Opinion ID: 677811
Heading Depth: 2
Heading Rank: 2

Heading: Validity of the Application of Section 1.861-8(e)(3) to

Text: CTI Computations 26 St. Jude allocated neither its insulin pump nor its pacemaker R & D expenditures against its artificial heart valve export receipts in its CTI computations. Section 1.861-8(e)(3)(i) required it to do so. St. Jude contends the Commissioner could not validly apply the broad SIC categories contained in Sec. 1.861-8(e)(3)(i) to its R & D expenditures because the insulin pump and pacemaker expenses were not definitely related to receipts from heart valve sales. The Commissioner, in response, contends that Sec. 1.861-8 deems insulin pumps and pacemakers to be factually related to heart valve export receipts, and that this deemed relationship is in harmony with the origin and purpose of the DISC statute. The tax court agreed with the Commissioner. We disagree. 27 We defer to the Commissioner's regulatory interpretations of the Code so long as they are reasonable. See Cottage Sav. Ass'n v. Commissioner, 499 U.S. 554, 561, 111 S.Ct. 1503, 1508, 113 L.Ed.2d 589 (1991) (citing National Muffler Dealer's Ass'n v. United States, 440 U.S. 472, 476-77, 99 S.Ct. 1304, 1306-07, 59 L.Ed.2d 519 (1979)). In determining whether a particular regulation carries out the congressional mandate in a proper manner, we look to see whether the regulation harmonizes with the plain language of the statute, its origin, and its purpose. National Muffler, 440 U.S. at 477, 99 S.Ct. at 1307 (describing the reasonableness requirement). 10 We may further consider the span of time between the enactment of the statute and promulgation of the regulation, the length of time the regulation has been in effect, the evolution of the regulation, the reliance placed on the regulation, the consistency of the Commissioner's interpretation, and the degree of congressional scrutiny. Id. 28 Congress authorized the Commissioner in the DISC statute to promulgate (1) intercompany pricing rules applicable to commission DISCs consistent with the statutory buy-sell pricing rules, see I.R.C. Sec. 994(b)(1); and (2) rules for the allocation of expenditures in computing CTI for buy-sell DISCs, id. Sec. 994(b)(2). Congress thus specifically authorized the Commissioner to promulgate commission intercompany pricing rules and CTI expenditure allocation rules. In deciding whether Sec. 1.8618(e)(3)'s SIC categories may validly be applied to carry out Congress's mandate in the DISC statute, we must examine the origin and purpose of the DISC statute. 11 See National Muffler, 440 U.S. at 477, 99 S.Ct. at 1307. 29 We interpret Sec. 994(b) to have authorized the promulgation of CTI allocation rules for commission DISCs consistent with those of buy-sell DISCs. However, we find nothing in the plain language of the statute to guide us further in our analysis. We learn from the legislative history that the DISC statute was intended to allow DISCs to earn profits in excess of those earned under the arms length pricing rules. See H.R.Rep. No. 533 at 73, reprinted in 1971 U.S.C.C.A.N. at 1887. And, we learn that the pricing rules, embodied in I.R.C. Sec. 994, were generally to be applied on a product-by-product basis, although the rules could be applied on the basis of product lines. H.R.Rep. No. 533 at 74, reprinted in 1971 U.S.C.C.A.N. at 1888. 30 The intended method for allocating expenses in CTI computations appears consistent throughout the legislative history of the DISC statute. The CTI intercompany pricing rule was 31 to be determined generally in accordance with the principles applicable under section 861 for determining the source (within or without the United States) of the income of a single entity with operations in more than one country. These rules generally allocate to each item of gross income all expenses directly related thereto, and then apportion other expenses among all items of gross income on a ratable basis. Thus, the combined taxable income of a DISC and a related person with respect to the sale by the DISC of export property would be determined by deducting from the DISC's gross receipts the related person's cost of goods sold with respect to the property, the selling, overhead and administrative expenses of both the DISC and the related person which are directly related to the production or sale of the export property.... 32 H.R.Rep. No. 533 at 74, reprinted in 1971 U.S.C.C.A.N. at 1887-89 (emphases added); accord S.Rep. No. 437, 92d Cong., 1st Sess. (1971), reprinted in 1971 U.S.C.C.A.N. 1918, 2013. 12 33 The parties stipulated to the tax court that cardiac pacemakers, insulin pumps, and artificial heart valves were separate products or product lines under recognized industry or trade usage. J.A. at 25. According to Sec. 1.994-1, such taxpayer-made transaction grouping should control and costs should be allocated and apportioned accordingly. Treas.Reg. Sec. 1.994-1(c)(6)(iv). Nonetheless, Sec. 1.861-8(e)(3)(i) required the allocation of R & D expenditures against broad SIC categories wider in scope than industry-approved product lines. According to Sec. 1.861-8(e)(3)(i), the insulin pump and cardiac pacemaker R & D expenditures should be allocated against export receipts resulting from either measuring instruments, analyzing instruments, controlling instruments, medical goods, optical goods, watches or clocks. See id. Sec. 1.861-8(e)(3)(i)(A)(38). 34 Mandating use of the SIC categories is inconsistent with Congress's intent to allow costs to be allocated on a product-by-product basis or on the basis of product lines. See H.R.Rep. No. 533 at 73, reprinted in 1971 U.S.C.C.A.N. at 1888; S.Rep. No. 437, 92d Cong., 1st Sess., reprinted in 1971 U.S.C.C.A.N. at 2014. Moreover, the deemed relationship mandated by Sec. 1.861-8(e)(3)(i) is inconsistent with Congress's intent to generally allocate to each item of gross income all expenses directly related thereto. H.R.Rep. No. 533 at 74, reprinted in 1971 U.S.C.C.A.N. at 1887 (emphasis added). Finally, we note that the SIC categories requiring gross income derived from successful research and development [to] bear the cost of unsuccessful research and development, Treas.Reg. Sec. 1.861-8(e)(3)(i), are inconsistent with Congress's stated intent to deduct[ ] from the DISC's gross receipts ... [the] cost of goods sold with respect to the property, the selling, overhead and administrative expenses of both the DISC and the related person which are directly related to the production or sale of the export property. H.R.Rep. No. 533 at 74, reprinted in 1971 U.S.C.C.A.N. at 1888. 35 In contrast, Sec. 1.994-1(c)(6)(iii), the regulation describing the manner in which the taxpayer is to allocate costs, is consistent with Congress's intent when it promulgated the DISC statute. Section 1.994-1(c)(6)(iii) requires the taxpayer to allocate and apportion costs, such as R & D, that are definitely related to the gross receipts from the sale of the export property. See Treas.Reg. Sec. 1.994-1(c)(6)(iii). Although Sec. 1.994-1(c)(6)(iv) and (7) allow a taxpayer the choice of grouping transactions, and hence costs, by SIC groups, the regulation does not mandate such transaction grouping as does Sec. 1.861-8(e)(3). Instead, the regulation mandates that the taxpayer's choice regarding the grouping of transactions shall control as long as it conforms to a recognized industry/trade usage or a SIC group. Id. Sec. 1.994-1(c)(6)(iv), (7)(ii). We do not find that this flexibility in the Sec. 1.994-1 regulation violates Congress's purpose or intent when it promulgated the DISC statute. 36 Section 1.994-1(c)(6)(iii) further requires that CTI costs be allocated and apportioned in a manner consistent with the rules set forth in Sec. 1.861-8. Treas.Reg. Sec. 1.994-1(c)(6)(iii). This mandate is consistent with the legislative history requiring that the rules be determined generally in accordance with the principles applicable under section 861 for determining the source (within or without the United States) of the income of a single entity with operations in more than one country. H.R.Rep. No. 533 at 74, reprinted in 1971 U.S.C.C.A.N. at 1887 (emphasis added). Thus, we find, on one hand, that Congress authorized Sec. 1.994-1(c)(6)'s incorporation of Sec. 1.861-8, and on the other hand, that Sec. 1.861-8 is inconsistent with the DISC statute's purpose. 37 We are left with a conflict between two Treasury regulations: Sec. 1.994-1 and Sec. 1.861-8. Section 1.994-1 allows the taxpayer's choice regarding the manner of grouping transactions to control. Section 1.861-8 mandates a specific method of grouping transactions. The first regulation, Sec. 1.994-1, was promulgated to interpret the DISC intercompany pricing rules. The second regulation, Sec. 1.861-8, was promulgated to state in general terms how to determine taxable income of a taxpayer from sources within the United States after gross income from sources within the United States has been determined. Treas.Reg. Sec. 1.861-8(a)(1). Because Sec. 1.861-8 only affects CTI computations through Sec. 1.994-1(c)(6)(iii)'s incorporation of its rules, we must analyze the source of Sec. 1.994-1(c)(6)(iii)'s authority for incorporating Sec. 1.861-8. 13 And, we must decide, in light of that history, whether applying Sec. 1.861-8's mandate to CTI computations carries out the congressional mandate in a proper manner, National Muffler, 440 U.S. at 477, 99 S.Ct. at 1307. 38 In DISC CTI computations, Congress intended for expenditures to be allocated generally in accordance with the principles applicable under section 861. H.R.Rep. No. 533 at 74, reprinted in 1971 U.S.C.C.A.N. at 1887. The language of I.R.C. Sec. 861 mirrored the language contained in the DISC legislative history, see H.R.Rep. No. 533 at 74, reprinted in 1971 U.S.C.C.A.N. at 1887-89. An examination of Sec. 861(b)'s language does not allow us to infer that Congress intended to impose mandatory SIC transaction grouping in CTI computations related to R & D expenditures. See id. 14 In fact, Sec. 1.861-8, at the time the DISC legislation was enacted, did not contain the SIC categories, but rather reiterated Sec. 861(b)'s language. See Treas.Reg. Sec. 1.861-8 (1957). 39 After examining the origin and the purpose of the DISC statute, we hold that Sec. 1.861-8 is unreasonable, and thus invalid, as applied to DISC CTI computations. See National Muffler, 440 U.S. at 476, 99 S.Ct. at 1306. 15 We believe Congress intended in CTI computations to allocate costs, such as R & D expenditures, to definitely related gross export receipts. See, e.g., Treas.Reg. Sec. 1.994-1(c)(6)(iii). Although a taxpayer may choose to allocate R & D expenditures to SIC categories consistent with Congress's intent when it promulgated the DISC intercompany pricing rules, mandating that a taxpayer do so is inconsistent with congressional intent. Doing so may improperly decrease the profits allocated to a DISC, thus thwarting Congress's intent when it promulgated the DISC intercompany pricing rules. 40