Opinion ID: 677811
Heading Depth: 3
Heading Rank: 1

Heading: The DISC Legislation

Text: 6 In 1971, Congress enacted the DISC statute intending to provide tax incentives to domestic firms, thereby increasing exports. At that time, Congress believed that domestic firms exporting goods in a foreign market were at a disadvantage as compared to foreign subsidiaries of domestic corporations. H.R.Rep. No. 533, 92d Cong., 1st Sess. 57, 58 (1971) [hereinafter H.R.Rep. No. 533], reprinted in 1971 U.S.C.C.A.N. 1825, 1872. Prior to the enactment of the DISC legislation, domestic companies directly marketing their goods in a foreign market were taxed on their foreign earnings at the full U.S. corporate income tax rate regardless of whether [the] earnings [were] kept abroad or repatriated. Id. 7 The DISC statute permitted a domestic corporation to set up a DISC, a subsidiary incorporated under the laws of any State. I.R.C. Sec. 992(a)(1). A corporation could elect to be treated as a DISC if it satisfied several specific requirements. See id. Most significantly, 95 percent or more of the gross receipts [of a DISC must] consist of qualified export receipts. Id. Sec. 992(a)(1)(A). Once qualified as a DISC, such a corporation's profits were generally not subject to taxation. Id. Sec. 991. However, the DISC's shareholders were taxed on a portion of the DISC's profits in the form of a deemed dividend. See id. Sec. 995. The remainder of DISC profit was not taxable until it was distributed to the shareholder, typically upon the dissolution or disqualification of the DISC. See e.g., id. Sec. 995(b)(2). The shareholder's yearly deemed dividend attributable to qualified export receipts was taxed as foreign source income, I.R.C. Sec. 862(a)(2), thus qualifying for a corresponding foreign tax credit, id. Secs. 901, 904. 8 The incentive created by Congress in the DISC legislation allowed the domestic corporation, the shareholder of the DISC, to defer from U.S. taxation a significant portion of the DISC profits. Congress also set up DISC intercompany pricing rules abrogating arms length pricing as the basis for sales or exchanges between the domestic parent corporation and the DISC. See H.R.Rep. No. 533 at 59, reprinted in 1971 U.S.C.C.A.N. at 1873. The intercompany pricing rules were intended to 9 avoid the complexities of the [arms length] pricing rules in the case of sales by a domestic parent corporation ... to a DISC and also to provide encouragement for the operation of DISC's.... [P]ricing rules ... may be used in determining the permissible profits--although in excess of profit under arm's length rules and regardless of the sales price actually charged--which a DISC may earn on products which it purchases from a related company and then resells for export. 10 H.R.Rep. No. 533 at 73, reprinted in 1971 U.S.C.C.A.N. at 1887. 11 The intercompany pricing rules, codified in Sec. 994, permitted a taxpayer to use one of three methods for determining the amount of deemed profit allocated to the DISC and its parent as a result of export sales. See I.R.C. Sec. 994(a). 3 The taxpayer/parent could choose the method resulting in the greatest amount of profit. Id. The greater the DISC profit, the larger the amount of tax-deferred income and the larger the deemed dividend. Thus, a shareholder, such as St. Jude, had an incentive to maximize DISC profit. The intercompany pricing rules, intended as an export incentive, allowed DISCs and parent corporations to transfer inventory through either a buy-sell arrangement, with the inventory's deemed price governed by Sec. 994(a), or on a commission basis, with the amount of commission governed by regulations promulgated pursuant to Sec. 994(b)(1). 12 Under the 1971 DISC statute, a commission DISC, such as International, never took title to the inventory that it sold in the foreign market. Rather, the parent company retained title and the DISC was paid a commission for selling the goods in the foreign market. The commission income, deemed received by the DISC for its services, was calculated according to methods established by regulation. See Treas.Reg. Sec. 1.994-1 (as amended in 1975). 13 If any transaction to which section 994 applies is handled on a commission basis for a related supplier by a DISC and such commissions give rise to qualified export receipts under section 993(a)-- 14 (i) The amount of the income that may be earned by the DISC in any year is the amount, computed in a manner consistent with [the sales transfer price], which the DISC would have been permitted to earn under the gross receipts method, the combined taxable income method, or [the] section 482 method. 15 Id. Sec. 1.994-1(d)(2). 16 A commission DISC choosing to use the CTI method for computing the permissible deemed commission must allocat[e] expenditures in computing combined taxable income, I.R.C. Sec. 994(b)(2). 4 The DISC statute did not define the term CTI, nor did the statute provide a method for allocat[ing] expenditures in computing combined taxable income, id. The term CTI, however, was defined in Sec. 1.994-1. 17 [T]he combined taxable income of a DISC and its related supplier from a sale of export property is the excess of the gross receipts ... of the DISC from such sale over the total costs of the DISC and related supplier which relate to such gross receipts. 18 Treas.Reg. Sec. 1.994-1(c)(6). The amount of the income that may be earned by the [commission] DISC in any year is [an] amount[ ] computed in a manner consistent with [Sec. 1.994-1] paragraph (c). Id. Sec. 1.994-1(d)(2)(i). Accordingly, the related costs of the DISC and its related supplier were subtracted from gross receipts in the CTI computation. The method of allocating these costs was also defined by regulation, as authorized by Sec. 994(b)(2). 19 Section 1.994-1(c)(6)(iii) provided that costs definitely related to the sales of export property should be allocated and apportioned to that property in a manner consistent with the rules set forth in Sec. 1.861-8. 5 Section 1.994-1(c)(6)(iv) further provided that the taxpayer's choice as it pertained to the grouping of transactions was controlling. 6 We examine Sec. 1.861-8 because Sec. 1.994-1(c)(6) incorporated its rules into its directions for calculating CTI.