Bowater, Inc. And Subsidiaries, Formerly Known as Bowater Holdings, Inc. v. Commissioner of Internal Revenue

Citations: 108 F.3d 12; 79 A.F.T.R.2d (RIA) 1317; 1997 U.S. App. LEXIS 3692Docket: 17-432

Court: Court of Appeals for the Second Circuit; March 2, 1997; Federal Appellate Court

SummaryOriginalCytator Case TreatmentBackward CitatorAnalysis

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The case involves Bowater, Inc. and subsidiaries, appealing a decision from the Tax Court regarding the interpretation of a Treasury regulation effective during 1979 and 1980, specifically 26 C.F.R. 1.861-8(e)(2)(ii). This regulation mandates that interest deductions must be allocated to all income-producing activities and properties of the taxpayer. The Tax Court had previously interpreted this regulation in favor of the Commissioner, following the precedent set in Dresser Ind. Inc. v. Commissioner, which stated that interest expenses should be allocated among all income-producing activities without netting interest income against interest expenses.

However, the Fifth Circuit had reversed the Tax Court's decision in Dresser, allowing for different interpretations. In this case, Bowater, Inc. used the "50/50 combined taxable income" method to compute its domestic international sales corporation (DISC) income, limiting taxable income to 50% of the combined taxable income attributable to export sales. In their consolidated tax returns for the relevant years, Bowater allocated interest expense to interest income before further allocating the remaining interest expense to income from export sales, effectively increasing the portion of taxable income benefiting from preferential tax treatment.

The Commissioner contends that this allocation method resulted in significant tax deficiencies for Bowater, amounting to $320,400 in 1979 and $686,700 in 1980. The Court ultimately sided with Bowater, reversing the Tax Court's prior decision in favor of the taxpayer's interpretation of the regulation.

The Commissioner asserts that Treasury regulation 1.861-8(e)(2) mandates that taxpayers allocate interest expenses evenly across all income-producing activities, including those generating interest income. Agreeing with the Commissioner and referencing the Tax Court's decision in Dresser, the regulation's clear language dictates that interest expenses apply to all activities and properties, regardless of the specific purpose for incurring interest. This includes defining interest as a type of income, with activities generating interest classified as income-producing. The regulation specifies that deductions for interest must be distributed to all income sources equally, with no exceptions, countering the taxpayer's suggestion to exclude interest-producing activities from this allocation. 

The taxpayer's interpretation relies on the concept that "money is fungible" to argue that interest expenses should be prioritized for interest income, but this interpretation is rejected. The regulation emphasizes that all money is fungible and mandates a broad allocation of interest expenses, recognizing that all activities require funding and allowing management flexibility in fund usage. The taxpayer's claim that the regulation treats interest as distinct from other income types lacks support in the regulation's language, which consistently applies the fungibility principle to both incoming and outgoing funds without exceptions.

The Taxpayer's argument for amending the Regulation to create an exception for interest income based on the fungibility of money is rejected. The sole case cited, Dresser, 911 F.2d at 1128, is critiqued for relying on a subjective interpretation of 'economic reality' that inaccurately relates interest expense directly to interest income. Dresser suggests that businesses borrow money in single transactions, investing surplus funds in interest-bearing instruments to minimize the cost of holding borrowed funds. This theory, however, conflicts with the Regulation's principle that money is fungible, which treats cash from all income-producing activities as interchangeable. The Regulation acknowledges that cash flows can vary greatly and that management exercises significant discretion over fund allocation, indicating that all activities contribute to borrowing costs by tying up funds. Consequently, both the Taxpayer's and Dresser's interpretations lack support in the Regulation. Additionally, the Commissioner argues for deference to the IRS's interpretation of the Regulation, which explicitly disagrees with Dresser and maintains that netting interest income against interest expense is not permitted before allocation. The Taxpayer’s objections to this IRS position, labeling it as self-serving, are dismissed based on the clarity of the Regulation’s language. The Taxpayer's concerns about potential tax law anomalies resulting from the government's position are noted, but no supporting authority is provided.

Taxpayer's interpretation of the Regulation suggests that one business could deduct less interest expense from its combined taxable income (CTI) than another, despite both incurring the same 'actual interest cost,' which is defined as interest expense minus interest income. This argument is based on a disputed economic theory rather than the Regulation's language. The analysis reveals that Taxpayer's reading would create inconsistencies between similarly situated Domestic International Sales Corporations (DISCs) and their suppliers. For example, if one DISC invests in interest-bearing securities and another in dividend-paying stock, Taxpayer’s approach would lead to different allocations of interest expense, resulting in a higher CTI for the first DISC due solely to the type of investment, contravening the Regulation's explicit directive that all income-producing activities, whether from interest or dividends, should be treated equally.

Taxpayer justifies this discrepancy by citing the varying risks associated with stocks versus bonds; however, such distinctions do not alter the fundamental principle that income from both types qualifies as income from income-producing activities. Furthermore, Taxpayer references a temporary regulation issued after the relevant tax years, asserting it supports their position. However, this temporary regulation merely clarifies the existing Regulation and does not substantively alter the rules regarding interest expense allocation. Therefore, the conclusion is that the existing Treasury regulation does not allow Taxpayer to increase the CTI of its DISCs by improperly allocating interest expense, which would yield an inflated income subject to preferential tax treatment.

The Tax Court's decision is reversed by Honorable William A. Norris of the Ninth Circuit. The relevant 1978 Treasury Regulation, specifically 1.861-8(e)(2), outlines the allocation and apportionment of interest expense. It establishes that money is fungible, meaning interest expenses are attributable to all activities and properties of the taxpayer regardless of the specific purpose for borrowing. This regulation implies that when funds are borrowed for one purpose, it allows other funds to be used for different purposes, making it reasonable to allocate part of the borrowing cost to those other purposes. Interest deductions are generally considered related to all income-producing activities and properties, thus allocable to all gross income generated or expected from those activities and properties.

The Commissioner supports its position with references to legislative history, while the taxpayer contends that the provision is ambiguous regarding whether interest expense should be allocated to interest income first before other income-producing activities. The court agrees with the taxpayer’s view. The Dresser case referenced involved less clear regulations than those applicable here, with the current regulation explicitly stating that interest expense relates to all income-producing activities. The taxpayer also contrasts stock dividends with interest payments, noting the uncertainties associated with stock dividends, including payment guarantees and price volatility, emphasizing that debt obligations must be satisfied before stockholder claims during financial distress.