & Root v.

TVA, 681 F.2d 1313, 1316-1317 (11th Cir. 1982). Even presuming

that we might disagree with the results of applying the PCR in

the instant case, we would not substitute our own construction of

the statute for that of the Secretary where the regulation

implements the congressional mandate in a reasonable manner. See

Florida Manufactured Housing Association, Inc. v. Cisneros, 53

F.3d at 1572-1573. Respondent may not ignore the requirements

set forth in the plain language of the regulations any more than

petitioner or other taxpayers. Intel Corp. & Consol. Subs. v.

Commissioner, 100 T.C. at 630. 

We cannot conclude that the regulation at issue presents an

impermissible construction of section 936(h). The Commissioner

was delegated the authority to make choices among reasonable

alternatives in interpreting section 936(h) and did so.

After considering the regulation in light of the language of

section 936(h) and the purpose behind it, we are satisfied that
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section 1.936-6(b)(1) Q&A-12, Income Tax Regs., constitutes a

valid exercise of the Secretary's regulatory authority. We

conclude that Q&A-12 is the controlling provision in the instant

case.

E. Exxon

Respondent argues in the alternative that this Court's

opinion in Exxon Corp. v. Commissioner, 102 T.C. 721 (1994),

provides an independent basis for denying the instant motion as

the application of Q&A-12 to the facts of the instant case would

cause absurd results. Petitioner, citing Abdalla v.

Commissioner, 647 F.2d 487, 497 (5th Cir. 1981), affg. 69 T.C.

697 (1978), contends that the plain and unambiguous meaning of a

provision may be overridden only in rare and exceptional

circumstances where the result of giving the provision its plain

and unambiguous meaning would be so absurd as to "shock the

general moral or common sense" and be against clear legislative

intent. 

Petitioner argues that respondent's reliance on Exxon Corp.

v. Commissioner, supra, is misplaced, and that respondent is

essentially asking this Court to rewrite the applicable

regulations. We agree. We find that Exxon Corp. is

distinguishable from the instant case. 

Exxon received a known and quantifiable amount of income

from sales of natural gas in 1979. Exxon claimed a 22-percent

depletion allowance on an amount larger than the actual sales
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proceeds from that gas. This larger amount against which the

depletion allowance was taken was derived from determining gross

income under the "representative market" or "field price" method

under the regulations. The issue in Exxon Corp. was the method

of computing “gross income from the property” for purposes of the

depletion allowance. See sec. 613(a). The statute itself was

silent on this issue. The regulation defined gross income in

terms of the representative market or field price, which in that

case produced hypothetical gross income far in excess of actual

gas sales.

The Commissioner argued that Exxon was not entitled to a

percentage depletion deduction based upon a hypothetical "gross

income from the property", which exceeded Exxon's actual gross

income from the sale of gas. The Commissioner maintained that

the "gross income from property", for purposes of percentage

depletion, must not exceed the actual gross income from the sale

of gas, and under those circumstances, the Commissioner was

entitled to employ a net-back methodology in determining "gross

income from the property". Exxon argued that under the plain

meaning of section 1.613-3(a), Income Tax Regs., it was required

to compute its percentage depletion deduction by using the

representative market or field price of the gas. 

Section 611 allows a "reasonable allowance for depletion" in

the case of oil and gas wells "according to the peculiar

conditions in each case". Section 613(a) provides for a
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percentage depletion deduction based upon a percentage of a

taxpayer's "gross income from the property". Section 611(a)

provides that reasonable depletion allowance in all cases is to

be made under regulations prescribed by the Secretary.

Although the statute was silent as to the definition of

"gross income from the property" as it related to the facts in

Exxon Corp. v. Commissioner, supra, section 1.613-3(a), Income

Tax Regs., provided that "gross income from the property" is:

the amount for which the taxpayer sells the oil or gas

in the immediate vicinity of the well. If the oil or

gas is not sold on the premises but is manufactured or

converted into a refined product prior to sale, or is

transported from the premises prior to sale, the gross

income from the property shall be assumed to be

equivalent to the representative market or field price

of the oil or gas before conversion or transportation.

Exxon argued that, under the literal terms of section 1.613-

3(a), Income Tax Regs., where the gas is transported from the

premises prior to sale, the Commissioner cannot use a net-back

methodology to determine gross income from the property. 

The Commissioner argued that not only was Exxon's

interpretation of the regulation at issue flawed, it also was

inconsistent with the legislative history behind percentage

depletion. Exxon essentially argued that, under the ordinary or

plain meaning rule, the literal terms of the regulation at issue

must be followed without further analysis.

We held that the rules of statutory construction require us

to determine whether the "plain meaning" of a regulation would
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have a nonsensical result. Exxon Corp. v. Commissioner, supra at

728. We held further that the plain meaning rule does not

preclude an examination behind the literal terms of the language

at issue if the lack of such an examination would compel an odd

result. Exxon Corp. v. Commissioner, supra at 728 (citing Public

Citizen v. United States, 491 U.S. 440, 454 (1989)).

We examined the legislative purpose and history of

percentage depletion to ascertain whether and to what extent the

statutory framework was consistent with a literal interpretation

of the regulation at issue. In so doing, we found that the plain

meaning of the regulation, as applied to the facts before us in

Exxon Corp., was against clear and longstanding congressional

intent. 

Accordingly, we found that in computing allowance for

percentage depletion, it was unreasonable for Exxon to determine

its 1979 "gross income from the property" for sales of natural

gas, after the gas was transported away from the wellhead, by the

method provided for in the last sentence of section 1.613-3(a),

Income Tax Regs., the representative market or field price

method, where those prices resulted in a "gross income from the

property" five times Exxon's actual contract sales revenue.

In the instant case, however, the only clear and consistent

congressional intent expressed with respect to the possession tax

credit regime is the encouragement of U.S. business operations in

U.S. possessions. We do not find that the application of the
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plain meaning of Q&A-12 in the instant case is inconsistent with

this stated policy. Indeed, no clear, longstanding congressional

intent exists with respect to the issue presented in the instant

case. 

Many tax provisions provide for favorable tax results, and

to conclude that a provision as applied is absurd simply because

the tax benefit is substantial is unwarranted. The results that

flow from the use of the PCR in the instant case, while quite

beneficial to petitioner, are not unreasonable or unsound and

certainly do not shock the general moral or common sense. 

Respondent argues that applying the PCR to apportion less

than the full amount of the expenses known to be factually

related to the component possession product causes absurd

results. The Commissioner, however, chose to implement a

formulaic method; i.e., the PCR. Formulas by their very nature

are arbitrary, and their use is intended to minimize factual

disputes. 

Respondent asks this Court, in effect, to rewrite the

regulations in order to avoid a result which Q&A-12 clearly

requires. Until Congress or the Secretary acts to modify the

result of Q&A-12, we will apply Q&A-12 as written.

We find that Exxon Corp. v. Commissioner, supra, is

distinguishable from the instant case and is therefore not

dispositive of the instant motion.
- 48 -

III. Conclusion

Accordingly, we find that section 1.936-6(b)(1) Q&A 12,

Income Tax Regs., (1) governs the computation of combined taxable

income with respect to sales of component concentrate produced by

CRI and sold by petitioner to unrelated third parties, (2)

requires U.S. affiliate expenses to be allocated and apportioned

to the component concentrate by applying the production cost

ratio to all expenses allocable and apportionable to the

integrated product, i.e., bottle and can soft drink, and (3)

requires U.S. affiliate expenses allocable and apportionable to

the integrated product, i.e., bottle and can soft drink, to be

determined under section 1.861-8, Income Tax Regs., as described

in section 1.936-6(b)(1), Q&A-1, Income Tax Regs. 

We find further, on the basis of Bowater Inc. v.

Commissioner, 101 T.C. 207 (1993), that petitioner is entitled to

offset interest income against interest expense in determining

the amount of interest deduction to be allocated and apportioned

in computing combined taxable income under section 936 and

section 1.861-8(e)(2), Income Tax Regs. 

 To reflect the foregoing,

An appropriate order

will be issued granting

petitioner’s motion for

partial summary judgment.