Under a 1971 statute providing special tax treatment for export sales made by an American manufacturer through a subsidiary that qualified as a "domestic international sales corporation" (DISC), no tax is payable on the DISC's retained income until it is distributed. See 26 U. S. C. §§991-997. The statute thus provides an incentive to maximize the DISC's share -- and to minimize the parent's share -- of the parties' aggregate income from export sales. The statute provides three alternative ways for a parent to divert a limited portion of its income to the DISC. See §994(a)(1)-(3). The alternative that The Boeing Company chose limited the DISC's taxable income to a little over half of the parties "combined taxable income" (CTI). In 1984, the "foreign sales corporation" (FSC) provisions replaced the DISC provisions. As under the DISC regime, it is in the parent's interest to maximize the FSC's share of the taxable income generated by export sales. Because most of the differences between these regimes are immaterial to this suit, the Court's analysis focuses mainly on the DISC provisions. The Treasury Regulation at issue, 26 CFR §1.861-8(e)(3) (1979), governs the accounting for research and development (R&D) expenses when a taxpayer elects to take a current deduction, telling the taxpaying parent and its DISC "what" must be treated as a cost when calculating CTI, and "how" those costs should be (a) allocated among different products and (b) apportioned between the DISC and its parent. With respect to the "what" question, the regulation includes a list of Standard Industrial Classification (SIC) categories (e.g., transportation equipment) and requires that R&D for any product within the same category as the exported product be taken into account. The regulations use gross receipts from sales as the basis for both "how" questions. Boeing organized its internal operations along product lines (e.g., aircraft model 767) for management and accounting purposes, each of which constituted a separate "program" within the organization; and $3.6 billion of its R&D expenses were spent on "Company Sponsored Product Development," i.e., product-specific research. Boeing's accountants treated all Company Sponsored costs as directly related to a single program and unrelated to any other program. Because nearly half of the Company Sponsored R&D at issue was allocated to programs that had no sales in the year in which the research was conducted, that amount was deducted by Boeing currently in calculating its taxable income for the years at issue, but never affected the calculation of the CTI derived by Boeing and its DISC from export sales. The Internal Revenue Service reallocated Boeing's Company Sponsored R&D costs for 1979 to 1987, thereby decreasing the untaxed profits of its export subsidiaries and increasing its taxable profits on export sales. After paying the additional taxes, Boeing filed this refund suit. In granting Boeing summary judgment, the District Court found §1.861-8(e)(3) invalid, reasoning that its categorical treatment of R&D conflicted with congressional intent that there be a direct relationship between items of gross income and expenses related thereto, and with a specific DISC regulation giving the taxpayer the right to group and allocate income and costs by product or product line. The Ninth Circuit reversed.
Held: Section 1.861-8(e)(3) is a proper exercise of the Secretary of the Treasury's rulemaking authority. Pp. 8-19.
(a) The relevant statutory text does not support Boeing's argument that the statute and certain regulations give it an unqualified right to allocate its Company Sponsored R&D expenses to the specific products to which they are factually related and to exclude such R&D from treatment as a cost of any other product. The method that Boeing chose to determine an export sale's transfer price allowed the DISC "to derive taxable income attributable to [an export sale] in an amount which does not exceed ... 50 percent of the combined taxable income of [the DISC and the parent] which is attributable to the qualified export receipts on such property derived as the result of a sale by the DISC plus 10 percent of the export promotion expenses of such DISC attributable to such receipts ... ." 26 U. S. C. §994(a)(2) (emphasis added). The statute does not define "combined taxable income" or specifically mention R&D expenditures. The Secretary's regulation must be treated with deference, see Cottage Savings Assn. v. Commissioner, 499 U. S. 554, 560-561, but the statute places some limits on the Secretary's interpretive authority. First, "does not exceed" places an upper limit on the share of the export profits that can be assigned to a DISC and gives three methods of setting the transfer price. Second, "combined taxable income" makes it clear that the domestic parent's taxable income is a part of the CTI equation. Third, "attributable" limits the portion of the domestic parent's taxable income that can be treated as a part of the CTI. The Secretary's classification of all R&D as an indirect cost of all export sales of products in a broadly defined SIC category is not arbitrary. It provides consistent treatment for cost items used in computing the taxpayer's domestic taxable income and CTI; and its allocation of R&D expenditures to all products in a category even when specifically intended to improve only one or a few of those products is no more tenuous than the allocation of a chief executive officer's salary to every product that a company sells even when he devotes virtually all of his time to the development of the Edsel. Reading §994 in light of §861, the more general provision dealing with the distinction between domestic and foreign source income, does not support Boeing's contrary view. If the Secretary reasonably determines that Company Sponsored R&D can be properly apportioned on a categorical basis, the portion of §861(b) that deducts from gross income "a ratable part of any expenses ... which cannot definitely be allocated to some item or class of gross income" is inapplicable. Pp. 8-13.
(b) Boeing's arguments based on specific DISC regulations are also unavailing. Language in 26 CFR §1.994-1(c)(6)(iii), part of the rule describing CTI computation, does not prohibit a ratable allocation of R&D expenditures that can be "definitely related" to particular export sales. Whether such an expense can be "definitely related" is determined by the rules set forth in the very rule that Boeing challenges, §1.861-8. Moreover, the Secretary could reasonably determine that expenditures on model 767 research conducted in years before any 767's were sold were not "definitely related" to any sales, but should be treated as an indirect cost of producing the gross income derived from the sale of all planes in the transportation equipment category. Nor do §§1.994-1(c)(7)(i) and (ii)(a), which control grouping of transactions for determining the transfer price of sales of export property, and §1.994-1(c)(6)(iv), which governs the grouping of receipts when the CTI method is used, speak to the questions whether or how research costs should be allocated and apportioned. Pp. 13-17.
(c) What little relevant legislative history there is in this suit weighs in the Government's favor. Pp. 18-19.
Stevens, J., delivered the opinion of the Court, in which Rehnquist, C. J., and O'Connor, Kennedy, Souter, Ginsburg, and Breyer, JJ., joined. Thomas, J., filed a dissenting opinion, in which Scalia, J., joined.
The opinion of the court was delivered by: Justice Stevens
On Writs Of Certiorari To The United States Court Of Appeals For The Ninth Circuit
This suit concerns tax provisions enacted by Congress in 1971 to provide incentives for domestic manufacturers to increase their exports and in 1984 to limit and modify those incentives. The specific question presented involves the interpretation of a Treasury Regulation (26 CFR §1.861-8(e)(3) (1979)) promulgated in 1977 that governs the accounting for research and development (R&D) expenses under both statutory schemes.*fn1 We shall explain the general outlines of the two statutes before we focus on that regulation.
The 1971 statute provided special tax treatment for export sales made by an American manufacturer through a subsidiary that qualified as a "domestic international sales corporation" (DISC).*fn2 The DISC itself is not a taxpayer; a portion of its income is deemed to have been distributed to its shareholders, and the shareholders must pay taxes on that portion, but no tax is payable on the DISC's retained income until it is actually distributed. See 26 U. S. C. §§991-997. Typically, "a DISC is a wholly owned subsidiary of a U. S. corporation." 1 Senate Finance Committee, Deficit Reduction Act of 1984, 98th Cong., p. 630, n. 1 (Comm. Print 1984) (hereinafter Committee Print). The statute thus provides an incentive to maximize the DISC's share -- and to minimize the parent's share -- of the parties' aggregate income from export sales.
The DISC statute does not, however, allow the parent simply to assign all of the profits on its export sales to the DISC. Rather, "to avoid granting undue tax advantages,"*fn3 the statute provides three alternative ways in which the parties may divert a limited portion of taxable income from the parent to the DISC. See 26 U. S. C. §§994(a)(1)-(3). Each of the alternatives assumes that the parent has sold the product to the DISC at a hypothetical "transfer price" that produced a profit for both seller and buyer when the product was resold to the foreign customer. The alternative used by Boeing in this suit limited the DISC's taxable income to a little over half of the parties' "combined taxable income" (CTI).*fn4
Soon after its enactment, the DISC statute became "the subject of an ongoing dispute between the United States and certain other signatories of the General Agreement on Tariffs and Trade (GATT)" regarding whether the DISC provisions were impermissible subsidies that violated our treaty obligations. Committee Print 634. "To remove the DISC as a contentious issue and to avoid further disputes over retaliation, the United States made a commitment to the GATT Council on October 1, 1982, to propose legislation that would address the concerns of other GATT members." Id., at 634-635. This ultimately resulted in the replacement of the DISC provisions in 1984 with the "foreign sales corporation" (FSC) provisions of the Code. See Deficit Reduction Act of 1984, Pub. L. 98-369, §§801-805, 98 Stat. 985.*fn5
Unlike a DISC, an FSC is a foreign corporation, and a portion of its income is taxable by the United States. See ibid.; see also B. Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholders ¶ ;17.14 (5th ed. 1987). Whereas a portion of a DISC's income was tax deferred, a portion of an FSC's income is exempted from taxation. Compare 26 U. S. C. §§991-997 with 26 U. S. C. §§921, 923 (1988 ed.). Hence, under the FSC regime, as under the DISC regime, it is in the parent's interest to maximize the FSC's share of the taxable income generated by export sales. Because the differences between the DISC and FSC regimes for the most part are immaterial to this suit, the analysis in this opinion will focus mainly on the DISC provisions.*fn6
The Internal Revenue Code gives the taxpayer an election either to capitalize and amortize the costs of R&D over a period of years or to deduct such expenses currently. See 26 U. S. C. §174. The regulation at issue here, 26 CFR §1.861-8(e)(3) (1979), deals with R&D expenditures for which the taxpayer has taken a current deduction. It tells the taxpaying parent and its DISC "what" must be treated as a cost when calculating CTI, and "how" those costs should be (a) allocated among different products and (b) apportioned between the DISC and its parent.*fn7
With respect to the "what" question, the Treasury might have adopted a broad approach defining the relevant R&D as including all of the parent's products, or, a narrow approach defining the relevant R&D as all R&D directly related to a particular product being exported. Instead, the regulation includes a list of two-digit Standard Industrial Classification (SIC) categories (examples are "chemicals and allied products" and "transportation equipment"), and it requires that R&D for any product within the same category as the exported product be taken into account.*fn8 See ibid. The regulation explains that R&D on any product "is an inherently speculative activity" that sometimes contributes unexpected benefits on other products, and "that the gross income derived from successful research and development must bear the cost of unsuccessful research and development." Ibid.
With respect to the two "how" questions, the regulations use gross receipts from sales as the basis both for allocating the costs among the products within the broad R&D categories and also for apportioning those costs between the parent and the DISC. Thus, if the exported product constitutes 20 percent of the parties' total sales of all products within an R&D category, 20 percent of the R&D cost is allocated to that product. And if export sales represent 70 percent of the total sales of that product, 70 percent of that amount, or 14 percent of the R&D, is apportioned to the DISC.
Petitioners (and cross-respondents) are The Boeing Company and subsidiaries that include a DISC and an FSC. For over 40 years Boeing has been a world leader in commercial aircraft development and a major exporter of commercial aircraft. During the period at issue in this litigation, the dollar volume of its sales amounted to about $64 billion, 67 percent of which were DISC-eligible export sales. The amount that Boeing spent on R&D during that period amounted to approximately $4.6 billion.
During the tax years at issue here, Boeing organized its internal operations along product lines (e.g., aircraft models 727, 737, 747, 757, 767) for management and accounting purposes, each of which constituted a separate "program" within the Boeing organization. For those purposes, it divided its R&D expenses into two broad categories: "Blue Sky" and "Company Sponsored Product Development." The former includes the cost of broad-based research aimed at generally advancing the state of aviation technology and developing alternative designs of new commercial planes. The latter includes product-specific research pertaining to a specific program after the board of directors has given its approval for the production of a new model. With respect to its $1 billion of "Blue Sky" R&D, Boeing's accounting was essentially consistent with 26 CFR §1.861-8(e)(3) (1979).*fn9 Its method of accounting for $3.6 billion of "Company Sponsored" R&D gave rise to this litigation.
Boeing's accountants treated all of the Company Sponsored research costs as directly related to a single program, and as totally unrelated to any other program. Thus, for DISC purposes, the cost of Company Sponsored R&D directly related to the 767 model, for example, had no effect on the calculation of the "combined taxable income" produced by export sales of any other models. Moreover, because immense Company Sponsored research costs were routinely incurred while a particular model was being completed and before any sales of that model occurred, those costs effectively "disappeared" in the calculation of the CTI even for the model to which the R&D was most directly related.*fn10 Almost half of the $3.6 billion of Company Sponsored R&D at issue in this suit was allocated to programs that had no sales in the year in which the research was conducted. That amount ...