Boeing Co., et al. v U.S. / U.S. v. Boeing Sales Corp. et al. (03/04/2003)

Questions presented: (1) Did the 9th Circuit, in direct conflict with the 8th Circuit, correctly conclude that Treas. Reg. @ 1.861-8(e)(3) of the Internal Revenue Code, which governs the allocation of research & development costs between foreign and domestic income, may be applied to the computation of taxable income for export subsidiaries entitled to special tax treatment under the Code? (2) If certiorari is granted and judgment is reversed in Case No. 01-1209, should the judgment of the appeals court in favor of the cross-respondent then also be reversed?

BY LEO MCKINNEY, MEDILL NEWS SERVICE

For some people, a squabble between the Internal Revenue Service and a huge multinational corporation is like a Battle of the Bands between Neil Diamond and Barry Manilow they dont really want either side to win, and no matter what happens they dont want to listen to it.

As the U.S. Supreme Court takes into consideration Boeing Co. v U.S., however, the repercussions could become too widespread for Americans to remain neutral, particularly as accusations involving tax-deduction improprieties in foreign markets envelop some of the nations largest corporations and threaten to fray U.S. trade ties with other countries.

At stake is a $419 million tax refund for the years between 1979 and 1987 granted to the aerospace corporation by a federal district court in 1998 and subsequently nullified by the 9th Circuit Court of Appeals in 2001. The district court found that the IRS had incorrectly allocated and therefore improperly taxed Boeings research and development ("R&D") expenditures while examining the companys income from export sales of commercial airplanes during the eight-year period in question. The appeals court ruled that the agency had done its work correctly.

So which ruling is right? Well, the Internal Revenue Code ("I.R.C.") and accompanying U.S. Treasury regulations support both of them. And therein lie a number of problems.

Two sections of the I.R.C. deal with the role of costs in the tabulation of a corporations net income from export sales. Both regulations give domestic companies a tax deferral on export earnings that come through a subsidiary, so long as that subsidiary which can be either domestic or foreign complies with appropriate legislation. If the subsidiary is domestic, it is regarded in the legislation as a Domestic International Sales Corporation ("DISC"); if foreign, a Foreign Sales Corporation ("FSC"). From 1972 to 1984, Boeing exported its commercial airplanes using an approved DISC, Boeing International Sales Corporation. In 1984, the company began using an FSC, Boeing Sales Corp.

So far, so good. But the two sets of rules differ somewhat on how R&D costs are weighed against profits, and the friction between them is what has driven the Boeing case to the Supreme Court.

The first set of regulations, contained in sections 991-997 of the I.R.C. and enacted by Congress in 1971, allows corporations to calculate export profits by counting costs only against the income to which the costs are related. In the case of Boeing, for example, this means that the airplane maker only has to report expenditures involving a particular type of plane during a particular year if that type of plane was actually sold during that year. In effect, the corporation is allowed to categorize its export income by product line. For the record, Boeing established or maintained a separate category for its 707, 727, 737, 737-300, 747, 757, and 767 models during the relevant tax years and hence had a different set of cost/income figures for each.

The second set of regulations, enacted in 1977 and contained within U.S. Treas. Reg. @1.861-8, establishes broader and more inclusive categories for calculating export profit, and the IRS used those regulations while auditing Boeing. When looking at Boeings export figures, the IRS deducted the total figure of R&D costs from that of all airplane sales for a particular year, the rationale being that all of Boeings costs and income regarding the companys exported airplanes fell into the same regulatory category Transportation Equipment. In essence, the IRS disregarded Boeings categorical distinctions stemming from the companys product lines and simply deducted all costs from all income for a given year. After its audit, the IRS claimed that Boeing had over-reported its net income from DISC and FSC sales and as a result had received an inflated tax credit during the years in question.

Judge David Thompson, who wrote the unanimous 9th Circuit opinion revoking Boeing's refund, insisted in that opinion that "there is no conflict" between the two regulations because they both allow for the inclusion of costs that are indirectly related to specific income categories, which diminishes the importance of how narrow or wide those categories are.

However, in his opinion, Thompson, who asserted that the solution to the conflict between Boeing and the government must ultimately be legislative rather than judicial, called for Congressional action to resolve the issue, which is muddied by lower court rulings (foremost among them St. Jude Medical, Inc. v. Commissioner and Intel Corp. v. Commissioner) in which one of the regulations was simply favored over the other at the courts discretion.

Both sides sought Supreme Court review.

"The most that can be said from these competing arguments," Thompson wrote, "is that Congressional inaction provides no reliable indication of how this case should be resolved."

Thompson is not the only one howling at Congress to do something. A Sept. 20, 2002, article in the New York Times reported that the European Union and the World Trade Organization had decried the FSC tax break as the equivalent of an illegal trade subsidy and threatened the American export industry with retaliatory tariffs if the break is not abolished or fundamentally altered.

On May 28, 2002, the Supreme Court granted certiorari in both cases and consolidated them for review.

On March 4, 2003, the Court, by a vote of 7-2, sided with the U.S., holding that the IRS, though not unlimited in its discretion, did not act arbitrarily in allocating R&D expenditures to all products in a category even when specifically intended to improve only one or a few of those products.

Justice John Paul Stevens wrote the majority opinion. Justice Clarence Thomas wrote the dissent for himself and Justice Antonin Scalia.

Attorneys: For Boeing Co., Boeing Sales Corporation, et al.:Kenneth Steven GellerMayer, Brown, Rowe & Maw1909 K Street, N. W.Washington, DC 20006(202) 263-3225For U.S.:Theodore OlsonSolicitor General, Counsel of RecordEileen J. O' ConnorAssistant Attorney GeneralDavid English CarmackFrank P. Cihlar