Texaco, Inc. v. Commissioner

                    UNITED STATES COURT OF APPEALS
                         For the Fifth Circuit
                      ___________________________

                            No. 95-60696
                     ___________________________



                   TEXACO, INC. and SUBSIDIARIES,

                                                Petitioner-Appellee,

                                  VERSUS


                  COMMISSIONER OF INTERNAL REVENUE,

                                               Respondent-Appellant.
         ___________________________________________________

               Appeal from the United States Tax Court
        ____________________________________________________

                           October 17, 1996

Before DAVIS, JONES and EMILIO M. GARZA, Circuit Judges.

DAVIS, Circuit Judge:

     The Commissioner of Internal Revenue challenges the Tax Court's

legal conclusion that Letter 103/z, a 1979 pronouncement of Saudi

Arabian oil policy by the Saudi Arabian Oil Minister, prohibits the

Commissioner from exercising her authority to reallocate income under

26 U.S.C. §§ 482 and 61 (1994).    We affirm.

                                   I.

     Texaco, Inc. is the parent corporation of a group of entities

engaged in the production, refining, transportation, and marketing of

crude oil and refined products in the United States and abroad. Texaco

has a number of subsidiary/affiliate corporations under its umbrella.

One of those affiliates is Texaco International Trader, Inc. (Textrad),

which acted as the international trading company for the worldwide
Texaco refining and marketing system during the period in question.

As the trading company, Textrad purchased Saudi crude oil from the

Saudi government by way of the Arabian American Oil Company (Aramco)

and resold that crude to both affiliates and unrelated customers.

     The Commissioner contends that Textrad unduly shifted profits to

its foreign affiliates during taxable years 1979-81, and she increased

Textrad’s U.S. taxable income for those years under §§ 4821 and 61 of

the Internal Revenue Code to reflect those profits. Texaco argues that

it had no power to control the allocation of profits on Saudi Oil

during those years because of the restrictions imposed by Letter 103/z,

which required Texaco and the other Aramco members to re-sell Saudi

Arabian crude at specified below market prices.         The Tax Court

conducted a lengthy trial and entered detailed findings of fact, which

we need not repeat here.     We state only those facts necessary to

understand our opinion.

                                  A.

     From early 1979 through late 1981, Saudi Arabia permitted Texaco

and the other Aramco participants to buy Saudi Arabian crude oil at

below market prices.      The Saudi government also established the


     1
         26 U.S.C. § 482 (1994) states:
     In any case of two or more 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 interests, the Secretary may distribute, apportion,
     or allocate gross income, deductions, credits, or allowances
     between or among such organizations, trades, or businesses,
     if he determines that such distribution, apportionment, or
     allocation is necessary in order to prevent evasion of taxes
     or clearly to reflect the income of any such organizations,
     trades, or businesses.

                                   2
official selling price (the OSP) for Saudi Arabian crude below the

market price.    The Saudi government took these actions in response to

requests by the United States and other consuming countries to moderate

the price of crude oil.      To ensure its price regulation had its

intended effect, the Saudi government prohibited Texaco and other

participants in Aramco from re-selling Saudi crude at prices higher

than the OSP.      As the Tax Court found, these restrictions were

authorized by the King and communicated to Aramco by Minister Yamani

in Letter 103/z, dated January 23, 1979.2   Except in instances where it

was excused from doing so, Textrad complied with Letter 103/z and

resold the Saudi crude at the OSP.

        During the period in question, Textrad sold approximately 34

percent of its Saudi crude or about 780,000,000 barrels to its refining

affiliates.    Of these, approximately 275,000,000 barrels were sold to

Texaco's domestic refining company and 505,000,000 barrels to Texaco's

foreign refining affiliates.3   Textrad also sold 15-20 percent of its

Saudi oil at the below market OSP to customers that were completely

unrelated to Texaco.   This was consistent with the pattern and volume

of Textrad's sales to unrelated customers in earlier years.   Moreover,

the Tax Court specifically found that any changes in Textrad’s sales

to both its affiliates and its unrelated customers during this period

were not related to the Saudi price restrictions.


    2
      Paragraph 5 of Letter 103/z required Texaco and the other Aramco
participants “to pledge that they will not sell to a third party at
prices in excess of what we have specified herein.”
    3
       Any profits made by Texaco's domestic affiliates from the sale
of products refined from this oil were included in Texaco's United
States taxable income.

                                   3
     The restrictions in Letter 103/z, however, applied only to Saudi

crude, not to the sale of products refined from Saudi crude.      As a

result, the companies that bought Saudi crude from Textrad at the below

market OSP, including Texaco’s refining affiliates, earned        large

profits from the sale of refined products.        Unlike its domestic

affiliates, Texaco's foreign refining affiliates reported no taxable

income in the United States.

                                  B.

     The commissioner alleges that Textrad shifted profits attributable

to the lower cost of Saudi crude out of Texaco's U.S. taxable income

when it sold Saudi crude at the OSP to its foreign refining affiliates.

The Commissioner reallocated over $1.7 billion in income to Textrad for

taxable years 1979, 1980, and 1981.    Following a five-week trial, the

Tax Court issued a detailed opinion.      The Tax Court held that the

Commissioner was precluded from allocating income to Texaco under §§

482 and 61 because the price restrictions in Letter 103/z were the

"virtual equivalent of law," which Texaco was required to obey.

     The Tax Court supported this conclusion with a number of factual

findings, including the following:

     1.    The Saudi government, with the approval of the King, issued

Letter 103/z prohibiting the resale of Saudi crude at amounts exceeding

the OSP.

     2.    Texaco was subject to that restriction and faced severe

economic repercussions, including loss of its supply of Saudi crude and

confiscation of its assets, if it violated Letter 103/z.

     3. This mandatory price restriction applied to all sales of Saudi


                                   4
crude, including sales to affiliated entities.

     4.   Neither Texaco nor any other Aramco participant had any power

to negotiate or alter the terms of this restriction.

     Based on its findings that Texaco was obligated to comply, and did

comply, with the Saudi government’s price restrictions, the Tax Court

concluded that Texaco's pricing policy to its foreign affiliates as

well as its unrelated customers was due to these restrictions and not

to any attempt to distort its true income for tax purposes. The

Commissioner has appealed the order disallowing the allocation.

                                  II.

                                   A.

     Based on the Tax Court’s factual findings, which are not clearly

erroneous, we agree that Letter 103/z had the effect of a legal

restriction in Saudi Arabia.      The 1979 pricing requirements were

authorized by the King and issued by Minister Yamani on behalf of the

Saudi government as mandatory restrictions. These restrictions applied

to all sales of Saudi crude by the Aramco participants and others. The

restrictions were in effect during the period at issue and were

followed by Texaco. The Tax Court's findings of fact fully support its

conclusion that Letter 103/z should be given the effect of law for

purposes of §§ 482 and 61.

     We also agree with the Tax Court's legal conclusion that the

teaching of Commissioner v. First Security Bank, 405 U.S. 394 (1972),

bars the Commissioner from allocating income to Textrad on its sales

of Saudi crude under § 482.   Because the sales price of the crude is

governed by Letter 103/z, Texaco did not have the power to control the


                                   5
sales price of the oil.

     Section 482 of the Internal Revenue Code authorizes the Secretary

to apportion or allocate income between organizations controlled by the

same interests “if he determines that such distribution, apportionment,

or allocation is necessary in order to prevent evasion of taxes or

clearly to reflect the income of any such organizations . . . .”    26

U.S.C. § 482.   The relevant IRS regulation explains that the purpose

of § 482 is “to place a controlled taxpayer on a tax parity with an

uncontrolled taxpayer” and to ensure that controlling entities conduct

their subsidiaries’ transactions in such a way as to reflect the “true

taxable income” of each controlled taxpayer. 26 C.F.R. § 1.482-1(b)(1)

(1996).4   The regulation further explains that “[t]he standard to be

applied in every case is that of an uncontrolled taxpayer dealing at

arm’s length with another uncontrolled taxpayer.”   Id.


     4
         26 C.F.R. § 1.482-1(b)(1) reads in full:

     The purpose of section 482 is to place a controlled taxpayer
     on a tax parity with an uncontrolled taxpayer, by
     determining, according to the standard of an uncontrolled
     taxpayer, the true taxable income from the property and
     business of a controlled taxpayer.           The interests
     controlling a group of controlled taxpayers are assumed to
     have complete power to cause each controlled taxpayer so to
     conduct its affairs that its transactions and accounting
     records truly reflect the taxable income from the property
     and business of each of the controlled taxpayers.        If,
     however, this has not been done, and the taxable incomes are
     thereby understated, the district director shall intervene,
     and, by making such distributions, apportionments, or
     allocations as he may deem necessary of gross income,
     deductions, credits, or allowances, or of any item or
     element affecting taxable income, between or among the
     controlled taxpayers constituting the group, shall determine
     the true taxable income of each controlled taxpayer. the
     standard to be applied in every case is that of an
     uncontrolled taxpayer dealing at arm's length with another
     uncontrolled taxpayer.

                                   6
      In First Security, the Court held that § 482 did not authorize the

Commissioner to allocate income to a party prohibited by law from

receiving it.       405 U.S. at 404.            In that case, two related banks

offered    credit    life    insurance   to      their   customers.     Federal   law

prohibited the banks from acting as insurance agents and receiving

premiums or commissions on the sale of insurance.                The banks referred

their customers to an unrelated insurance company to purchase this

insurance.     The insurance company retained a small percent of the

premiums for administrative services and transferred the bulk of the

premiums through a reinsurance agreement to an insurance company

affiliated with the banks, which reported all of the reinsurance

premiums it received as income.             The Commissioner reallocated 40% of

the related insurance company’s income from these reinsurance premiums

to   the   banks    as   compensation    for     originating    and   referring   the

insurance business.         Id. at 396-99.

      The Court concluded that due to the restrictions of federal

banking law, the holding company that controlled the banks and the

insurance affiliate did not have the power to shift income among its

subsidiaries.        In     so   holding,       the   Court   emphasized   that   the

Commissioner’s authority to allocate income under § 482 presupposes

that the taxpayer has the power to control its income: “The underlying

assumption always has been that in order to be taxed for income, a

taxpayer must have complete dominion over it.”                 Id. at 403.   Indeed,

as the Court noted, the Commissioner’s own regulations for implementing

§ 482 contemplate that the controlling interest “must have ‘complete

power’ to shift income among its subsidiaries.” Id. at 404-05 (quoting


                                            7
26 C.F.R. § 1.482-1(b)(1) (1971)).

     Moreover, the regulations and First Security make clear that this

standard is not limited to cases where the government contends the

taxpayer attempted to evade taxes.          Rather, the Court explicitly

extends its reasoning to circumstances where the government contends

that the organization's “true taxable income” has not been reflected.5

After explaining that the right to control the allocation of income is

critical, the Court stated:      "It is only where this power exists, and

has been exercised in such a way that the ‘true, taxable income’ of a

subsidiary has been understated, that the Commissioner is authorized

to reallocate under § 482. . . . The ‘complete power’ referred to in

the regulations hardly includes the power to force a subsidiary to

violate the law."    Id. (emphasis added).    Because the holding company

in First Security could not have allocated the income to the banks

unless it acted in violation of the law, the Court concluded that the

banks’   true   income   was   not   understated   and   the   Commissioner’s

allocation under § 482 was improper.



     5
        We find no indication from the facts and contentions of the
parties in First Security that the government contended that the banks
or the holding company sought to evade taxes. Rather, First Security
explains in general terms the type case § 482 is designed to reach
without distinguishing between claims of evasion and other claims that
the true income of the taxpayer has not been reflected: "The question
we must answer is whether there was a shifting or distorting of the
[taxpayers] true net income." Id. at 400-401 (emphasis added); see also
id. at 407 (concluding that because the holding company “did not
utilize its control over the [banks and the affiliated insurance
company] to distort their true net incomes,” the Commissioner could not
exercise his § 482 authority) (emphasis added). This is consistent
with the approach and structure of the regulation, which also does not
distinguish between evasion and other conduct that fails to reflect the
true taxable income of the taxpayer.      See 26 C.F.R. § 1.482(b)(1)
(1996).

                                       8
       The    Sixth     Circuit     decision        in   Procter     &   Gamble        Co.     v.

Commissioner, 961 F.2d 1255 (6th Cir 1992) also supports the Tax

Court's conclusion.           In that case, the court held that a Spanish law

prohibiting a foreign affiliate from paying royalties for the use of

patents was sufficient to preclude the Commissioner from reallocating

income to account for a reasonable royalty. The court stated that “the

purpose of § 482 is to prevent artificial shifting of income between

related taxpayers.”           Id. at 1259 (emphasis added).            Again the deciding

issue was one of control: “Because Spanish law prohibited royalty

payments, [the controlling company] could not exercise the control that

§ 482 contemplates, and allocation under § 482 is inappropriate.”                             Id.

at 1259.     See also L.E. Shunk Latex Products, Inc. v. Commissioner, 18

T.C.   940    (1952)     (holding      that    Commissioner        could    not    allocate

additional income to condom manufacturer where manufacturer sold

condoms      to   its    affiliate      at    price      set    by     Office     of     Price

Administration, even though affiliate made substantial profits on the

transactions).

       It is precisely this ability to control the flow of its income

that Texaco lacked.           The Tax Court found, and we agree, that Letter

103/z had the force and effect of law, that Textrad was obligated to

comply with its requirements, and that it did so comply.                               Because

Textrad      lacked     the    power   to    sell    Saudi     crude     above    the        OSP,

reallocation under § 482 is inappropriate.

                                              B.

       The Commissioner tries to justify the allocation by analogizing

Texaco’s conduct to an “assignment of income” and places much reliance


                                              9
on the Supreme Court’s decision in United States v. Basye, 410 U.S. 441

(1973).     However, nothing in Basye is contrary to the principles

discussed above, and the Commissioner’s reliance on this case is

misplaced.

      In Basye, the Court relied on familiar principles “that income is

taxed to the party who earns it and that liability may not be avoided

through an anticipatory assignment of that income” to hold that a group

of doctors’ failure to actually receive a portion of their compensation

that was instead placed in a retirement trust did not preclude the

Commissioner from allocating that income to them.              Id. at 457.      The

Court found that the sole reason the doctors could not receive the

challenged    portion    of   their   income     was   because   their    medical

partnership had agreed with a health plan foundation to service the

foundation’s members for free in exchange for contributions to a

retirement trust.    Id. at 449.

      The Court’s holding in Basye turned on the consensual nature of

the agreement and is entirely consistent with the principles of control

expressed in the regulations adopted under § 482 and in First Security.

As   the   regulations   make   clear,    the   goal   of   inquiring    into   the

transactions of controlled taxpayers under § 482 is “to ascertain

whether the common control is being used to reduce, avoid or escape

taxes.” 26 C.F.R. § 1.482-1(c) (1996).          The Court in Basye agreed with

the Commissioner that the doctors’ compensation scheme was entirely

voluntary -- that the medical partnership possessed common control and

used it to reduce, avoid, or escape taxes.         That the doctors exercised

that control prior to their actual possession of the income was


                                         10
irrelevant.

     But where, as here, the taxpayer lacks the power to control the

allocation of the profits, reallocation under § 482 is inappropriate.

As stated above, we fully agree with the Tax Court that Letter 103/z

deprived Textrad of the power to sell Saudi crude to its foreign

refining affiliates for a price that exceeded the OSP.     Because Texaco

lacked the ability to control the allocation of the income in question,

it follows that it could not have used its control to evade taxes or

artificially shift its income to its foreign affiliates so that its

true taxable income was not reflected.

                                  C.

     Nor would the Commissioner’s proposed allocation be consistent

with § 482's goal of achieving tax parity between controlled and

uncontrolled   taxpayers.   As   the   First   Security   Court   and   the

regulations make clear, the “‘purpose of § 482 is to place a controlled

taxpayer on a tax parity with an uncontrolled taxpayer.’”     405 U.S. at

407 (citing 26 C.F.R. § 1.482-1(b)(1) (1971)).    Thus, “[t]he standard

to be applied in every case is that of an uncontrolled taxpayer dealing

at arm’s length with another uncontrolled taxpayer.”         26 C.F.R. §

1.482-1(b)(1) (1996).

     The record evidence fully supports the Tax Court’s findings that

Textrad sold significant amounts of Saudi crude to unrelated customers

at the same OSP it sold to its affiliates, that the volume of Textrad’s

sales of Saudi crude to unrelated customers during this period remained

generally consistent with historic levels, and that any changes in

Textrad’s sales to its affiliates and its unrelated customers during


                                  11
this period had no nexus with the restrictions imposed by Letter 103/z.

Therefore,   the   Tax   Court   did   not   err   in   concluding   that   the

Commissioner failed to demonstrate any disparity between Texaco’s

treatment of its affiliates and its unrelated customers as a result of

the Saudi price restrictions.     Thus, under the regulation’s tax parity

standard, the Commissioner’s allocation of Texaco’s income under § 482

is improper.

     In sum, the Tax Court did not err in concluding that Textrad sold

the Saudi crude to both its affiliates and its unrelated customers at

the below market OSP to avoid violating Letter 103/z and the severe

economic reprisal that would have flowed from such a violation.

Accordingly, the Commissioner had no authority to allocate the income

under § 482.

     For the reasons stated above, the Tax Court properly concluded

that the Commissioner was without authority to reallocate Texaco's

income under § 482.

     AFFIRMED.




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