Summary
In Addison Int'l, Inc. v. Commissioner, 90 T.C. at 1213-1219, a former DISC became disqualified because of a failure to comply with certain DISC technical rules.
Summary of this case from Summa Holdings, Inc. v. Comm'rOpinion
Docket No. 6058-82.
1988-06-21
ADDISON INTERNATIONAL, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Ernest Getz, Michael D. Horlick, Timothy G. Reaume and Joseph M. Persinger, for the petitioner. Beth L. Williams, for the respondent.
P, a DISC, was organized and operated in reliance upon the Handbook, a guidebook for DISCs issued by the Department of the Treasury. P held no property, had neither employees nor place of business, and conducted no activity beyond those steps necessary to ensure qualification as a DISC. R sent a statutory notice of deficiency to P in which R determined that P failed to qualify as a DISC for taxable years 1976 and 1977 on the grounds that a commission payment was not made within the 60-day period allowed by regulation. HELD: Because P was entitled to rely on the Handbook the regulation cannot be applied retroactively to P with respect to taxable year 1976. Therefore, P was disqualified as a DISC for taxable year 1977 only. HELD FURTHER: P was the proper taxpayer with respect to its current income for taxable year 1977. Ernest Getz, Michael D. Horlick, Timothy G. Reaume and Joseph M. Persinger, for the petitioner. Beth L. Williams, for the respondent.
WRIGHT, JUDGE:
By notice of deficiency dated December 15, 1981, respondent determined deficiencies in petitioner's Federal income taxes for the taxable years 1976 and 1977 in the amounts of $1,100,583 and $1,170,603, respectively.
After concessions by the parties, the issues for our decision are (1) whether petitioner Addison International, Inc., failed to qualify as a Domestic International Sales Corporation (DISC) under sections 991 through 997 during its taxable years 1976 and 1977 and, if so, (2) whether petitioner Addison International, Inc., is properly taxable under section 11 on its taxable income.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulated facts and attached exhibits are incorporated herein by this reference.
Petitioner, Addison International, Inc. (AI), was incorporated on September 21, 1973, under the laws of the State of Michigan as a Domestic International Sales Corporation (DISC) pursuant to sections 991 through 997 of the Internal Revenue Code.
Since its inception, AI has been the wholly owned subsidiary of Addison Products Company (APC), a corporation organized and operated under the laws of the State of Michigan. AI's outstanding stock consists of 2,500 shares of common stock with a par value of $1 per share. Both AI and APC use the accrual method of accounting and report taxable income on a calendar year. APC and AI have never filed consolidated returns.
The second basis presents a more persuasive rationale for finding that th general rule of regulation retroactivity should apply. The handbook containing the guidelines or, lack of same, was published and issued by the Treasury Department during January 1972. ‘The handbook provided that its rules would be followed until modified 'in regulations or other Treasury publications.’‘ CWT Farms, Inc. v. Commissioner, 79 T.C. at 1069. The Treasury Department published and issued proposed regulations containing the disputed requirements during October 1972. The petitioner in this case did not rely upon the handbook or proposed regulations or apparently consider DISC status until ‘September 1973, as a result of information learned at a seminar, * * *.‘ The final regulations were adopted in final form on September 29, 1976, and October 14, 1977. The dates of the final regulations were both before the commission payment in question occurred and at least one of the final regulations was adopted before petitioner's income tax return for the period in question was due to be filed.
In our finding that petitioner in CWT Farms, Inc. v. Commissioner, failed to demonstrate that respondent abused his discretion in applying the subject regulations retroactively, the following reasoning and principles, amply supported by precedent, were provided: (1) Respondent's regulatory interpretation did not alter settled prior law and taxpayers had no ‘'vested interest in a hypothetical decision in * * * »their† favor prior to the advent of the regulations.’ CWT Farms, Inc. v. Commissioner, 79 T.C. at 1070; Helvering v. Reynolds, 313 U.S. at 433; Chock Full O'Nuts Corp. v. United States, 453 F.2d at 303.‘ (2) The respondent made his position publicly known in proposed regulations during 1972 and that constituted adequate notice. See Wendland v. Commissioner, 79 T.C. 355, 382 n. 15 (1982). (3) A published proposed regulation, at very least, complied with the terms for modification or variance from the terms (or lack thereof) of the handbook. CWT Farms, Inc. v. Commissioner, 79 T.C. at 1069-1070.
Our reasoning in support of retroactive application in CWT Farms, Inc. v. Commissioner, is equally appropriate here, where petitioner did not consider use of a DISC until after issuance of both the handbook and proposed regulations. In light of the respondent's published intent, petitioner was taking a risk in blindly following the handbook. Moreover, it appears that the handbook was not dispositive or in any way concise about the circumstances covered in the proposed or final regulations. Most importantly, the majority does not set forth any changed conditions or law to justify overruling our established and affirmed precedent in CWT Farms, Inc. v. Commissioner.
The opinions of the Courts of Appeals for the Second and Seventh Circuits which overruled memorandum opinions of this Court and supported a position contrary to the Court of Appeals for the Eleventh Circuit and this Court, essentially, offered the following reasoning: (1) that the handbook in question was something more than a statement of current law, because it contained promises to be relied upon in the future; and (2) that proposed regulations are merely ‘suggestions made for comment‘ and are not intended to modify anything. Gehl Co. v. Commissioner, 795 F.2d 1324 (7th Cir. 1986); LeCroy Research Systems Corp. v. Commissioner, 751 F.2d 123 (2d Cir. 1984).
Although I agree that proposed regulations do not have the authority or standing of temporary or final regulations, they are regularly used to present the Treasury Department's position on a particular subject. The purpose for issuing proposed regulations is to put taxpayers on notice and to elicit commentary that may be considered in finalizing the regulation. See section 601.601(a) and (b), Procedural Regs. As jurists we have adhered to the principle that respondent's revenue rulings and procedures are nothing more than the position of a party and they are afforded little or no weight as authority. Estate of Lang v. Commissioner, 613 F.2d 770, 776 (9th Cir. 1980), affg. on this point 64 T.C. 404 (1975); Stubbs, Overbeck & Assoc. v. United States, 445 F.2d 1142 (5th Cir. 1971); Sims v. United States, 252 F.2d 434 (4th Cir. 1958), affd. 359 U.S. 108 (1959); Minnis v. Commissioner, 71 T.C. 1049, 1057 (1979). The opinions of the Courts of Appeals for the Second and Seventh Circuits have placed proposed regulations below the level afforded revenue rulings and procedures and placed the handbook in the same status as temporary or final regulations. This approach is both divisive and disruptive to a long established order of significance upon which both taxpayers and Government have long relied.
To reiterate, in effect, the Government made no promises to this petitioner or any taxpayer with a taxable year after 1972. The handbook and proposed regulations were published within 9 months of each other during 1972. I find the majority's position that a proposed regulation is insufficient to put the public on notice to be simply incorrect.
For the foregoing reasons, I respectfully dissent from the majority's opinion.
The DISC legislative history quoted on page 25 of the majority opinion is consistent with the above analysis. It is unquestioned that a corporate entity that is a DISC or former DISC can have ‘'normal’ earnings and profits * * * which are the same as the earnings and profits of an ordinary corporation which never was a DISC.‘ S. Rept. No. 92-437, 1972-1 C.B. 559, 628. There is nothing, however, in this legislative history indicating that when a former DISC ostensibly earns ‘normal‘ profits, that the bona fides of its corporate activities should be judged on standards other than those applied to other corporations which are not DISC's. The legislative history describes as ‘normal‘ those earnings and profits generated before the corporation became a DISC and those generated during a period when it was disqualified as a DISC. S. Rept. No. 92-437, supra, 1972-1 C.B. at 628. It seems beyond question that corporate activities preceding initial DISC election and qualification would be judged on the basis of business purpose and economic substance without any regard to the DISC provisions. Since the legislative history equates pre-DISC earnings with earnings during a disqualification period, why would we use DISC concepts in judging the latter and not the former? The DISC provisions simply don't apply in making that judgment.
Having eliminated the problem of potentially undermining the DISC statutory framework, this transaction should be judged on the basis of the facts presented. Petitioner contends that, in reality, it had no income because it did nothing to earn the income. Indeed, it could not have done anything based upon the findings of fact since it had no employees, performed no services, dealt with no customers and did not even receive the payment of the amounts of income which respondent argues it earned until the following year.
Although one might make that argument, it is a matter of judgment and would appear to be a close call. In this regard we have already taken a position on this aspect in CWT Farms, Inc. v. Commissioner, 79 T.C. 1054 (1982), and numerous Memorandum Opinions. In close situations, such as this one, we have a duty of consistency and should not change our opinion or judgment unless it is clearly wrong.
Section 1.992-2(d) also indicates that a ‘former DISC‘ is subject to the DISC provisions of the Code. This is necessary only because prior accumulations of earnings and profits earned while qualified as a DISC must be accounted for. S. Rept. No. 92-437, 1972- 1 C.B. 559, 611. It does not and cannot be meant to attribute all DISC corporate attributes to a former DISC. To do so would render the qualification requirements meaningless.
APC manufactures heating and air conditioning equipment for commercial and residential use. At the time of trial APC had its primary manufacturing plant in Addison, Michigan, and additional facilities in Michigan and in Texas. Initially, APC sold heating and air conditioning equipment exclusively in domestic markets. Using the Original Equipment Manufacturing (OEM) method, APC would sell its product to a retailing company which was usually a major manufacturing company with brand-name recognition. In addition to selling its own manufactured products, the retailer would affix its own brand-name to the APC product for sale. Neither the names ‘Addison‘ nor ‘APC‘ achieved name-brand recognition because the products manufactured by APC did not carry either name. Furthermore, under the OEM method of selling, APC saved costs by not having to maintain a retail or distribution network.
In the mid-1960's, APC began exporting its products overseas. When it commenced its export operations, APC did not use the OEM method of selling; instead its products were exported under its own name through the sales management firm of J.D. Marshall International (Marshall). Marshall purchased the products from APC and exported them independently. Although Marshall was not APC's agent, Marshall was granted an exclusive right to sell APC products bearing the Addison name on the retail level in the overseas market. The products proved very marketable and successful, particularly with respect to the sales of air conditioners in the Middle East.
In 1964 or 1965, APC expanded its export activities and began exporting products under the OEM method. APC sold its products to name-brand retailers who in turn sold the APC products overseas under their own names and labels. Often these export retailers were the same companies or individuals who purchased APC products for domestic resale. Although APC was selling its products to both Marshall and to Marshall's competitors, the name-brand retailers, during this period, there was no conflict because the products prepared for OEM resale were cosmetically and superficially altered to satisfy the retailer's specifications. Under both arrangements, the export of APC products proved highly successful.
In September 1973, as a result of information learned at a seminar, APC organized and incorporated AI as a DISC. On the Certificate of Incorporation AI's sole purpose was listed as ‘any activity permitted to be carried on by a Domestic International Sales Corporation.‘ Donald L. Ball (Ball) who was vice president and treasurer for APC during the years in issue, stated that APC's sole reason for incorporating AI was to receive the tax deferral benefits available to a DISC. According to Ball, there were no additional economic considerations for such action.
On October 1, 1973, APC and AI executed an Agreement pursuant to which AI promised that it would conduct its business at all times in such a fashion as to ensure its status as a DISC. In return, APC granted a franchise to AI with respect to all qualified export property sold for use outside of the United States and Puerto Rico. APC agreed to be responsible for the solicitation and satisfaction of orders. APC agreed to pay AI the maximum amount allowable as a commission, occasionally in advance. Such commissions were to be determined and paid within eight months of the end of each accounting period.
Even the amount which petitioner received in March 1978, ostensibly due to commissions earned in 1977, was immediately paid back to APC in the form of an advance payment on a producer's loan and a distribution of previously taxed income on the assumption that petitioner qualified as a DISC. Since these characterizations of amounts petitioner paid back to APC depend on petitioner's DISC qualification, they must be disregarded. It is then clear that petitioner was merely a conduit.
In considering the arguments with respect to the retroactive application of sections 1.993-2(d)(3) and 1.994-1(e)(3), Income Tax Regs., we initially note that our decision should have limited impact. The tax years in question must, by definition, precede 1978, because the regulations became final on October 14, 1977. Commencing with the tax year 1978, all taxpayers were responsible for complying with the enacted regulations.
The Seventh Circuit and the Second Circuit both base their decisions to deny retroactive application on the narrow grounds of the singular and unusual nature of the DISC. Because the entire purpose of the DISC legislation was to entice taxpayers into following a path of behavior which satisfied the Congressional objective of increasing United States exports, taxpayer compliance with the Handbook implicitly served Congressional objectives. The Handbook promised the taxpayers that any modifications would be prospective and many taxpayers relied on that. As the Seventh Circuit noted, regulations are subject to change, even substantial change, prior to final promulgation. Strict compliance with proposed regulations could cause extra time and labor if the proposed regulations undergo substantial modification upon final promulgation. In the uncharted sea of structuring and operating a DISC, taxpayers who followed the guidelines in the Handbook were adhering to the most reliable information available. Because the DISC is a creature of statutory artifice, a taxpayer would have no independent reasons for any actions taken with respect to the organization and operation of a DISC. Thus, we conclude that the positions taken by the Second and the Seventh Circuits are well founded. When sections of the Internal Revenue Code are designed to invoke taxpayers to follow a course of behavior for which they have no other motives, respondent cannot, in fairness, complain when the desired compliance is forthcoming and the taxpayers take the Commissioner at his word.
Petitioner did not maintain that the commission payment made by APC to AI on October 19, 1977, was motivated by the discovery that the regulations had been promulgated in final form. Although payment was made within five days of the promulgation, the timing was purely coincidental. Nonetheless, even if petitioner had been aware of the final promulgation of the regulations, it would not have expected that they affected it, because it believed it was protected according to the promises contained in the Handbook. While we cannot condone willful ignorance, we conclude that petitioner's failure to comply with the 60-day payment rule stemmed from its reliance on the Handbook. Accordingly, sections 1.993-2(d)(3) and 1.994-1(e)(3), Income Tax Regs., may not be retroactively applied to petitioner for taxable year 1976.
Petitioner's next argument is that the payments, although late, were sufficiently timely to constitute substantial compliance with the regulations in issue. This argument has been considered and rejected on several occasions. Gehl Co. v. Commissioner, supra at 1331; Thomas International Ltd. v. United States, supra at 305.
Because the regulations in this case are substantive rather than procedural, compliance must be strict and total. Tipps v. Commissioner, 74 T.C. 458, 468 (1980). Petitioner's position that substantial compliance with sections 1.993-2(d)(3) and 1.994-1(e)(3), Income Tax Regs., will suffice, is without merit.
See also Fritzsche Dodge & Olcott, Inc. v. Commissioner, supra 45 T.C.M. at 609-610, 52 P-H Memo T.C. par. 83,056 at 83-163 - 83-164.
Normally, the choice of doing business in corporate form will be respected.
Whether the purpose be to gain an advantage under the law of the state of incorporation or to avoid or to comply with the demands of creditors or to serve the creator's personal or undisclosed convenience, SO LONG AS THAT PURPOSE IS THE EQUIVALENT OF BUSINESS ACTIVITY OR IS FOLLOWED BY THE CARRYING ON OF BUSINESS BY THE CORPORATION, the corporation remains a separate taxable entity. * * * »Moline Properties, Inc. v. Commissioner, 319 U.S. 436, 438-439 (1943). Emphasis added.† However, tax avoidance, standing alone, is not sufficient to meet the business purpose test in Moline Properties and the fact finding in this case indicates clearly that there was no other business purpose and no business activity. See National Carbide Corp. v. Commissioner, 336 U.S. 422 (1949); Noonan v. Commissioner, 52 T.C. 907 (1969), affd. 451 F.2d 992 (9th Cir. 1971); Aldon Homes, Inc. v. Commissioner, 33 T.C. 582 (1959). The only thing that petitioner did that might be construed as corporate activity was to maintain a bank account and separate records, and act as a conduit regarding funds of APC.
These are minimum DISC requirements. See sec. 1.992-1(a)(1) through (8). Even respondent's own regulations explicitly recognize that DISC qualification (which requires incorporation, books and records, a bank account, and payments) entitles a corporation to be recognized for tax purposes ‘even though such corporation would not be treated (if it were not a DISC) as a corporate entity for Federal income tax purposes.‘ Sec. 1.992-1(a), Income Tax Regs. One can hardly imagine a corporate entity more devoid of substance than petitioner during the year 1977.
The majority suggests that because petitioner maintained a bank account, kept books and records, and held annual meetings, it must be recognized as a corporation for Federal income tax purposes under Moline Properties, Inc. v. Commissioner, 319 U.S. 436 (1943). I disagree. This Court has held that, although an entity has engaged in similar activities, it would not be recognized as a corporation for tax purposes where it lacked a substantial business purpose for organization and had not engaged in any substantive business activities. See Aldon Homes, Inc. v. Commissioner, 33 T.C. 582 (1959). See also Visnapuu v. Commissioner, T.C. Memo. 1987-354; Horn v. Commissioner, T.C. Memo. 1982-741.
On November 30, 1973, AI elected DISC status and APC simultaneously filed its consent to the election. For all taxable years subsequent to this election, including taxable years 1976 and 1977, AI reported income by filing Forms 1120-DISC, the income tax return for DISC's.
Throughout 1976 and 1977, AI maintained a separate bank account at the Detroit Bank and Trust Company and kept books and records. The books and records consisted of a cash journal, a general journal and a general ledger. AI had no employees, and maintained no office or facilities separate from those owned by APC. The officers of AI were V. C. Knight (Knight) as president, Ball as vice president and treasurer, Fred W. Freeman (Freeman) as secretary in 1976, and John Coyne (Coyne) as secretary 1977. The board of directors consisted of Knight, Freeman and Ball in 1976, and Knight, Coyne and Ball in 1977. During this period Knight, Coyne and Ball also served as officers of APC. In all matters relating to the organization and operation of AI, the officers and directors were guided by the ‘DISC-Handbook for Exporters‘ (the Handbook) which was issued by the Treasury Department in January of 1972. This Handbook explained how to handle the affairs of the DISC in such a way as to ensure DISC qualification.
After incorporating AI, APC made no changes in its routine business conduct. APC continued to sell to brand-name retailers and to Marshall. Robert E. Dyas (Dyas), who was vice president of appliance and export sales during the years in issue, explained that after the incorporation of AI, business continued as usual. Indeed, AI had ‘absolutely no bearing on‘ the manufacturing department, of which Dyas was in control. AI had no assets and no employees. Except for services relating to qualification, AI performed no services for APC or anyone else, nor did AI request the performance of services from APC or anyone else. AI did not ship goods under its own name and did not issue documents of title or invoices. However, AI's shareholders and officers did hold annual meetings.
During taxable years 1976 and 1977, AI computed income under the methods prescribed by section 1.994-1, Income Tax Regs. These methods relate to the proper allocation of income between related entities. Under the 50/50 method the price charged by the parent corporation to the DISC for the exported products may be set at a price which allows the DISC to obtain taxable income up to 50 percent of the combined taxable income of the parent corporation and the DISC plus 10 percent of the export promotion expenses. The 4 percent method allows the parent corporation to set the price charged to the DISC for the exported products at 4 percent of the qualified export receipts plus 10 percent of the export promotion expenses incurred by the DISC. Petitioner's income for taxable year 1976 was computed in accordance with section 1.994-1(a), Income Tax Regs., by using the 50/50 method, resulting in income in the amount of $2,185,016, and in conjunction with the 4 percent method, resulting in income in the amount of $4,730, for total commission income of $2,189,746. Income for taxable year 1977 was computed using these same two formulas, resulting in income in the amount of $2,313,141, under the 50/50 method, and resulting in income in the amount of $594 under the 4 percent method, for total commission income of $2,313,146. In addition to the commission income reported for taxable years 1976 and 1977, AI reported interest income derived from a producer's loan in the amounts of $108,591 and $125,626, respectively. After deducting expenses in the amounts of $5,456 in 1976 and $10 in 1977, AI reported taxable income for the years in issue in the amounts of $2,292,881 and $2,438,757, respectively.
Although APC claimed commission expense deductions attributable to commissions payable to AI for taxable years 1976 and 1977 in the amounts of $2,189,746 and $2,313,141, respectively, the money was not actually paid by the close of AI's taxable year. On October 19, 1977, APC issued a check to AI in payment of the commission owing for the taxable year 1976. The payment was made at this time because it was APC's practice to pay AI at or about the time the DISC tax returns were filed.
3 The next day AI made a producer's loan to APC in the amount of $1,141,400.
The remainder of the commission payment, in the amount of $1,048,346, was distributed by AI to APC as previously taxed income. On March 21, 1978, APC issued a check in the amount of $2,324,840 to AI in payment of the commissions and interest owing for the taxable year 1977. Of this amount AI made an advance payment for a producer's loan to APC in the amount of $979,112, and made a distribution of the remainder to APC in the amount of $1,345,728. AI's only other expenditures for taxable years 1976 and 1977 were payments for Michigan franchise taxes in the amounts of $5,456 and $10, respectively.
If we were to recognize petitioner as the bona fide recipient of sales commissions which are really a portion of APC's profits, we would also be violating the principle that income must be taxed to the person or entity that earned it. Lucas v. Earl, 281 U.S. 111 (1930).
In March 1978, independent auditors informed APC's officers and directors that they had failed to follow one of the procedures required to qualify AI as a DISC. Specifically, the memorandum advised that sections 1.993-2(d)(2) and 1.994-1(e)(3), Income Tax Regs., were no longer in proposed form but had been promulgated in final form. In brief, those regulations required, among other things, that the commission payment made by a related supplier to a DISC had to be paid within the 60 days following the close of the DISC's taxable year (the 60-day payment rule).
The 60-day payment rule was not included in the Handbook. Immediately upon learning of the change, APC made the required payments on March 21, 1978. On September 6, 1978, the officers and directors of APC received an internal memorandum from their management consultant which confirmed the warning APC had received from independent auditors.
The majority does not, and could not, apply principles of equitable estoppel given the facts in this case. See Century Data Systems, Inc. v. Commissioner, 86 T.C. 157 (1986).
Having failed to qualify as a DISC, the only purpose for petitioner's existence, i.e., tax deferral, became impossible. Petitioner had no other business purpose and no business activity during the year 1977. To the extent that it received funds, it served as a conduit of the income earned by APC. As a mere conduit, petitioner was essentially acting as an agent for APC. Under the principles set forth in Commissioner v. Bollinger, ___ U.S. ___, 108 S. Ct. 1173 (1988), APC, rather than petitioner, is the proper taxpayer with respect to the income earned during the taxable year 1977.
This is not a case where we need be concerned with the equities of allowing a taxpayer to unfairly avoid taxation under a form which it chose. It is clear that APC formed petitioner solely to take advantage of the DISC provisions, but for which there would have been no tax advantages under the facts of this case. When respondent determined that petitioner was not qualified as a DISC, the statute of limitations was still open with respect to APC and respondent had the knowledge and ability to totally disregard this purely tax motivated transaction.
5 Instead, respondent chose form over substance. This should not be allowed in a situation where a taxpayer fails to meet highly technical provisions of a statutory scheme that was intended to encourage and benefit taxpayers who engaged in exporting activities.
In similar cases respondent has disallowed the parent's commission expense or reallocated the former DISC's ‘income‘ back to the parent under section 482. It is possible that respondent will now feel free to choose whichever alternative produces the most tax.
The statute of limitations with respect to APC was extended for the taxable years 1976 and 1977 to June 30, 1982, pursuant to written agreement. The statute of limitations with respect to APC for taxable years 1976 and 1977 expired at midnight on June 30, 1982. Respondent issued a timely notice of deficiency to AI for taxable years 1976 and 1977 on December 15, 1981.
OPINION
In his notice of deficiency to AI, respondent determined that the commissions receivable reported by AI in the taxable years 1976 and 1977 did not constitute qualified export assets because those amounts had not been paid by APC to AI within 60 days after the close of each taxable year. Respondent therefore determined that AI did not qualify as a DISC under section 992 in the taxable years 1978 and 1977. Respondent allocated the income and expenses to AI itself rather than to APC.
Petitioner contends that the regulations containing the 60-day payment rule are invalid but that, if they are valid, retroactive application of the regulations in this case would be improper. In the alternative, petitioner argues that it substantially complied with the regulations. With respect to the second issue for our consideration, petitioner contends that if AI is not qualified as a DISC for the taxable years 1976 and 1977 then the taxable income is properly taxable to APC rather than AI. Petitioner bears the burden of proof on all issues. Welch v. Helvering, 290 U.S. 111, 115 (1933); Rule 142(a).
The DISC provisions were enacted by Congress in 1971
6 to provide tax deferral for that portion of income earned by United States corporations from the sale or lease of domestic products to foreign buyers and lessees. Generally, a corporation that qualifies as a DISC is not taxable on its profits. Secs. 991 and 995(a). Approximately half of the profits is taxed as a constructive distribution to the shareholders, whether or not such distribution actually occurs, while taxation on the remaining half is deferred. Sec. 995(b); Westinghouse Electric Corp. v. Tully, 466 U.S. 388, 391- 392 (1984); Gehl Co. v. Commissioner, 795 F.2d 1324, 1327 (7th Cir. 1986), affg. in part and revg. in part a Memorandum Opinion of this Court. Any distributions that are made by the DISC to its shareholders out of previously untaxed earnings and profits are taxable to the shareholders under sections 301 and 316. The retained earnings and profits of a DISC that are not taxed currently remain exempt from taxation until they are actually distributed to the shareholders, until a shareholder disposes of his DISC stock in a taxable transaction or until the corporation ceases to qualify as a DISC. Secs. 996(a)(1), 995(c) and 995(b)(2). Subject to certain restrictions, a DISC is allowed to transfer additional funds to its shareholders in the form of a ‘producer's loan.‘
In order to qualify as a DISC, at least 95 percent of the adjusted basis of all assets of the corporation, measured on the last day of the taxable year, must be qualified export assets. Sec. 992(a)(1)(B); Goldberger, Inc. v. Commissioner, 88 T.C. 1532, 1542 (1987). The term ‘qualified export asset,‘ as defined in section 993(b), includes accounts receivables. Sections 1.993-2(a)(3) and 1.993-2(d)(2), Income Tax Regs., provide generally that a DISC's accounts receivable will be qualified export assets if the receivables arise as commissions earned by a commission DISC.
Where, however, the domestic parent corporation of the commission DISC is a ‘related supplier‘ of the DISC, the circumstances under which commissions receivable are treated as qualifying export assets are restricted by the regulations. A related supplier is a person or corporation who is owned or controlled by the same parties who own or control the DISC and who deals individually with the DISC in a transaction which is controlled by section 994. The purview of section 994 includes a transaction in which the DISC is a commission agent for the related supplier on sales of export property to third parties such as the transactions between APC and AI. Sec. 1.994- 1(a)(3) and (b)(1), Income Tax Regs. In such a case, the amount of commissions receivable that qualify as qualified export assets for each tax year must be paid by the parent corporation to the DISC within 60 days after the close of the DISC's taxable year. Sec. 1.994-1(e)(3)(i), Income Tax Regs.
The pertinent provisions of section 1.993-2(d)(2), Income Tax Regs., provide:(2) Trade receivables representing commissions. If a DISC acts as commission agent for a principal in a transaction * * * which results in qualified export receipts for the DISC, and if an account receivable or evidence of indebtedness held by the DISC and representing the commission payable to the DISC as result of the transaction arises * * * such account receivable or evidence of indebtedness shall be treated as a trade receivable. If, however, the principal is a related supplier (as defined in section 1.994- 1(a)(3)) with respect to the DISC, such account receivable of evidence of indebtedness will not be treated as a trade receivable unless it is payable and paid in a time and manner which satisfy the requirements of section 1.994-1(e)(3) * * *Section 1.994-1(e)(3)(i), Income Tax Regs., provides in pertinent part:(i) The amount * * * a sales commission (or reasonable estimate thereof) actually charged by a DISC to a related supplier * * * must be paid no later than 60 days following the close of the taxable year of the DISC during which the transaction occurred.
CHABOT, WHITAKER, KORNER, HAMBLEN, CLAPP, and GERBER, JJ., agree with this dissent.
1 Unless otherwise indicated all section references are to the Internal Revenue Code of 1954, as amended and in effect during the years in issue and all Rule references are to the Tax Court Rules of Practice and Procedure.
2 On December 28, 1979, APC and AI entered into a subsequent franchise agreement which amended certain aspects of the initial franchise agreement. However, the alterations were minor and do not concern the taxable years in issue here.
3 Under section 6072(b) a DISC's tax return is due on or before the fifteenth day of the ninth month following the close of its taxable year.
4 The parties have stipulated that the producer's loan of October 20, 1977, was not, in its entirety, a qualified producer's loan. Of that amount, only $634,299 was a qualified producer's loan and the balance, in the amount of $507,101, did not qualify as a producer's loan.
5 October 19, 1977, the actual date of the commission payment for the taxable year 1976, was more than seven months after the date when payment should have been made in order to comply with the 60-day payment rule. The due date was March 1, 1977. When APC made the payment it included a portion labeled interest accruing for this seven month extension.
6 Secs. 501-507 of the Revenue Act of 1971, Pub. L. 92-178, 85 Stat. 497, 535-553.
7 The parties agree that AI is a commission DISC rather than a buy-sell DISC.
Since APC was a related supplier with respect to AI, AI's commissions receivable from APC had to be paid within 60 days following the close of AI's taxable year in order for such commissions receivable to constitute trade receivables and, accordingly, qualified export assets, under section 1.993-2(d)(2), Income Tax Regs. It is undisputed that APC did not, in fact, pay the commissions it owed to AI within the 60 days following the close of AI's taxable years 1976 and 1977 and that therefore, under the unambiguous language of the regulations, the commissions owed for the taxable years 1976 and 1977 do not constitute qualified export assets. Therefore, if the commissions in issue are not qualified export assets, AI was not qualified as a DISC in 1976 and 1977 because less than 95 percent of the basis of its total assets was attributable to qualified export assets.
Petitioner first argues that the regulations imposing the 60-day payment rules are invalid. Petitioner maintains that the regulations are interpretive, rather than legislative regulations, and, as such, they exceed the scope of the Secretary's authority under section 7805. This very question has been considered on several prior occasions and the regulations have consistently been upheld as representing a proper exercise of the Secretary's authority. Gehl Co. v. Commissioner, supra; CWT Farms, Inc. v. Commissioner, 755 F.2d 790 (11th Cir. 1985) affg. 79 T.C. 1054 (1982); LeCroy Research Systems Corp. v. Commissioner, 751 F.2d 123 (2d Cir. 1984), revg. on other grounds T.C. Memo. 1984-145; Thomas International Ltd. v. United States, 773 F.2d 300 (Fed. Cir. 1985). Because this point is well settled, we will not exhume it today.
Petitioner next contends that, even if the regulations which contain the 60-day payment rules are valid, the regulations may not be retroactively applied to it. Section 1.994-1(e)(3), Income Tax Regs., which contained the 60-day payment rule, was proposed on September 21, 1972, and promulgated in final form on September 29, 1976. Section 1.993-2(d)(2), Income Tax Regs., which applied the 60- day payment rule to the accounts receivable of commission DISCs, was proposed on October 4, 1972, and promulgated in final form on October 14, 1977. APC's commission payment to AI for the taxable year 1978 occurred on October 14, 1977, just five days after the regulations were promulgated in final form. Although the officers and directors of APC were aware that the regulations existed in proposed form, they did not know that the regulations had been promulgated in final form until nearly six months later, in March of 1978. At that time APC made the commission payment owing to AI for the taxable year 1977. The 60-day payment rule was not mentioned in the Handbook.
STERRETT
WHALEN, J., dissents.
DISSENT OF JUDGE GERBER
GERBER, J., DISSENTING:
The majority has overruled our recent and well reasoned opinion in CWT Farms, Inc. v. Commissioner, 79 T.C. 1054 (1982), which was embraced and affirmed by the Court of Appeals for the Eleventh Circuit at 755 F.2d 790 (11th Cir. 1985). I respectfully dissent because the majority has not provided adequate rationale in support of its decision to overrule our established and affirmed precedent. Also, the majority has ignored long established principles concerning the retroactive application of regulations.
All courts which have considered the final regulations in question have found them to be valid and ‘consistent with the statutes' origin and purpose.‘ CWT Farms, Inc. v. Commissioner, 755 F.2d 790, 797-802 (11th Cir. 1985), affg. 79 T.C. 1054, 1061-1067 (1982); Gehl Co. v. Commissioner, 795 F.2d 1324, 1327 (7th Cir. 1986); LeCroy Research Systems Corp. v. Commissioner, 751 F.2d 123 (2d Cir. 1984); Thomas International Ltd. v. United States, 773 F.2d 300 (Fed. Cir. 1985). The Courts of Appeals for both the Second and Seventh Circuits have decided that the regulations should not be retroactively applied, whereas this Court and Court of Appeals for the Eleventh Circuit have held otherwise.
Judge Simpson, in his thorough analysis of the retroactivity of regulations, set forth the following three principles (each of which was, at very least, supported by a Supreme Court citation), as follows: (1) ‘Internal Revenue regulations are retroactive in effect unless the Commissioner provides otherwise.‘ (2) ‘The Commissioner's failure to make regulations nonretroactive may not be disturbed unless it amounts to an abuse of discretion.‘ (3) ‘An abuse of discretion may be found if the retroactive regulations alter settled prior law or policy upon which the taxpayer justifiably relied and if the change causes the taxpayer to suffer inordinate harm.‘ CWT Farms, Inc. v. Commissioner, 79 T.C. at 1068.
Our Court and the Court of Appeals for the Eleventh Circuit considered two bases in deciding whether the situation involved herein presented an exception to the general rule that regulations are to be retroactively applied. First considered was the principle that statements contained in publications, such as the handbook in question, do not bind the Commissioner in subsequent litigation. See cases cited at 79 T.C. 1069. Although that general principle is appropriate in most circumstances, one might reasonably argue that the handbook in question had a more significant stature or that it was in other ways extraordinary.
DISSENT OF JUDGE RUWE
RUWE, J., DISSENTING:
For the following reasons, I do not agree with the majority's holding that petitioner, a former DISC, was the proper taxpayer with respect to income attributed to it for the year 1977.
The majority opinion is based on a concern that were we to find petitioner totally lacking in substance, this ‘would, in effect, be calling a DISC a sham corporation‘ and thus undermine the purpose of the DISC legislation. Majority opinion at p. 23. We need not be concerned with undermining the purpose of the DISC legislation in this case for the simple reason that petitioner was not a DISC during 1977.
The majority opinion implies that even though petitioner was disqualified, it was still a DISC for some purposes. Section 992(a)(1) defines a DISC. Petitioner failed to meet the qualifications for DISC status which are contained in section 992(a)(1)(B) and section 993(b) and the regulations thereunder. This is undisputed. Section 992(a)(3) defines a ‘former DISC‘ as ‘with respect to any taxable year, a corporation WHICH IS NOT A DISC FOR SUCH YEAR but was a DISC in a preceding taxable year.‘ (Emphasis added.) Section 1.992-1(e), Income Tax Regs., states that ‘A corporation is a DISC for a taxable year ONLY if such an election is in effect for that year AND the corporation also satisfies the requirements of paragraphs (a) through (d) of this section.‘ (Emphasis added.) The majority opinion has already found that petitioner failed the test contained in section 1.992-1(c), Income Tax Regs., which is the same requirement set forth in section 992(a)(1)(B).
It is true that once having made an election to be treated as a DISC, a corporation that fails to qualify as a DISC for a particular year will be considered as a DISC for subsequent years in which it meets DISC qualifications. There is no need to make another election. See sec. 1.992-2(d), Income Tax Regs. However, the benefits of tax deferral available through the DISC arrangement are simply unavailable for export transactions occurring during a year when the former DISC is disqualified. Arrangements related to foreign sales transactions during a year when a former DISC is not qualified should be judged using the same criteria that we would use in judging the substance of any other corporate transactions.