SCOTUS Reports

Tag: Income Apportionment

  • Phillips Petroleum Co. v. Commissioner, 105 T.C. 486 (1995): Apportionment of Income from Cross-Border Sales of LNG

    Phillips Petroleum Co. v. Commissioner, 105 T. C. 486 (1995)

    Income from cross-border sales of personal property must be apportioned between domestic and foreign sources using specific regulatory examples when an independent factory price cannot be established.

    Summary

    Phillips Petroleum Co. sought to apportion income from the sale of liquefied natural gas (LNG) produced in Alaska and sold in Japan as partly foreign-sourced. The IRS determined that all income was domestic-sourced. The Tax Court, in a prior ruling, invalidated the IRS’s regulation and mandated apportionment under section 863(b). The key issue was whether the income should be apportioned using an independent factory price (Example 1) or a 50/50 split method (Example 2). The court held that Example 1 was inapplicable due to the absence of sales to independent distributors, and thus applied Example 2, which splits the income equally between production and sales, further apportioning each half based on property and sales location.

    Facts

    Phillips Petroleum Co. extracted natural gas from the North Cook Inlet in Alaska, liquefied it at a plant in Kenai, Alaska, and sold it to Tokyo Electric Power Co. and Tokyo Gas Co. in Japan under a long-term contract. The sales agreement stipulated delivery and title transfer in Japan. Phillips and Marathon Oil Co. formed a joint venture to fulfill the contract. Phillips engaged in extensive negotiations with Japanese buyers, involving multiple trips to Japan and assistance from its subsidiary, Phillips Petroleum International Corp. The price of LNG was renegotiated several times due to changing market conditions and political pressures.

    Procedural History

    The IRS issued a notice of deficiency to Phillips, asserting that all income from LNG sales was domestic-sourced. Phillips challenged this in the Tax Court. In a prior opinion (97 T. C. 30 (1991)), the court invalidated the IRS’s regulation under section 1. 863-1(b) and held that the income was partly foreign-sourced under section 863(b). The case returned to the court to determine the appropriate method for apportioning the income.

    Issue(s)

    1. Whether the income from Phillips’ sale of LNG to Tokyo Electric and Tokyo Gas should be apportioned under Example 1 of section 1. 863-3(b)(2), Income Tax Regs. , which requires an independent factory price?
    2. If Example 1 is inapplicable, whether the income should be apportioned under Example 2 of section 1. 863-3(b)(2), Income Tax Regs. , which uses a 50/50 split method?

    Holding

    1. No, because the sales were not made to independent distributors or selling concerns as required by Example 1, and thus an independent factory price could not be established.
    2. Yes, because Example 1 was inapplicable, the income was apportioned under Example 2, which splits the income equally between production and sales, with each half further apportioned based on the location of property and sales.

    Court’s Reasoning

    The court analyzed the regulatory framework under section 863(b) and the related regulations, focusing on the examples provided for apportioning income from cross-border sales. The court determined that Example 1 required sales to be made to independent distributors or selling concerns to establish an independent factory price, which was not the case with Tokyo Electric and Tokyo Gas, who transformed the LNG before resale. The court rejected the IRS’s broad interpretation of “distributor” and found that the buyers did not fit the traditional definition of a distributor. Consequently, the court applied Example 2, which mandates a 50/50 split of taxable income, with one half apportioned based on the location of property and the other half based on the location of sales. The court also addressed disputes over the valuation and location of certain assets used in the apportionment formula, ultimately excluding leased property and inventory in international waters from the property apportionment fraction.

    Practical Implications

    This decision clarifies the methodology for apportioning income from cross-border sales of personal property when an independent factory price cannot be established. It underscores the importance of the nature of the buyer in determining whether an independent factory price can be used. For companies engaged in similar transactions, this case provides guidance on how to structure sales agreements and manage tax implications. It also highlights the need for careful documentation and valuation of assets used in the production and sale of goods for tax purposes. The decision may influence future tax planning and negotiations in international trade, particularly in industries involving the sale of natural resources or manufactured goods across borders.

  • Manning v. Commissioner, 8 T.C. 537 (1947): Apportioning Business Income Between Separate Capital and Community Property

    8 T.C. 537 (1947)

    In community property states, income from a business started before marriage is allocated between separate property (return on invested capital) and community property (compensation for the owner’s services).

    Summary

    Ashley Manning, residing in California, contested a tax deficiency, arguing the IRS incorrectly apportioned income from his piano business between his separate capital and community property after his marriage. The Tax Court held that 8% of the business’s income attributable to Manning’s separate capital was indeed separate property. However, the income exceeding that 8% was attributable to Manning’s personal services and was therefore community property, aligning with California community property law and the precedent set in Lawrence Oliver.

    Facts

    Ashley Manning owned and operated a successful piano business before marrying in 1939. He continued to operate the business after his marriage. The business’s profits were generated by Manning’s invested capital and his skills and efforts. Manning and his wife filed separate tax returns, allocating business income based on an 8% return on capital and treating the remaining income as community property earned through Manning’s services.

    Procedural History

    The Commissioner of Internal Revenue determined a deficiency in Manning’s income tax for 1941, reallocating a larger portion of the business income as Manning’s separate property. Manning challenged this adjustment in the Tax Court. The Tax Court reviewed the Commissioner’s allocation and the evidence presented by Manning regarding the source of the business’s income.

    Issue(s)

    Whether the Commissioner properly allocated income from Manning’s business between his separate capital and community property, considering California community property law.

    Holding

    No, because the court determined that the income should be apportioned between the capital invested and Manning’s services. The apportionment to capital should be an amount equal to 8% of the capital, and the remainder of the income should be apportioned to Manning’s services and considered community income.

    Court’s Reasoning

    The Tax Court relied on California community property law, which dictates that income from separate property remains separate, while income from a spouse’s labor during marriage is community property. The court cited Pereira v. Pereira, stating that profits from a business partly attributable to separate capital and partly to personal services must be apportioned accordingly. Applying this principle, the court determined, based on the facts, that 8% was a fair return on Manning’s invested capital, and the remaining income was attributable to his personal services. The court distinguished Clara B. Parker, Executrix and J. Z. Todd, noting that in those cases, the taxpayers failed to provide sufficient evidence to challenge the Commissioner’s allocations, whereas Manning presented compelling evidence demonstrating the primary role of his skills and efforts in generating the business’s income. The court also emphasized testimony about Manning’s unique contributions to the business, which supported the allocation primarily to personal services.

    Practical Implications

    Manning v. Commissioner provides a practical framework for apportioning business income in community property states when a business owner brings separate capital into the marriage. This case highlights the importance of substantiating the contributions of personal services versus capital investment. Taxpayers in similar situations should meticulously document their labor and management activities to support a claim that a significant portion of business income is attributable to community effort rather than separate capital. Later cases often cite Manning and Oliver together when addressing the allocation of business income between separate and community property. The case also demonstrates that a “reasonable rate of return” on capital is not a fixed number, but is a factual question to be determined based on evidence presented.