Ward Europa, Inc. v. Comptroller of the Treasury

BLOOM, Judge. Ward Europa, Incorporated, a Maryland corporation, and Ward Overseas, Incorporated, a Delaware corporation, appeal from the judgment of the Circuit Court for Baltimore County affirming an order of the Maryland Tax Court upholding income tax deficiency assessments. Both appellants are wholly owned subsidiaries of The Ward Machinery Company, a Maryland corporation in the business of manufacturing and selling machinery and equipment. For the tax years at issue, each appellant was qualified as a domestic international sales corporation, commonly referred to as a DISC.

DISCs were creatures of federal tax law; they existed by virtue of the Internal Revenue Code (IRC) for the sole purpose of affording tax benefits to their ³³⁴ parent corporations, businesses engaged in the export trade. 1 The IRC excused these heteroclite corporations from paying taxes on a certain calculable percentage of their income. Maryland tax legislation, however, makes no provisions for these federal phantasms. When appellants calculated their Maryland taxes, they used formulas created for conventional corporations and concluded that they owed no tax at all. Appellee, the Comptroller of the Treasury, then adjusted the formulas and assessed a deficiency against appellants.

Appellants contest the authority of the Comptroller to make such adjustments. This appeal turns more on the interpretation of relatively clear statutory law than it does on the alchemy of taxation. Concluding that the Comptroller had adequate authority to adjust the apportionment formulas, we shall affirm the judgment below. Prefatory Note The entities involved in this appeal — DISCs—were abolished and replaced with entities called Foreign Sales Corporations (FSCs) through the Tax Reform Act of 1984 (TRA).

Although the TRA substantially amended that part of the IRC dealing with DISCs, the amendments did not become effective until January 1, 1985, and therefore do not affect this appeal. It should be noted, however, that this opinion focuses only on DISCs, entities formed under the then-existing sections of the IRC, and may not be applicable to foreign sales corporations. ³³⁵ Introduction DISCs were created by Congress in 1971 to encourage exports and remedy disadvantages suffered by U.S.-based exporting companies. Westinghouse Electric Corporation v. Tally, 466 U.S. 388, 389-90 , 104 S.Ct. 1856, 1858-59 , 80 L.Ed.2d 388 (1984). Until then, domestic corporations received better tax treatment if they had foreign subsidiaries manufacture products destined for foreign markets.

Thomas International Limited v. United States, 6 Cl.Ct. 414 (1984). Congress sought not only to remedy the inequitable tax treatment received by exporting companies based in this country but also to encourage domestic employment. See LeCroy Research Systems Corporation v. Commissioner of Internal Revenue, 751 F.2d 123, 124 (2d Cir.1984); Comment, Disc: A Tax Primer, 20 Loy.L.Rev. 325 (1974). To realize these goals, Congress elected to allow exporting corporations to create subsidiaries which were no more than accounting devices through which the parent corporation could defer tax liability on some of its income.

These shell corporations were created as DISCs through the Revenue Act of 1971, codified as 26 U.S.C. §§ 991-997 (1971). The paper corporations created by their parents had no assets, owned no property, and employed no personnel of their own; their sole activity was receiving money from the parent. Thomas International Limited v. United States, 773 F.2d 300, 301 (Fed.Cir.1985). The only purpose of a DISC was to postpone, forever if possible, tax liability on income earned by the parent.

The parent corporation essentially credited the DISC with some or all of its export income, using one of two methods. The parent could either sell its goods to the DISC, on paper, and then cause the DISC to sell them to the ultimate foreign purchaser, in which case the subsidiary was a “sales DISC,” or the parent could simply pay the DISC a commission out of the proceeds of sales made by the parent, in which case the subsidiary was a “commissions DISC.” I.R.C. § 994(b)(1); ³³⁶ Treas.Reg. § 1.993-1(1) (1977). Ward Europa was a sales DISC; Ward Overseas was a commissions DISC. Each year the DISC was deemed to have' distributed a certain percentage of its income, approximately one-half, to its shareholders (almost invariably the parent corporation) as a constructive dividend regardless of whether the dividend was actually paid.

The shareholder (parent) then paid taxes on the constructive dividend as it would on any other corporate dividend. The remaining portion of DISC income was called “accumulated DISC income,” with taxes thereon being deferred until one of three things happened: one, actual distribution of the income to the shareholder, at which time it became taxable income to the shareholder; two, sale of its stock by the DISC shareholder, at which time the shareholder would pay a tax based upon the amount of funds then remaining in the accumulated DISC income account; or three, loss of DISC qualification by the corporation, at which time all the income would become taxable. Note, Fine-Tuning the DISC: Evaluation and Framework, 11 Ga.L.Rev. 902 (1977); B. Bittker and J. Eustice, Federal Income Taxation of Corporations and Shareholders, § 17.14 (4th ed. 1979) (hereinafter cited as Bittker and Eustice). For purposes of relating this to Maryland law, it is important to note that although the DISC was exempt from paying taxes on its income by virtue of I.R.C. § 991, the income itself was fully taxable to its shareholders, some as constructive dividends and the remainder upon actual distribution.

Bittker and Eustice, supra. The DISC structure merely afforded a tax deferral, not an exemption. The parent corporation was not required to let its income waste away in the DISC, however, for I.R.C. § 993(d) permitted the DISC to lend money to the parent without the loan being construed as a taxable distribution of income, provided the loans were used by the parent only for export activities. Thomas International, 773 F.2d at 301-02 . ³³⁷ The most obvious problem with DISCs is that they were not traditional corporations.

When corporations were first beginning to be recognized by courts, the notion that a non-living entity should have an independent legal existence was seen as the dubious product of overly fertile legal imaginations. The wholly fictitious life afforded a DISC required an even more active imagination. DISCs had absolutely nothing that would signify their existence. They were hollow corporations, mere bookkeeping entries, sponsored by the federal government; they owned, leased or used no property, real or personal, and had no employees.

See Caterpillar Tractor Company v. United States, 589 F.2d 1040, 1044 , 218 Ct.Cl. 517 (1978). It is not surprising that state courts and legislatures were unprepared to deal with them. This case is the inevitable result of the Comptroller’s attempts to find a place for DISCs in Maryland’s taxation scheme. Background The tax years at issue in this case are those ending May 31 of 1979, 1980, 1981, and 1982 for Ward Europa.

Ward Overseas is concerned with its initial tax year, which ended June 30, 1982. For the years in question, appellants were duly qualified DISCs conducting all of their business out of the offices of their parent in Cockeysville in Baltimore County. This meant that neither Ward Europa nor Ward Overseas employed any personnel or owned any property and that at least 95 percent of their sales (commissions) were made in (or derived from sales to) foreign countries. Income realized by Ward Europa consisted solely of the difference between the price for which it sold goods to the foreign purchaser and the price it paid to its parent for those goods.

Ward Overseas’s income consisted entirely of commissions paid by the parent out of the proceeds the parent realized from direct sales to foreign purchasers. This appeal revolves around the determination of how much of the income earned by the two appellants is attributable to Maryland, and hence taxable by Maryland. The ³³⁸ question is controlled by statutes and regulations promulgated under them. The net income of a corporation is defined under Md.Ann.Code art. 81, § 280A(a) (1980), which, during the years in question, read: “The net income of a corporation shall be the taxable income of such taxpayer as defined in the laws of the United States as amended from time to time and for the corresponding taxable period ... except as hereinafter modified.” 2 As discussed supra, DISC income, while tax-deferred, was not tax exempt under the IRC; it was taxable income and hence eligible for inclusion as the net income of a corporation under § 280A(a).

The crucial statute is Md.Ann.Code art. 81, § 316(c) (1980), which prescribes how a corporation’s net income is to be allocated. After discussing income from real estate or tangible personal property in § 316(a) and capital gains and losses in § 316(b), the statute concludes: (c) Business income. — The remaining net income, hereinafter referred to as business income, shall be allocated to this State if the trade or business of the corporation is carried on wholly within this State, but if the trade or business of the corporation is carried on partly within and partly without this State so much of the business income of the corporation as is derived from or reasonably attributable to the trade or business of the corporation carried on within this State, shall be allocated to this State and any balance of the business income shall be allocated outside this State. The portion of the business income derived from or reasonably attributable to the trade or business carried on within this State may be determined by a separate accounting where practicable, but never in the case of a unitary business; however, where separate accounting is neither allowable nor practicable the portion of the business income of the corporation allowable to this State shall be determined in accordance with a three- ³³⁹ factor formula of property, payroll and sales, in which each factor shall be given equal weight and in which the property factor shall include rented as well as owned property and tangible personal property having a permanent situs within this State and used in the trade or business shall be included as well as real property. 3 The proper use of the three-factor formula, and the Comptroller’s authority to modify that formula, are at the heart of this appeal. For the tax year ending May 31, 1979, Ward Europa concluded that it and its parent constituted a unitary business 4 and that therefore it was entitled to apportion its income under a three-factor formula of payroll, property, and sales.

The actual composition of the formula is controlled by Md.Admin.Code tit. 03.04.01.03 § E (1978). When Ward Europa calculated its apportionment factor, however, it inadvertently used the formula provided in COMAR 03.-04.01.03 § E as it existed prior to amendment in 1978. Under the regulations in effect before 1978, a subsidiary obtaining the benefit of its parents’ employees, which Ward Europa did, having no employees of its own, had to account for that in the formula. Similarly, the old formula provided that the sales factor was to be determined by sales that were negotiated in Maryland, not merely sales “in this State.” Using the old formula, Ward Europa calculated ³⁴⁰ that it owed $40,243 in taxes, which it paid to the Comptroller.

In fact, the regulations on which Ward Europa had relied were substantially changed in 1978 to read as follows: .03 Allocation of Corporate Income The net income of every domestic and foreign corporation ... shall be allocated in the following manner: E. When separate accounting is neither allowable nor practicable, the portion of the business income of the corporation allocable to this State shall be determined as follows: (1) Corporations engaged in “manufacturing” and “selling” tangible personal property .producing business income allocable under these regulations shall allocate to this State the percentage of the business income as shall be determined in accordance with a three factor formula of property, payroll, and sales in which each factor shall be given equal weight and in which the property factor shall include rented as well as owned property, this rented and owned property to include tangible personal property having a permanent situs within this State and used in the trade or business, real property owned, rented or leased and used in the trade or business carried on within this State, but may not include, however, property rented or leased for the storage of tangible personal property or property, real or personal, held solely for the production of non-business income. (2) Of the amount of business income derived from the manufacture or sale of tangible personal property, there shall be allocated to this State such percentage of the business income as the average value of the property referred to in § E(l) above, and business within this State and payroll within this State bears to the average value of the total property referred to in § E(l) above and total business and total payroll; the percentage of property ³⁴¹ referred to in § E(l) of business and payroll to be separately determined and the three percentages averaged. (5) Payroll Factor. The payroll factor is a fraction, the numerator of which is the total amount paid in this State during the tax period by the taxpayer for compensation and the denominator of which is the total compensation paid everywhere during the tax period.

Compensation is paid in this State if: (a) The individual’s service is performed entirely within this State; (b) The individual’s service is performed both within and outside this State, but the service performed outside this State is incidental to the individual’s service within this State; or (c) Some part of the service is performed in this State and (i) The base of operations or, if there is no base of operations, the place from which the service is directed or controlled is in this State, or (ii) The base of operations or the place from which the service is directed or controlled is not in any state in which some part of the service is performed, but the individual’s residence is in this State. (6) Sales Factor. (a) The sales factor is a fraction, the numerator of which is the total sales of the taxpayer in this State during the tax period, and the denominator of which is the total sales of the taxpayer everywhere during the tax period. (b) Sales of tangible personal property are in this State if the property is delivered or shipped to a purchaser within this State regardless of the