In a case on appeal before the Sixth Circuit, household consumer goods manufacturer Procter & Gamble (P&G) and a related entity claim a refund of taxes paid on a foreign sales corporation (FSC) advance payment transaction (APT). The U.S. District Court for the Southern District of Ohio had denied the claim by P&G and P&G FSC, which is based on a claimed deduction of more than $362 million for tax year 2000.
P&G, P&G Canada, and P&G FSC are related entities but file separate tax returns. During tax year 2000, P&G Canada made a $374,790,000 advance payment to P&G FSC. P&G FSC, in turn, made a $288,588,300 advance payment and an interest-free loan of the difference—$86,201,700—to P&G. P&G FSC reported sales income of $374,790,000 attributable to the APT, while P&G reported only $288,588,300 (the transfer price) in sales income on its tax return.
The manufacturing cost of the products subject to the APT was $359,344,974. P&G and P&G FSC calculated combined taxable income (CTI) by adding P&G FSC’s gross receipts for the APT and not subtracting any of the $359,344,974, on the rationale that the costs were not incurred until tax year 2001. P&G reported these costs as cost of goods sold on its 2001 tax return. P&G also reported a net loss of $70,756,674 on its 2000 and 2001 tax returns in connection with the APT.
The essence of the transactions was to allow the taxpayers to shift the difference between the gross receipts and the transfer price to P&G FSC, which P&G FSC reported as a profit. Under the now-repealed FSC rules, the taxpayers were allowed to exempt 23% of their CTI permanently from tax under IRC §§ 921 and 923. The amount excluded equaled the profit reported by P&G FSC.
During its audit, the IRS determined that the transfer price was based on a CTI calculation that did not include total costs, thereby violating the FSC administrative pricing rules and resulting in an understatement of P&G income of $86,201,700.
The IRS assessed P&G for the understatement. P&G paid the assessment and sought a refund of the taxes at the administrative level. When the claim was denied, the taxpayers sought judicial review under IRC § 7422.
In a 2007 opinion, the district court found that because of the huge disparity between the arm’s-length price of $374,790,000 and the transfer price of $288,588,300, as a matter of law, the prices could not be viewed as an approximation of each other. The court concluded that the transfer price ran counter to legislative intent, which was to limit the FSC exemption to an approximation of an arm’s-length price in compliance with the General Agreement on Tariffs and Trade. The court ruled that the taxpayers’ calculation of CTI violated the FSC administrative pricing rules. The taxpayers filed a motion to clarify and modify the court’s 2007 opinion.
In its 2008 opinion, the court addressed only whether the taxes should have been calculated under the gross receipts method of determining CTI, as proposed by P&G, or under the arm’s-length pricing method, as used by the government in its calculation. According to P&G’s calculation, under the gross receipts method, its deduction would have been $362,066,663 for tax year 2000. However, the court found that because P&G failed to submit these calculations under the gross receipts method when it initially filed its administrative refund claim, it was barred under the variance doctrine from asserting this claim at the judicial level. The court rejected P&G’s argument that the government waived the variance doctrine defense when it first advanced at the judicial level its argument that P&G miscalculated CTI in violation of the administrative pricing rules. The court reasoned that even though the government did not expressly assert this miscalculation at the administrative level, P&G should have anticipated that the government would challenge its failure to take total costs into account when calculating CTI.
IRS' calculation of CTI:
|Less: Cost of goods sold|| |
|Less: Other costs|| |
P&G also argued that P&G FSC did present the gross receipts method alternative in its refund claim. However, the court admonished P&G for attempting to “ride on the coattails” of a claim made by P&G FSC, since P&G and P&G FSC are treated as separate taxpayers, file separate returns, report separate income items and, most important, make separate refund claims. As a result, the court ruled that it lacked jurisdiction to consider P&G’s request for the $362,066,663 deduction for tax year 2000.
In its appeal brief before the Sixth Circuit, P&G argued that the district court’s summary judgment was incorrect because it did not consider whether the IRS correctly assessed tax according to the Service’s arm’s-length position under section 482, among other reasons. The government’s appeal brief countered that the District Court correctly held that P&G’s transfer price was understated because its computation did not account for the total costs of the APT. P&G requested oral arguments, which had not been scheduled by press time.
By Jean T. Wells, CPA, J.D., assistant professor of accounting, Howard University, Washington, D.C.