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2001 Term, Number 17 / May 28, 2002

Today the Supreme Court granted certiorari in one case of potential interest to the business community. Amicus briefs in support of the petitioner are due on Friday, July 12, 2002, and amicus briefs in support of the respondent are due on Monday, August 12, 2002. Any questions about this case should be directed to Miriam Nemetz (202-263-3253) or Robert Bronston (202-263-3244) in our Washington office.

Taxation — Export Subsidiaries — Allocation of Research and Development Costs. The Supreme Court granted certiorari in Boeing Co. v. United States, No. 01-1209, to resolve a split among the circuits regarding the proper allocation of research and development costs between foreign and domestic income when computing taxable income for export subsidiaries.

In order to encourage export sales, since the mid-1970s the Internal Revenue Code has allowed United States manufacturers to create special export subsidiaries, initially known as Domestic International Sales Corporations and later called Foreign Sales Corporations, whose income receives partial tax deferral. At the time relevant to the petition, in order to determine the income attributable to export sales and thus qualifying for favorable tax treatment, the Internal Revenue Code permitted the taxpayer to elect one of three methods for determining the amount of deemed profit to be allocated to the export subsidiary and its parent as a result of export sales. 

Petitioner Boeing exported commercial aircraft through a qualified export subsidiary and computed its profits according to the combined taxable income method. Boeing allocated all its research and development expenses related to a particular aircraft product group to the export receipts for that product group, as permitted by Treas. Reg. § 1.994-1(c), and it apportioned general research and development costs unrelated to any particular product group across product groups on a pro rata basis. After conducting an audit, the IRS concluded that Boeing had improperly allocated research and development costs. Disagreeing with Boeing's approach of applying R&D expenses to the product groups to which they related, the IRS claimed that Treas. Reg. § 1.861-8(e)(3) required Boeing to use standard industry classifications for its allocation decisions and therefore to allocate all of its research and development costs in any given year to all of its airplane sales. The IRS concluded that Boeing had underpaid its taxes by $419 million.

Boeing paid the additional tax and filed suit seeking a refund. The district court accepted Boeing's method of allocating R&D, and it granted judgment in favor of Boeing for $419 million. 1998 WL 767305 (W.D. Wash. 1998). Relying heavily on the Eighth Circuit's decision in St. Jude Medical, Inc. v. Commissioner of Internal Revenue, 34 F.3d 1394 (8th Cir. 1994), the court held that Treas. Reg. § 1.861-8(e)(3) is invalid as applied to computations of combined taxable income. The district court explained that, by mandating that export sales be grouped according to broad industry classifications, Treas. Reg. § 1.861-8(e)(3) conflicts with Treas. Reg. §§ 1.994-1(c)(6)(iv) and (7), which provide taxpayers may group income and allocate costs by product or product line. See id. at *4. In addition, the court noted that Treas. Reg. § 1.861-8(e)(3) creates an artificial "deemed" relationship between sales and research and development costs that conflicts with Congress's intent to "generally allocate to each item of gross income all expenses directly related thereto." Id. (quoting St. Jude Medical, 34 F.3d at 1401) (emphasis in St. Jude Medical). Finally, the court determined that Congress intended export subsidiaries to deduct only those costs "directly related to the production or sale of the export property" and that to charge unsuccessful research and development that is never actualized through a successful product would be "inconsistent" with that expressed intent. Id. (quoting St. Jude Medical, 34 F.3d at 1401).

The Ninth Circuit reversed. 258 F.3d 958 (9th Cir. 2001). The court of appeals opined that Treas. Reg. § 1.861-8(e)(3) can be "harmonized" with Treas. Reg. § 1.994-1(c)(7) by recognizing that "the more narrowly a taxpayer chooses to define income items, the more costs become ‘indirectly' or ‘indefinitely' related to specific items of income." Id. at 967. The court also held that Treas. Reg. § 1.861-8(e)(3) was a reasonable interpretation of the statutes and regulations as applied to this case because "Congress recognized [that] some of the costs incurred in a given tax year would not be ‘directly related' to specific income items." Id. at 966.

This case is of obvious interest to any corporation concerned with the tax treatment of export sales. Although the Domestic International Sales Corporation and the Foreign Sales Corporation regimes have been replaced by the Extraterritorial Income Exclusion Act of 2000 ("ETI"), that regime is sufficiently similar to its predecessor regimes that the Court's guidance on the treatment of research and development expenses when computing export income should apply to the ETI.

Mayer, Brown, Rowe & Maw represents Boeing in this case. 

* * * * *

On May 13, 2002, the Court invited the Solicitor General to express the views of the United States in the following case of interest to the business community: 

Attorney General of Canada v. R.J. Reynolds Tobacco Holdings, Inc., No. 00-1317: The question presented is whether the common law revenue rule, which bars courts of one sovereign from enforcing final tax judgments or unadjudicated tax claims of other sovereigns, precludes a United States court from adjudicating Canada's claims under the Racketeer Influenced and Corrupt Organizations Act for damages resulting from tobacco companies' alleged schemes to avoid Canadian cigarette taxes.

This Mayer, Brown, Rowe & Maw Supreme Court Docket Report provides information and comments on legal issues and developments of interest to our clients and friends. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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