The Tax Court, Quealy, J., sustained and modified a determination by the Commissioner of Internal Revenue that certain income of a subsidiary was subject to reallocation to taxpayer United States Steel Corporation; and rejected the Commissioner's determination that taxpayer was required to reduce its basis in obligations of a subsidiary. Reversed.
Before Lumbard, Meskill and Newman, Circuit Judges.
This consolidated appeal*fn1 from two decisions of the Tax Court, Quealy, J., arises out of the development by United States Steel Corporation ("Steel") of newly discovered Venezuelan iron mines in the 1950's, and the financial arrangements resulting from the creation of two Steel subsidiaries to mine and transport ore. Two distinct questions of tax law are presented: first, what kind of evidence is sufficient for a taxpayer to challenge successfully the Commissioner's determination that payments between a parent and a subsidiary are not "arm's length" and thus are subject to reallocation under § 482 of the Internal Revenue Code; and second, whether Treasury Regulations 1.1502-34A and 1.1502-35A,*fn2 which require a corporation filing consolidated returns to reduce its basis in obligations of an affiliate to the extent it takes advantage of losses sustained by the affiliate which the affiliate could not itself have utilized, require a basis reduction in the case of an affiliate which could not have taken the losses in question during the period when consolidated returns were filed, but could have made use of them in subsequent separate return years.
We find that the Tax Court, in the first case, T.C. Memo. 1977-140, did not give sufficient weight to the taxpayer's evidence supporting its contention that charges between the taxpayer and its subsidiary were arm's length, and for that reason we reverse the judgment of the Tax Court sustaining, with modifications, the Commissioner's reallocation of income; in the second case, T.C. Memo. 1977-290, in which the Tax Court held that no basis reduction was required, we also reverse, because we think that the applicable Treasury Regulations allow a taxpayer to look, for basis reduction purposes, only to consolidated return years in determining whether losses could have been availed of by an affiliate.
Taxpayer, United States Steel Corporation, is a major vertically integrated producer of steel. In addition to steel-making plants, it owns iron ore mines in the United States and elsewhere. In 1947, Steel discovered a vast new source of iron ore in Cerro Bolivar, a remote part of northeastern Venezuela on the Orinoco River. The transport of Orinoco ore to the Atlantic required the dredging of an extensive channel. Steel proceeded to develop these mines at a cost of approximately two hundred million dollars. In 1949, Steel formed Orinoco Mining Company ("Orinoco"), a wholly-owned Delaware subsidiary, to own and exploit the Cerro Bolivar mines.
Orinoco began selling ore from its mines in 1953. Initially, the ore purchased by Steel from Orinoco was transported to the United States in chartered vessels owned by two independent companies, Universe Tankships, Inc., ("Universe") and Joshua Hendy Corp. ("Hendy"). But in December 1953, Steel incorporated another wholly-owned subsidiary, Navios, Inc., ("Navios") in Liberia. Navios, with its principal place of business in Nassau, in the Bahamas, was a carrier which did not own any vessels. From July 1954 on, Navios, instead of Steel, chartered vessels from Universe, Hendy, and other owners, and Steel paid Navios for the transport of ore from Venezuela to the United States.*fn3 Navios was an active company, having in the period 1954-60 between 53 and 81 fulltime employees.*fn4
Although Steel was by far the largest customer of Navios, Navios sold its transport services to other domestic steel producers (collectively "the independents") and to foreign steel companies. The prices charged by Navios to other domestic ore importers during the relevant period were the same prices charged to Steel, though the rates charged to companies importing ore to countries other than the United States were different.
Like Navios, Orinoco did not sell exclusively to Steel, although its parent was by far its largest customer. Orinoco sold to the independents and to foreign steel companies at the same prices it charged Steel.
Orinoco sold ore bound for the United States FOB Puerto Ordaz, Venezuela in an attempt to arrive at a fair market price in order to minimize conflict with the Venezuelan taxing authorities, who had the power to revalue, for taxation purposes, the price at which Orinoco sold its ore if they considered that price too low. United States prices of iron ore were set, during the period in question, by an annual auction of ore from the Mesabi range of Minnesota, which established the so-called "Lower Lake Erie" price. Through its subsidiary Oliver Mining Co., Steel sold significant amounts of Mesabi ore.
Orinoco was subject to a Venezuelan tax of up to 50% on income, and to a United States tax of 48% on any residue not offset by foreign tax credits. Steel was subject to a United States tax of 48% of net income. Navios was subject to a 2.5% excise tax in Venezuela and no tax in the United States. Dividends paid by Navios to Steel, of course, would be taxed at a rate of 48%.
Navios was a highly successful venture: Steel found itself in 1960 with a wholly-owned subsidiary possessing nearly $80 million in cash and cash equivalents. Navios paid no dividends to Steel during the period involved in this case. In effect, then, Navios became an offshore tax shelter. But, as the Tax Court found, Steel's decision to create Navios is not in itself a justification for the Commissioner's reallocation of income, since Navios served a major business purpose unrelated to tax-shifting: allowing Steel to reap the cost savings of using a non-United States-flag fleet.
In the tax years 1957 through 1960, Navios earned approximately $391 million in gross revenues, all on the transport of iron ore from Venezuela to various points in the eastern continental United States and in Europe. Of this total, revenues from Steel amounted to $286 million, or 73% of the total; and from independent domestic steel purchasers $21 million, or 5% of the total.*fn5
Two steel companies, Bethlehem Steel and Eastern Gas and Fuel Associates, used other means of transportation for ore which they purchased from Orinoco. Bethlehem had mines and exported from Venezuela small quantities of ore from the Orinoco area prior to Steel's development of its mines. Bethlehem had earlier set up a transportation system from minehead to the United States to which it adhered during the period in question. Eastern Fuel and Gas, a much smaller concern, contracted directly with shipowners, including its own shipowning affiliates.*fn6
During 1957-60, there was no information publicly available from which a "market price" for the carriage of iron ore by sea could be determined. Unlike the practice in the oil tanker industry, for example, ship charter contract prices for ore carriage were not published.
The Commissioner determined that Navios had overcharged Steel by 25%, and allocated income from Navios to Steel as follows:
Taxable Year Amount Allocated
On the basis of these figures, the Commissioner asserted deficiencies against Steel as follows: