P&G Appeals Deduction Denial

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 chimed 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 FSCg 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 Under the now-repealed FSC rules, the taxpayers were allowed to exempt 23% of their CTI permanently from tax under IRC [section][section] 921 and 923.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 [section] 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. …

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