Decided: January 14, 1993; As Corrected January 27, 1993.
Appealed from: U.S. Court of Federal Claims. Judge Harkins
Before Archer, Circuit Judge, Cowen, Senior Circuit Judge, and Michel, Circuit Judge.
Dow Corning Corporation (Dow Corning) appeals from the summary judgment of the United States Claims Court,*fn1 No. 255-87T (July 3, 1990), upholding the validity of section 1.994-2(b)(3) of the Treasury Regulations. 26 C.F.R. § 1.994-2(b)(3) (1981). That section of the regulations provides for an overall profit percentage limitation (OPPL) on the marginal costing method of allocating export sales income to a Domestic International Sales Corporation (DISC) for federal income tax purposes. See 26 U.S.C. (IRC) §§ 991-997 (1982).*fn2 We affirm.
In 1971, Congress enacted the DISC provisions to afford tax incentives to United States corporations engaged in export sales. Dow Corning formed a wholly-owned subsidiary, Dow Corning International Sales Corporation (Sales) which, during the years at issue in this case, 1976-1981, qualified as a DISC within the meaning of IRC § 992(a).
Generally, the DISC provisions permitted deferral of federal income taxes on a portion of the export sales or commission income allocable to the DISC. The DISC itself was not subject to tax. IRC § 991. Part of the DISC's income, however, was currently taxed to the DISC's shareholders as though received as a dividend. The balance of such income was not taxed to the shareholders until distributed (or on the happening of certain events). IRC § 995.*fn3
For purposes of determining the income allocable to the DISC, IRC § 994*fn4 set forth intercompany pricing rules describing permissible methods for determining the transfer prices between a related corporation and the DISC for property sold by the DISC overseas. The transfer pricing method pertinent here permitted the DISC to derive taxable income equal to 50 percent of the combined taxable income of the related party and the DISC on the export sales. IRC § 994(a)(2). If the DISC did not purchase the export property from a related corporation but merely acted as a commission or sales agent, as Sales did for Dow Corning in this case, the statute required regulations to be prescribed setting forth rules consistent with the transfer pricing rules of IRC § 994(a) to cover commissions, rentals and other income. IRC § 994(b)(1). The regulation issued by the Secretary permitted the same 50 percent of taxable income from export sales made by a commission DISC to be allocated to the DISC.
For a DISC seeking to establish or maintain a foreign market for export property the statute further provided that the Secretary was to prescribe regulations setting forth "rules for the allocation of expenditures" in computing the combined taxable income of the DISC and the related corporation. IRC § 994(b)(2). As the heading to IRC § 994(b) and its legislative history indicate, Congress contemplated that marginal costing to compute the income on export sales would be made a part of these rules. See H.R. Rep. No. 533, 92d Cong. 1st Sess. 1, 75 (1971), reprinted in 1972-1 C.B. 538; S. Rep. No. 427, 92d Cong., 1st Sess. 1, 108 (1971), reprinted in 1972-1 C.B. 619.
The Commissioner promulgated Treasury Regulation § 1.994-2, 26 C.F.R. § 1.994-2 (1981), for this purpose. The DISC and its related supplier were permitted, subject to some limitations not here pertinent, to determine what "marginal or variable costs" should be taken into account in computing the income allocable to the DISC. Thus, the regulation provided:
(1)In general. Marginal costing is a method under which only marginal or variable costs of producing and selling a particular item, product, or product line are taken into account for purposes of section 994. Where this section is applicable, costs attributable to deriving qualified export receipts for the DISC's taxable year from sales of an item, product, or product line may be determined in any manner the related supplier (as defined in § 1.994-(1)(a)(3)(ii)) chooses, provided that the requirements of both subparagraphs (2) and (3) of this paragraph are met.
(2) Variable costs taken into account. There are taken into account in computing the combined taxable income of the DISC and its related supplier from sales of an item, product, or product line the following costs: (i) Direct production costs (as defined in § 1.47-11(b)(2)(i)) . . . .
Treas. Reg. § 1.9942(b)(1), (2) (1981). In section 1.994-2(b)(3) the regulation imposed an overall profit percentage limitation (OPPL) on the export sales to which marginal costing applied, as follows:
(3) Overall profit percentage limitation. As a result of such determination of costs attributable to such qualified export receipts for the DISC's taxable year, the combined taxable income of the DISC and its related supplier from sales of such item, product, or product line for the DISC's taxable year does not exceed gross receipts (determined under § 1.993-6) of the DISC derived from such sales, multiplied by the overall profit percentage (determined under paragraph (c)(2) of this section).
Treas. Reg. § 1.994-2(b)(3) (1981). The overall profit percentage for purposes of this limitation was defined in ...