Brown-Forman Corp. v. Commissioner

955 F.2d 1037

• Court: Court of Appeals for the Sixth Circuit
• Decided: February 3, 1992
• Docket: No. 91-1108
• Status: Published

Opinions

SUHRHEINRICH, Circuit Judge.

The Brown-Forman Corporation appeals a decision of the United States Tax Court holding that, for the purposes of computing the overall profit percentage limitation, Treas.Reg. § 1.994-2(b)(3), the taxpayer’s gross receipts are not reduced by federal excise taxes paid during the tax year. We affirm.

I

The Brown-Forman Corporation now holds all the assets of the Southern Comfort Corporation (“Southern Comfort”). Southern Comfort engages in the production and sale of Southern Comfort liqueur for domestic consumption and for export to foreign markets. In 1981 and 1983, Southern Comfort conducted export sales through a Domestic International Sales Corporation (“DISC”), Jack Daniel International (“JDI”).

Congress enacted legislation permitting the establishment of DISCs out of concern over the balance of trade. Congress found that tax considerations were causing domestic companies to supply foreign markets through foreign subsidiaries rather than by exporting domestically produced commodities. The DISC legislation was adopted as a vehicle through which domestic enterprises would receive a tax deferral for export-related income, providing an incentive to produce goods for export in the United States.

The actual process by which a DISC yields a tax deferral is fairly complicated. The DISC does not pay tax on its income. Instead, the DISC’S shareholders, typically the domestic producer that conducts export activities through the DISC, are taxed on a specified percentage of the DISC’S current income. The remainder of the DISC’S income is not taxed until it is actually distributed to shareholders, the shareholders dispose of their stock, or the corporation ceases to qualify as a DISC. I.R.C. § 995(b)-(c). Thus, the more income allocated to the DISC, the greater the tax deferral.

The Internal Revenue Code provides three methods to determine the amount of income that may be allocated to a DISC. At issue in this case is the Combined Taxable Income method. This method allocates to the DISC fifty percent of the combined taxable income of the DISC and its related supplier, in this case Southern Comfort, attributable to export sales plus ten percent of the DISC’S export promotion expenses. I.R.C. § 994(a)(2).¹ Combined taxable income is generally derived using the full costs involved in generating the export income. Thus, combined taxable income is equal to gross receipts from export sales minus the total costs of these sales to the DISC and its related supplier. Treas. Reg. § 1.994-1(c)(6).

As an exception to this general formula, the Commissioner of Internal Revenue has promulgated regulations allowing a taxpayer to compute combined taxable income using the marginal, rather than full, costs of the DISC and its related supplier. This exception applies only if the DISC is “seeking to establish or maintain a foreign market.” Treas.Reg. § 1.994-2(a). However, the combined taxable income derived through marginal costing may not exceed the Overall Profit Percentage Limitation (“OPPL”). The OPPL restricts the combined taxable income from export sales of a DISC and its related supplier to “gross receipts (determined under [Treas.Reg.] § 1.993-6) ... multiplied by the overall profit percentage.” Id. § 1.994-2(b)(3). The overall profit percentage is the combined worldwide taxable income of the DISC and its related supplier (including the related supplier’s income from domestic sales) divided by its worldwide gross receipts, determined under § 1.993-6. Expressed mathematically,

Comb. Taxable Income (export)

Combined Taxable Income (worldwide) Gross Receipts (worldwide)

X

Gross Receipts (export).

The effect of this provision is to allow a DISC that is establishing or maintaining an export market to use marginal costing only to the extent that the profitability of its export activities does not exceed the profitability of the corporation’s worldwide activities, including domestic sales.

In their original returns for 1981 and 1983, Southern Comfort and JDI did not use marginal costing to compute DISC commissions. However, Southern Comfort and JDI have filed amended returns for these years that utilize marginal costing. In computing the OPPL, Southern Comfort and JDI reduced worldwide gross receipts by the amount of federal excise tax paid.

A federal excise tax is imposed on each proof gallon of distilled spirits sold for domestic consumption. I.R.C. § 5001(a)(1). This tax liability is represented by a lien attaching at the moment the distilled spirits are created. Id. § 5004. The lien and tax liability are extinguished when the spirits are exported. The distiller retains tax liability for spirits not exported, even after the distiller sells the spirits for consumption. Distillers, including Southern Comfort, typically recoup this liability by increasing the price of the spirits by a corresponding amount.

The issue raised here is whether worldwide gross receipts include funds received in domestic sales that are used to pay the federal excise tax.

II

The regulations establishing the OPPL expressly adopt the definition of “gross receipts” contained in Treas.Reg. § 1.993-6, see Treas.Reg. § 1.994—2(b)(3); id. § 1.994—2(c)(2), which defines gross receipts as “[t]he total amounts received or accrued by the person from the sale or lease of property held primarily for sale or lease in the ordinary course of a trade or business....” Treas.Reg. § 1.993-6(a). “The total amounts received” plainly includes excise tax receipts.

The Ninth Circuit construed a similar definition of gross receipts in Lucky Lager Brewing Co. v. Commissioner, 246 F.2d 621 (9th Cir.1957). At issue in Lucky Lager was interpretation of I.R.C. § 435, enacted to recapture “excess profits” that manufacturers received during the Korean War. In particular, the court was asked whether gross receipts included excise taxes paid by the manufacturer and passed on to its customers. The Ninth Circuit held that “[t]he language ... that ‘gross receipts’ are ‘the total amount received or accrued ... from the sale ... of stock in trade’ is irrefutably plain.” Id. at 623 (quoting I.R.C. § 435(e)). The court continued, “[i]t is a logical absurdity to contend that the ‘total amount received’ from the sales is not what the customer paid but a lesser amount determined by a deduction of a particular tax paid, here required to be paid and in fact paid by the seller, before the delivery of the [goods].” Id.

Southern Comfort urges us to ignore the definition in section 1.993-6 in favor of interpreting gross receipts under Treas. Reg. § 1.936-(5)(b)(5) (Q & A #1). This regulation excludes federal excise taxes from the computation of gross receipts from sales of “possession products.” But this section does not apply to DISCs. See I.R.C. § 936(f). Given the clarity of the definition of gross receipts in section 1.993-6, we are unmoved by Southern Comfort’s argument.

Southern Comfort contends that the OPPL is designed to limit export profitability, derived under marginal costing, to worldwide profitability. If worldwide profitability is computed without a reduction for excise taxes, the argument continues, worldwide profitability ceases to be a valid parameter because export profitability does not include excise taxes. This argument assumes its conclusion: that excise taxes are not a valid component of worldwide profitability.

This assumption is misplaced. The federal excise tax is a cost of doing business. See Thompson v. United States, 142 U.S. 471, 12 S.Ct. 299, 35 L.Ed. 1084 (1892); Schenley Distillers, Inc. v. United States, 255 F.2d 334 (3d Cir.1958). Liability for the federal excise tax attaches when the distilled spirits come into existence and remains constant regardless of the price the customer pays. Southern Comfort did not add the excise tax separately to the sales price on customer invoices or otherwise differentiate this amount. It did not, and was not required to, maintain a separate bank account to hold and pay the excise tax. Because tax liability attached as soon as the distilled spirits were created, Southern Comfort was liable for the tax regardless of its ability to pass this cost on to customers. It is thus perfectly appropriate to consider excise taxes when determining profitability.

Ill

Southern Comfort also argues that the inclusion of federal excise taxes among its gross receipts exceeds the scope of the commissioner’s authority. Treasury regulations are to be accorded deference and “ ‘must be sustained unless unreasonable and plainly inconsistent with the revenue statutes.’ ” Commissioner v. Portland Cement Co., 450 U.S. 156, 169, 101 S.Ct. 1037, 1045, 67 L.Ed.2d 140 (1981) (quoting Commissioner v. South Texas Lumber Co., 333 U.S. 496, 501, 68 S.Ct. 695, 698, 92 L.Ed. 831 (1948)). Even greater deference is accorded to legislative regulations. Rowan Cos. v. United States, 452 U.S. 247, 253, 101 S.Ct. 2288, 2292, 68 L.Ed.2d 814 (1981).²

According to Southern Comfort, Congress created DISCs to put exporters in the shoes of foreign subsidiaries. This, however, is inaccurate. Congress sought only to create an incentive for domestic corporations to export their goods. For instance, federal tax is generally not paid on the income of a foreign subsidiary until that income is distributed to the subsidiary’s shareholders in the United States. However, DISCs must pay tax on a fixed percentage of their income in the year it is acquired, regardless of whether the DISC distributes any income. I.R.C. § 995(a). This discrepancy indicates that by establishing the DISC, Congress did not attempt or intend to replicate precisely the treatment of a foreign subsidiary. Even if gross receipts are not reduced by payments attributable to the federal excise tax, Southern Comfort receives a tax deferral through its DISC and may still employ marginal costing.

Southern Comfort claims that the OPPL allocates the cost of excise taxes to export sales, which exceeds the Commissioner’s authority because excise taxes are a solely domestic cost. This argument is misconceived. The OPPL does not allocate costs; it serves to limit the profitability under marginal costing of a DISC and its related supplier to the related supplier’s worldwide profitability. Because no reduction for excise taxes is allowed, this cost decreases worldwide profitability and limits the combined taxable income of the DISC and its related supplier. However, the same is true for any other exclusively domestic cost.

By accepting the validity of the OPPL scheme, Southern Comfort accepts that worldwide profitability is an appropriate limit on the use of marginal costing.³ Although a particular cost of doing business is exclusively domestic, it may nevertheless be a valid component of worldwide profitability. As indicated earlier, federal excise taxes are properly viewed as a cost of doing business. See Thompson v. United States, 142 U.S. 471, 12 S.Ct. 299, 35 L.Ed. 1084 (1892); Schenley Distillers, Inc. v. United States, 255 F.2d 334 (3d Cir.1958). Thus, it is neither unreasonable nor inconsistent with the revenue statutes that gross receipts are not reduced to exclude payments attributable to the federal excise tax.

IV

For the foregoing reasons, we affirm the decision of the Tax Court.

1 . Section 994(a)(1) allows a DISC to earn taxable income equal to four percent of combined taxable income plus 10% of its export promotion expenses. Section 994(a)(3) allows a DISC to earn income based on the actual price charged by its related supplier, subject to the arm’s length pricing rules of section 482.

These rules apply to "buy/sell” DISCs, those that actually purchase product from a related supplier and resell them on an export market. Some DISCs, such as JDI, never actually purchase the product exported. Instead, they arrange export sales on a commission basis. These are referred to as commission DISCs. Section 994(b) directed the commissioner to promulgate regulations governing the computation of taxable income for commission DISCs in a manner consistent with the three methods set forth in section 994(a). In Treas.Reg. § 1.994-1(c)(1)-(4), the commissioner established rules that give commission DISCs the same options for income computation that are available to buy/sell DISCs.

2 . A legislative regulation is promulgated pursuant to specific congressional direction. An interpretive regulation is issued in the absence of a specific directive in order to interpret a congressional enactment. The OPPL is a legislative regulation promulgated in response to I.R.C. § 994(b)(2), which directed the commissioner to prescribe "rules for the allocation of expenditures in computing combined taxable income ... where a DISC is seeking to establish or maintain a[n export] market.” Id.

3 . In considering marginal costing, the House and Senate committees both stated:

Where a DISC is attempting to establish a market abroad, or seeking to maintain a market abroad, for exports, the Secretary of the Treasury may prescribe by regulations special rules governing the allocation of expenses incurred on the sale of the export property for purposes of determining the combined taxable income of the related person and the DISC. It is expected that in the appropriate cases the regulations will allow, for purposes of applying the second pricing rule, the combined taxable income on the sale of export property to reflect a profit equal to that which a DISC and a related party would earn if they took into account only the marginal costs of producing the property.

H.R.Rep. No. 92-533, at 75; S.Rep. No. 93-427, at 108. We read this passage to indicate an intent to have the commissioner promulgate marginal costing rules "in the appropriate cases.” The dissent defines appropriate cases as any instance where a DISC is attempting to establish or maintain an export market. However, the report’s first sentence directs the commissioner to issue regulations governing the allocation of expenses between a DISC and its related supplier for DISCs seeking to establish or maintain an export market. The second sentence directs the commissioner to promulgate marginal costing regulations in the appropriate cases. Given this structure, “in the appropriate cases” modifies attempting to establish or maintain an export market; that is, not all instances where a DISC is attempting to establish or maintain an export market are appropriate cases for full marginal costing, and the OPPL determines the extent to which it is appropriate for a particular DISC to use marginal costing. As we have explained, the OPPL limits the use of marginal costing to worldwide profitability. In so doing, the commissioner has determined "the appropriate cases” to be those cases in which export profitability does not exceed worldwide profitability. This does not exceed the scope of the commissioner’s authority.