Sixth Circuit: FSC regs bar IRS from arm's length adjustment where taxpayer used partnership method for CTI calculation

In an unpublished opinion, the U.S. Court of Appeals for the Sixth Circuit on April 28 reversed the district court's summary judgment in favor of the IRS in a case involving the former foreign sales corporation (FSC) regime (Procter & Gamble Co. v. United States, No. 08-4078 (6th Cir. Apr. 28, 2010)).

After determining that the district court had erred in its conclusion, the Sixth Circuit ruled that Procter & Gamble (P&G) had misapplied the combined taxable income (CTI) method of pricing under former section 925(a)(2), that the IRS had no authority to impose its preferred arm's length pricing method under former section 925(a)(3), and that the district court erred in holding that P&G was not entitled to use the passthrough method (also referred to as the "gross receipts" method) under former section 925(a)(1).

The district court had reasoned that P&G's alternate method was barred by the variance doctrine because P&G did not raise the method in its refund claim. The appeals court, however, found that P&G and its FSC (P&G-FSC) had, in fact, done so and that P&G therefore was entitled to calculate its tax liability under former section 925(a)(1).

At issue was the treatment of an Advance Payment Transaction, in which a P&G subsidiary (P&G-Canada) had paid P&G-FSC in advance and P&G-FSC had paid P&G in advance, so that P&G and P&G-FSC recorded income under the transaction for the 2000 tax year but recorded the related expenses in the 2001 tax year. The district court had examined whether the FSC CTI provision (former section 925(a)(2)) required a matching of expenses with income in completing the CTI calculation, concluding that matching was required and citing General Dynamics Corp. v. Commissioner, 108 T.C. 107 (1997), for the proposition that the CTI provision trumps prevailing accounting practices and other regulatory requirements. In reversing the district court on this point, the Sixth Circuit found that such a rule was not apparent in the plain language of the statute or related regulation and that the facts, issues, arguments, and analysis of the P&G case were virtually the opposite of those in General Dynamics.

While the Sixth Circuit found P&G's interpretation and application of the CTI method (former section 925(a)(2)) were erroneous, the court stated that, even assuming P&G's treatment of the transaction had led to a "material distortion of income," the IRS had no statutory or regulatory authority to impose its own arm's length calculation. Referencing former Treasury reg. section 1.925(a)-1T(a)(1), the appeals court found it dispositive that the IRS's own regulations went so far as to forbid the IRS from doing so where the taxpayer had employed the combined taxable income or the gross receipts method in calculating its CTI.

Given that the IRS was prohibited from making the adjustment, and the variance doctrine was inapplicable, the Sixth Circuit reversed and remanded for further proceedings.