No. 96-1107 IN THE SUPREME COURT OF THE UNITED STATES OCTOBER TERM, 1996 COMMISSIONER OF INTERNAL REVENUE, PETITIONER v. TEXACO, INC. AND SUBSIDIARIES ON PETITION FOR A WRIT OF CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR THE FIFTH CIRCUIT REPLY BRIEF FOR THE PETITIONER WALTER DELLINGER Acting Solicitor General Department of Justice Washington, D.C. 20530-0001 (202)514-2217 ---------------------------------------- Page Break ---------------------------------------- TABLE OF AUTHORITIES Cases Page Argentina v. Weltover, 504 U. S. 607 (1997) . . . . 4, 6 Commissioner v. Culbertson, 337 U.S.733 (1949) . . . . 3, 6 Commissioner v. First Security Bank, 405 U.S. 394 (1972) . . . . 1, 2, 5, 6 L.E. Shunk Latex Products, Inc. v. Commissioner, 18 T. C. 940(1952) . . . . 4, 5 United States v. Basye, 410 U.S.441 (1973) . . . . 1, 2, 5, 6 Statute and regulation Internal Revenue Code, 26 U.S.C. 482 . . . . 5, 6, 7 26 C. F.R. 1.482.1 (b) (1981) . . . . 6 Miscellaneous: B. Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholders (1987 cd.) . . . . 5-6 (I) ---------------------------------------- Page Break ---------------------------------------- In the Supreme Court OCTOBER TERM, 1996 No. 96-1107 COMMISSIONER OF INTERNAL REVENUE, PETITIONER v. TEXACO, INC. AND SUBSIDIARIES ON PETITION FOR A WRIT OF CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR THE FIFTH CIRCUIT REPLY BRIEF FOR THE PETITIONER Respondent errs in asserting that its purchases of Saudi crude oil did not stem from "a consensual agreement" but were instead dictated by foreign law (Br. in Opp. 15). Building upon that flawed foundation, respondent mistakenly asserts that this Court's deci- sion in Commissioner v. First Security Bank, 405 U.S. 394 (1972), rather than its decision in United States v. Basye, 410 U.S. 441 (1973), governs this case. Review by this Court is warranted because of the fundamental misapplication by the courts below of the decisions of this Court and the extraordinary impor- tance of the question presented. 1. The mere fact that Texaco was unusually depen- dent upon supplies of Saudi crude oil in 1979 and 1980 (see Pet. 7-8 & n. 7) does not exempt Texaco from the (1) ---------------------------------------- Page Break ---------------------------------------- 2 operation of the internal revenue laws of the United States. As the Chairman of Exxon has straightfor- wardly acknowledged, the Saudi resale condition was nothing more than a "condition[] of sale" (Tr. 154- 155). Texaco, Exxon and the other Aramco partici pants "always had the choice of not buying Mr. Yamani's oil" (ibid.). The fact that Texaco had a great need for supplies in 1979 and 1930 does not mean that Texaco had a legal obligation to purchase Saudi oil or to purchase such oil under any specific set of contractual terms. For the reasons described in the petition (Pet. 16-19), the fact that the seller had sufficient market power to dictate the terms of sale does not make those terms a "law." 1 Respondent does not dispute that, in determining whether the reasoning of First Security or Basye controls, the critical focus should be on whether the conduct of the taxpayer was restrained by law or was instead consensual. See Br. in Opp. 17 ([b]oth courts below agreed with this proposition"). Respondent and the courts below err, however, in assuming that a consensual agreement cannnot exist within the mean- ing of Basye unless the taxpayer could have success- fully negotiated a different result. The Tax Court, for example, did not conclude that Texaco's purchases ___________________(footnotes) 1 If, for example, any private supplier had imposed a resale price condition on sales to Texaco, the fact that Texaco `[really needed" those supplies would not exempt Texaco from the con- sequences that attach to such "a consensual agreement" under the laws of the United States-whether those consequences stem from antitrust laws or internal revenue laws. Respondent and the courts below erred precisely in concluding that the mere fact that the seller in this case was the Saudi government somehow converts a consensual commercial arrangement into a "law" that removed all freedom of action from Texaco. ---------------------------------------- Page Break ---------------------------------------- 3 of crude oil were not the product of "a consensual agreement"; it concluded only that Texaco had insuf- ficient market power to avoid the "non-negotiable" resale price demand of the seller (Pet. App. 149a; see Br. in Opp. 18). The fact that the seller's demand was "non-negotiable," however, does not mean that Texaco had to agree to it. It means only that Texaco did agree to it in order to purchase the crude oil. By agreeing to this term of sale, Texaco voluntar- ily surrendered its power to allocate the associated income among its subsidiaries. Texaco's voluntary decision to accept the terms demanded by the seller does not prevent the Commissioner from applying "the first principle of income taxation that income must be taxed to him who earns it." Commissioner v. Culbertson, 337 U.S. 733, 739-740 (1949). As this Court held in Basye-in language that applies di- rectly to this case-''[t]he entity earning the income * * * cannot avoid taxation by entering into a con- tractual arrangement whereby that income is di- verted to some other person or entity." 410 U.S. at 449.2 2. The question of recurring importance that is presented in this case is whether a foreign govern- ment can enter the marketplace and, in dealings with private parties, establish terms of sale that displace the provisions of United States law that govern the taxation of United States corporations. In the pre- ___________________(footnotes) 2 Respondent does not dispute that, for the reasons de- scribed in the petition, the allocation of this income to respon- dent does not violate the terms of the Saudi restriction. See Pet. 14-15 & n.9. In being required to pay tax on the income it has earned, Texaco is merely being required to comply with United States law; it is not being required to violate any foreign law. ---------------------------------------- Page Break ---------------------------------------- 4 sent case, the foreign government was selling sup- plies of a commodity that was temporarily in short supply, and it was imposing restrictions only for the supplies that it sold.3 The "restriction" thus imposed was purely contractual in character and in effect, for it did not purport to bind or in any other fashion regulate anyone other than those who consented to the restriction by purchasing the supply. The facts of L.E. Shunk Latex Products, Inc. v. Commissioner, 18 T.C. 940 (1952), on which respon- dent relies (Br. in Opp. 24), are therefore markedly different. In Shunk Latex, the United States govern- ment was not in the business of selling either raw rubber or condoms. The United States also did not seek to impose any contractual resale price re- straints as a condition of sale of such materials. In- stead, the government established price ceilings on those products and made it unlawful for any taxpayer to conduct business at prices in excess of those established ceilings. On these facts, the court held in ___________________(footnotes) 3 The cases cited by respondent (Br. in opp. 22 n. 21) that involve situations in which a foreign government is acting as a "regulator of a market" (Argentina v. Weltover, Inc., 504 U.S. 607, 614 (1992)) are thus inapposite. The Saudi terms of sale were not provisions of general application that "regulated" a market; they were contractual terms of sale that bound only its customers-those who purchased oil directly from the govern- ment. See Pet. 21-24. 4 Moreover, when those parties converted the crude oil into refined products (or when their affiliates did so), the contrac- tual resale "restriction" utterly disappeared. Pet. App. 4a. As the Saudi Oil Minister emphasized (Pet. App. 48a): [T]he oil companies are definitely making much higher pro- fits in the downstream by refining Saudi crude and selling the products at higher prices. This we cannot control. ---------------------------------------- Page Break ---------------------------------------- 5 Shunk Latex that the Commissioner could not allo- cate profits to sellers based upon theoretical-prices that exceeded the ceilings established by federal law. 18 T.C. at 961. 5 The difference between a law that requires univer- sal obedience and a contractual term that is binding only on those who have agreed to it is the core dis- tinction between First Security and Basye. The decision in First Security precludes the allocation of income to a taxpayer who, under a generally applica- ble law, is precluded from conducting the commerce being taxed. 405 U.S. at 405. The decision in Basye, by contrast, permits the allocation of income to a taxpayer who, under a consensual commercial ar- rangement, has agreed to terms that cause a deflec- tion of the income it has earned to an untaxed affili- ate. 410 U.S. at 449. 3. The courts below misunderstood and misapplied this critical, controlling distinction between First Security and Basye. As the petition explains (Pet. 25- 26 &n. 14), the decision of the court of appeals there- by creates favorable tax consequences for commercial restrictions imposed on commercial sales made to United States corporations by foreign Nations. The reasoning applied by the courts below would create an enduring opportunity for substantial abuse, for it ob- structs the plain objective of Section 482 of the Inter- nal Revenue Code to "prevent[] artificial shifting, milking, or distorting of the true taxable incomes of ___________________(footnotes) 5 In the course of holding that income could not be allocated to a corporation that could not lawfully participate in the business that generated the income, this Court cited Shunk Latex with approval in Commissioner v. First Security Bank, 405 U.S. at 406. ---------------------------------------- Page Break ---------------------------------------- 6 commonly controlled enterprises" (B. Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholder 15.03, at 15-14 (1987 cd.)). See Pet. 25-26 & n.14. Respondent misses the point of the statute in con- tending that there is no opportunity for abuse if courts apply "heightened scrutiny" to ensure that a foreign sales restriction was adopted by the foreign government without the collusion of the United States taxpayer (Br. in Opp. 25, quoting Pet. App. 113a). The function of Section 482 is to determine the "true taxable income" of a United States taxpayer (26 C.F.R. 1.482-1(b) [1981)) and " to correct artificial intragroup pricing policies" that shift income "to affiliated foreign corporations that are not generally subject to U.S. tax." B. Bittker & J. Eustice, supra, at 15-16. The taxpayer's "motivation or purpose" in entering into the arrangement is not relevant (id. at 15-14). A reallocation is necessary clearly to reflect the taxpayer's income when, as here, the taxpayer's activities have earned the income that has been realized instead by foreign affiliates that the taxpayer controls-for income is to be taxed "to him who earns it" (Commissioner v. Culbertson, 337 U.S. at 739- 740). 4. This case-along with the companion case in- volving amicus Exxon-involves more than five bil- lion dollars of taxes and interest. The issue pre- sented in this case arises at the interstices of this Court's decisions in Basye and First Security, and it implicates principles that the Court has applied in the governmental immunity context in decisions such as Argentina v. Weltover, Inc., 504 U.S. 607 (1992). See Pet. 19-23. Its resolution thus requires an ex- planation of this Court's jurisprudence that only this ---------------------------------------- Page Break ---------------------------------------- 7 Court can authoritatively provide. Review by this Court is warranted by the extraordinary importance of this case for the public fisc, by the broad scope of its potential future applications, and by the evident need for guidance in the lower courts on the proper application of Section 482 to commercial transactions involving foreign governments. For the reasons stated above and in the petition, the petition for a writ of certiorari should be granted. Respectfully submitted. WALTER DELLINGER Acting Solicitor General MARCH 1997