CHURCH OF SCIENTOLOGY OF CALIFORNIA, Petitioner
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 3352-78.
United States Tax Court
Filed September 24, 1984.
Petitioner, a Church incorporated in the State of California, was granted tax-
exempt status in 1957 under sec. 501(c)(3), I.R.C. 1954. In 1967 respondent
sent petitioner a letter revoking its exemption following audit of petitioner's
records which was in part sparked by litigation involving the tax-exempt status
of an affiliated Church of Scientology. Subsequent to issuing the letter of
revocation, respondent conducted several audits of petitioner's records for
various tax years and also reviewed the tax status of several affiliated
churches. Petitioner was also investigated by several intelligence groups which
respondent specially formed during 1969 through 1975 to investigate taxpayers
allegedly selected by essentially political criteria. During the period that
petitioner's taxes were under administrative review, petitioner conspired to
prevent the IRS from determining and collecting taxes due from petitioner and
affiliated churches. Petitioner sold religious services, books, and artifacts
according to a fixed fee schedule through its branch churches and franchises.
Petitioner's profits from these sales were not less than $1,494,617.53 in
1970, $881,131.18 in 1971, and $1,707,287.17 in 1972. Petitioner maintained
large cash reserves in a sham corporation and in a bogus trust controlled by
key church officials including petitioner's founder. HELD, petitioner was not
the victim of selective enforcement of the tax laws since the notice of
deficiency was based on valid regulatory considerations. HELD FURTHER, various
other asserted constitutional rights of petitioner not violated. HELD FURTHER,
petitioner was not operated exclusively for an exempt purpose under sec.
501(c)(3), I.R.C. 1954, since petitioner had a substantial commercial purpose,
since its net earnings benefited key Scientology officials, and since it had
the illegal purpose of conspiring to impede the IRS from collecting taxes due
from petitioner and affiliated churches and thus its activities, dictated at
the highest level, violated well-defined public policy.
*382 ROBERT H. HARRIS, CHRISTOPHER COBB, MICHAEL WELLS, and PETER YOUNG,
specially recognized, for the petitioner.
MARTIN D. COHEN, for the respondent.
STERRETT, JUDGE:
Petitioner, the Church of Scientology of California (California Church or
Church), was incorporated as a non-profit corporation in the State of
California in 1954. In 1957 respondent recognized petitioner as an organization
described in section 501(c)(3) [FN1] exempt from Federal income taxes under
section 501(a). In 1967 respondent revoked petitioner's tax-exempt status.
Following an extensive audit of petitioner's records for the years 1971-1974,
respondent, by notice of deficiency dated December 28, 1977, determined
deficiencies in petitioner's Federal income taxes and additions to tax as
follows:
Addition to tax
Taxable year Deficiency under sec. 6651(a)
1970 $581,245.29 $145,311.32
1971 70,881.48 17,720.37
1972 498,332.10 124,583.02
*383 The controversy in this case is simply stated: Petitioner claims it is
exempt from taxation and respondent claims it is not. Subsumed within this
simple controversy, however, are numerous and complex subsidiary issues
including several challenges to the constitutionality of section 501(c)(3). The
questions presented for resolution in this case are:
1) Is the notice of deficiency null and void because respondent never issued a
final letter of revocation of exempt status?
2) Is the notice of deficiency or the letter revoking petitioner's tax-exempt
status based upon political animus or hostility to the religion of Scientology
in violation of the First and Fifth Amendments?
3) To the express conditions in section 501(c)(3) for exempting religious
organizations from taxation violate the First Amendment because they tax
religious income?
4) Do the express conditions in section 501(c)(3) for exempting religious
organizations from taxation violate the First Amendment because the Government
has no compelling interest in taxing religious income?
5) Are the express conditions in section 501(c)(3) for exempting religious
organizations overbroad provisions because they restrict commercial activity in
aid of religion which is affirmatively protected by the free exercise clause?
6) Are the express and implied statutory conditions for exempting religious
organizations from taxation unduly vague in violation of the First and Fifth
Amendments?
7) Does section 501(c)(3) violate the establishment clause of the First
Amendment because its enforcement advances some religions and inhibits others?
8) Does section 501(c)(3) violate the establishment clause because its
enforcement results in excessive Government entanglement in church affairs?
9) Does the First Amendment's protection for religious organizations relieve
petitioner of the burden of proof in this case and require respondent to assume
it?
*384 10) Is the statutory scheme prohibiting some tax-exempt organizations
but not others from using their net earning to benefit private interests
arbitrary and capricious?
11) Does the application of common law charitable trust doctrine to churches,
requiring their conformity to fundamental public policy standards evidenced by
criminal or civil statutes, violate the free exercise clause of the First
Amendment because there are less restrictive ways of regulating church-
sponsored misconduct?
12) Does the retroactive application of public policy standards derived from
the common law of charitable trusts to petitioner's operations deprive
petitioner of due process of law in violation of the Fifth Amendment?
13) May respondent, consistent with fairness, be heard to argue after the
start of trial the new position that the United Kingdom Church of Scientology
(United Kingdom Church) is a branch of petitioner?
14) During the years 1970, 1971 and 1972 did petitioner's activities include a
substantial commercial purpose?
15) During the taxable years in issue, did any part of petitioner's net
earnings inure to the benefit of any private shareholder or individual?
16) During the taxable years in issue, did petitioner's activities violate
common law standards of public policy applicable to charities and incorporated
in section 501(c)(3)?
17) If petitioner is not exempt from taxation, can the determinations in
respondent's notice of deficiency be upheld?
18) Is petitioner liable for additions to tax under section 6651(a) for
willfully failing without reasonable cause to file corporate income tax
returns (Forms 1120) in 1970, 1971 and 1972?
FINDINGS OF FACT
Some of the facts have been stipulated. They represent a miniscule part of the
record. In some instances, the stipulated facts were contradicted by the
remainder of the record. We, therefore, decline to incorporate in toto the
stipulations of fact in our findings. Instead we have made our own findings
giving weight to the stipulations only where their trustworthiness was not
discredited by the remainder of the record.
*385 Petitioner, the Church of Scientology of California, was incorporated
on February 18, 1954, as a non-profit corporation in the State of California.
When the petition herein was filed, petitioner's principal place of business
was located at 5930 Franklin Avenue, Los Angeles, California. Petitioner was
one of many Churches of Scientology organized worldwide. During the tax years
at issue, 1970-1972, it was considered the 'Mother Church' of all Churches of
Scientology in the United States.
The parties have stipulated that petitioner was organized exclusively for
religious purposes and that petitioner has satisfied the organizational
requirements found in section 1.501(c)(3)-1(b), Income Tax Regs. The Court
adopts this stipulation and finds that petitioner was organized to propagate
the faith of Scientology, a religion founded by L. Ron Hubbard, through such
means as the indoctrination of the laity, the training and ordination of
ministers, the creation of congregations and the provision of support to
affiliates and similar organizations.
THE RELIGION
Scientology teaches that the individual is a spiritual being having a mind and
a body. Part of the mind, called the 'reactive mind' is unconscious. It is
filled with mental images that are frequently the source of irrational
behavior. Through the administration of a Scientology process known as
'auditing,' an individual, called a 'preclear,' is helped to erase his reactive
mind and gain spiritual competence. A trained Scientologist known as an
'auditor' administers the auditing. He is aided by an electronic device called
an 'E-meter' which helps the auditor identify areas of spiritual difficulty for
the preclear by measuring skin responses during a question and answer session.
Scientology teaches that spiritual awareness is achieved in stages. The
religion defines different levels of awareness and prescribes the requisite
auditing to achieve each level. L. Ron Hubbard researched and developed the
spiritual awareness levels and the courses to train auditors. During the
docketed years L. Ron Hubbard continued this research. A chart entitled
'Classification Gradation and Awareness Chart of Levels and Certificates'
depicts levels of spiritual awareness *386 and corresponding auditor
training requirements in effect in 1970.
One of the tenets of Scientology is that anytime a person receives something,
he must pay something back. This is called the doctrine of exchange.
Petitioner's branch churches applied this doctrine by exacting a 'fixed
donation' for training and auditing.
Scientology is an international religion and during the docketed years there
were numerous Churches of Scientology around the world. These Churches were
organized along hierarchical lines according to the level of services (training
and auditing) they were authorized to provide. Churches which delivered
Scientology services at the lowest levels were called 'franchises' and later
'missions.' Churches which delivered auditing (also referred to as 'processing
') through Grade IV and training through Level IV as depicted on the
Classification Gradation and Awareness Chart were known as 'Class IV Orgs.'
Saint Hill Organizations and Advanced Organizations offered intermediate and
higher level services. A branch of petitioner known as 'Flag' offered the
highest level training and auditing.
Petitioner's branch churches were opened daily and nightly to provide auditing
and training. Petitioner's ministers also officiated at weekly Sunday services
and performed services such as marriages, baptism and funerals.
CORPORATE STRUCTURE
The parties stipulated to seven divisions. They are:
1) San Francisco Organization (SFO) 2) Los Angeles Organization (LAO) 3)
American Saint Hill Organization (ASHO) 4) Advanced Organization of Los
Angeles (AOLA) 5) Flag Operations Liaison Office (FOLO or FOLO WUS) (prior to
June 6, 1972 known as United States Liaison Office (USLO)) 6) Flag 7) United
States Guardian Office (USGO)
In addition to these seven stipulated divisions, we find that Scientology
Churches and organizations in the United Kingdom (hereinafter collectively
referred to as the United Kingdom *387 Church) were part of the California
Church. Furthermore, the Operation Transport Corporation, Ltd. (also known as
Operation Transport Services, OTC or OTS), a noncharitable Panamanian
corporation, had no true, independent existence apart from petitioner's Flag
division.
A. THE STIPULATED DIVISIONS
The San Francisco Organization (SFO) and the Los Angeles Organization (LAO)
were both 'Class IV organizations.' As such they were authorized to conduct
training through Class IV and auditing through Grade IV as depicted on the
Classification Gradation and Awareness Chart. They were open 7 days a week for
training and auditing and related activities. The American Saint Hill
Organization (ASHO) located in Los Angeles, like SFO and LAO, provided auditing
and training but at higher levels. ASHO also published and distributed
Scientology books, prerecorded tapes, and E-meters throughout the United
States. The staff at ASHO were mostly members of the Sea Organization, an elite
order of Scientologists. The Advanced Organization of Los Angeles (AOLA)
provided high levels of auditing and training to persons who had completed
services at a Class IV organization. The staff at AOLA were mostly Sea
Organization members and the parishioners came from all over the United States
and Canada.
The Flag Operations Liaison Office (FOLO), located in Los Angeles, was an
administrative unit of the California Church. [FN2] It did not provide
religious services except to the staff. FOLO relayed administrative advice
emanating from Flag, the headquarters of the California Church, to other
branches of the California Church and to other Scientology Churches. The staff
at FOLO played a significant role in promoting the growth and development of
Scientology by providing training to staff from other organizations, by
supervising the implementation of new programs developed at Flag, and by
providing administrative assistance to new organizations. FOLO also relayed
funds from other branches of the California Church and from other churches to
Flag. The staff at FOLO were members of the Sea *388 Organization. Other
Scientology Churches in the United States and abroad had counterpart FOLO
units.
Flag was the highest division of the California Church. It provided spiritual
leadership. It also acted as petitioner's administrative center. During the
taxable years, the Flag division was headquartered aboard a ship, the Apollo,
which cruised the Mediterraneen Sea and docked in various countries along its
shores. L. Ron Hubbard, his wife, Mary Sue, and their family lived on the
Apollo with other members of the ship's crew and staff. All staff and crew were
Sea Organization members. Flag also had two outposts: The Tangier Reception
Center (TRC) and the Mission European Agency (MEA). MEA served as a relay point
for personnel, deliveries, and communications going to Flag, and TRC, among
other things, housed the overload of students who came to Flag for training.
Flag activities fell into three general areas, each conducted by a separate
organization within Flag. The Flagship Organization was responsible for all
nautical functions--sailing, maintenance and port relations. The Flag
Administrative Organization provided religious and administrative training and
auditing at the highest levels. The majority of the students who came to Flag
for training were staff members sent from petitioner's other divisions or from
other Churches of Scientology. Students lived aboard the ship or stayed at TRC.
After completing their course work they generally returned to their local
organizations.
The Flagship Bureau was petitioner's management body. This management function
was fulfilled in a variety of ways which are only briefly recounted here.
First, petitioner's other divisions and other Churches sent reports on a
regular basis to Flag. These reports supplied information, often in statistical
form, about the organizations' operations. Flag staff, on the basis of their
review of these reports, issued policy letters, directives and other kinds of
administrative advice geared to improving local church operations. Second, Flag
personnel researched and developed programs and techniques for improving the
administration of local organizations. Finally, Flag sent teams of individuals
specially trained in management techniques 'on mission' to help other units or
churches which were experiencing difficulties.
*389 L. Ron Hubbard officially resigned his position as executive head of
the California and other Churches of Scientology in 1966. Despite his official
resignation various charts of petitioner depicting management functions during
the docketed years continued to place him in the top position. He also held the
rank of Commodore, the highest rank in the Sea Organization, which was an elite
fraternity of Scientologists. He kept control over the California Church policy
by authoring numerous policy letters and by allowing others to go out in his
behalf. He also wrote other types of policy directives including Flag Orders,
L. Ron Hubbard Executive Directives, and Orders of the Day. He made important
decisions affecting Church administration, transferring U.S. Pubs from the
Denmark Church to ASHO and disbanding the Executive Council Worldwide which had
overseen the day-to-day operations of the Church. He supervised the activities
of the Franchise Office. Staff consulted with him before inagurating major
plans and whenever an operation of the Church was foundering.
L. Ron Hubbard's control over petitioner's financial affairs was particularly
notable and was longstanding. In the years immediately preceding the taxable
years, L. Ron Hubbard was a signatory on all Churches of Scientology bank
accounts including petitioner's. His approval was required for all financial
planning. He was the sole 'trustee' of a major Scientology fund into which
petitioner made substantial payments. He decided to open Swiss bank accounts
for petitioner and to put them in the name of OTC. He sent a Flag executive to
AOLA to revamp its financial operations. He authorized the purchase of a ranch
in Ensenada, Mexico and wrote a check for $80,000 on one of petitioner's Zurich
accounts for its purchase. His control continued during the docketed years. He
remained a signatory on petitioner's bank accounts including the OTC accounts.
His approval was required for financial planning. He authorized the removal of
huge sums of money from petitioner's Swiss bank accounts maintained in the name
of OTC.
Apart from his executive duties, L. Ron Hubbard also engaged in research and
writing and supervised auditing.
During the docketed years L. Ron Hubbard was served by an executive group
variously known as the Commodore's Staff *390 Aides, the Aides Council, and
the International Board of Scientology Organizations. Mary Sue Hubbard was the
senior person on the Aides Council. The Aides Council had seven other members,
one to oversee the planning for each division on the Scientology Org. Board.
The Org. Board is a theoretical model or blueprint of the organization of a
Scientology Church. All Scientology Churches around the world were organized
along similar lines. The Org. Board shows that each Scientology Church was
organized to have seven divisions and that each division carried on a specific
function. Division 1, called the HCO Division, was responsible for
communications. Division 2, called the Dissemination Division, was responsible
for the dissemination of Scientology literature, materials, and services.
Division 3, called the Treasury Division, was responsible for finances.
Division 4, called the Technical Division, was responsible for training and
auditing. Division 5, called the Qualifications Division, was responsible for
quality control in the delivery of services. Division 6, called the
Distribution Division, was responsible for public relations and Division 7, the
Executive Division, was responsible for managing the organization and
coordinating the programs and policies of the other divisions on the
Scientology Org. Board. A member of the Aides Council called a 'CS-1, CS-2,'
etc., depending on the area of divisional responsibility, was in charge of the
overall planning for each division. In sum, the Aides Council helped L, Ron
Hubbard manage petitioner's operations and plan for Churches of Scientology
around the world.
The CS-3 on the Aides Council was in charge of a Flag Banking Officer network.
Each Scientology Organization offering advanced services had a Flag Banking
Officer (FBO) who banked the organizations funds, reviewed and approved its
weekly financial plan and generally monitored its financial affairs. The FBO's
primary responsibility was to insure his church's solvency. The FBO was also
responsible for collecting and sending to Flag weekly sums for support and
training. The FBO network was international. During the taxable years in issue,
the following branches of petitioner's stipulated divisions had an FBO: AOLA,
ASHO, USLO, and Flag. A precise description of the FBO chain of command does
not emerge from the record. However, it is clear that the top officials of the
FBO network were the Flag FBO, the Staff Banking *391 Officer (SBO), and the
CS-3, all posted at Flag. The continental FBOs operated over the local FBOs,
under the authority of the top officials of the network. At least during 1969,
and perhaps during the docketed years, the FBO International, posted at AOLA,
also exercised mid-level leadership.
The United States Guardian Office (USGO) located in Los Angeles was in charge
of petitioner's external affairs. Its chief responsibility was to safeguard
petitioner's institutional well-being. Towards this end it performed a number
of functions. It handled petitioner's relations with other organizations
including governmental bodies and agencies. It also handled legal matters for
petitioner and other Churches of Scientology in the United States. It performed
accounting services for petitioner and prepared petitioner's tax returns. It
informed the public on a national level about the works and doctrines of
Scientology and documented unfavorable or inaccurate public comment on
Scientology. During the docketed years, the United States Guardian Office had
five divisions: Legal, Public Relations, Finance, Intelligence and Technology.
The United States Guardian Office was part of an international network of
Guardian offices and Guardian personnel. The highest ranking Guardian was Mary
Sue Hubbard, L. Ron Hubbard's wife. She held the position of Commodore Staff
Guardian (CSG). Although Mary Sue Hubbard lived on the Apollo and was the
senior Guardian, the senior Guardian office, called the Guardian Office
Worldwide, was part of petitioner's United Kingdom operations. Jane Kember, the
Guardian Worldwide, headed the office. In addition to USGO and the Guardian
Office Worldwide, the Guardian network consisted of Guardian personnel attached
to other branches of the California Church and other Churches of Scientology.
B. UNITED KINGDOM CHURCH
The notice of deficiency issued on December 28, 1977 did not treat the United
Kingdom Church as a branch of petitioner. It did not include the accounts of
the United Kingdom Church, and specific transactions between the two Churches
were treated as transactions between separate entities. Thus, payments made by
the United Kingdom Church to petitioner's Flag branch were shown as income to
petitioner and not as internal transfers of funds. Respondent's pretrial
pleadings and memoranda, reflecting the notice of deficiency, also
*392 treated the United Kingdom Church as a separate entity from petitioner.
The trial of this case began on November 10, 1980 and lasted 10 weeks spread
out over the course of a year. [FN3] The relationship between petitioner and
the United Kingdom Church was first raised during the third week of trial, on
December 11, 1980, immediately after petitioner rested its case-in-chief.
Respondent raised the issue when he sought to introduce into evidence certain
checks representing franchise payments drawn by the Calgary Scientology Mission
and variously made payable to the Church of Scientology of California or the
Church of Scientology of California, WW. Since Worldwide, or its abbreviation
'WW', was a name used by the United Kingdom Church, respondent sought to show
by these checks and other evidence that the United Kingdom Church was a branch
of petitioner. On December 12, 1980, the second day of respondent's case,
respondent again pressed the Court to hear evidence relating to the United
Kingdom Church. Respondent disavowed any intention of seeking an increase in
the notice of deficiency by reason of the United Kingdom Church's income.
However, respondent urged the Court to entertain the matter on the limited
issue of petitioner's entitlement to tax-exempt status. Respondent proffered
three theories of relevance. First, the franchises managed by the United
Kingdom Church were a commercial operation. Second, petitioner's attempt to
conceal the corporate status of the United Kingdom Church was one more link in
the chain of activities making up petitioner's conspiracy to obstruct the
Internal Revenue Service (IRS or Service). Third, L. Ron Hubbard possibly
benefited from the money deposited in the Worldwide franchise accounts.
As the trial progressed, respondent, on February 9, 1981 and again on April 9,
1981, stated his intention to reduce the scope of his reliance on matters
relating to the United Kingdom Church so that on April 9, 1981 respondent said
he planned to use the matter solely as it was relevant to proving petitioner
conspired to obstruct the IRS. However, respondent quickly retracted this
decision the following day. On July 20, *393 1981, the first day of the
seventh week of trial, this Court ruled that respondent could present evidence
relating to the United Kingdom Church's activities and corporate status under
three theories of relevance: commercialism, inurement and conspiracy.
Petitioner began its rebuttal case on August 17, 1981. With continuances
petitioner completed rebuttal on November 12, 1981. During rebuttal, petitioner
presented documentary and testimonial evidence directed toward refuting loss of
tax-exempt status as a result of the United Kingdom Church's operations.
Respondent knew that his claim that the United Kingdom Church was a branch of
petitioner made the determination in the notice of deficiency, treating
payments from the British Church to OTC as Flag income, erroneous. He was aware
that his new position would therefore necessitate a hearing under Rule 155 to
recompute the notice of deficiency. Respondent consistently disavowed any
intention to use the income from the United Kingdom Church to increase the
notice of deficiency.
By the end of 1974, respondent's files contained documents from various
sources identifying the United Kingdom Church as a branch of petitioner. One
such document was a report entitled 'Enquiry Into the Practice and Effects of
Scientology' (Foster Report) prepared for the House of Commons in the United
Kingdom on December 21, 1971 by Sir John G. Foster, K.B.E., Q.C., M.P. The
report quoted part of a letter from British Scientologists which stated:
The main activities of Scientology in the United Kingdom are carried on by the
Church of Scientology of California (non-profit Corporation in California
registered under Part X of the Companies Act) with its branches at St. Hill
Manor, London, Brighton, and Swansea. (Foster Report at 26.)
The report also reprinted in full a policy letter written by L. Ron Hubbard
explaining the financial considerations which led the California Church to take
over the United Kingdom Scientology organization and detailing the history of
the transfer. The files of the IRS also contained balance sheets for the fiscal
years ended April 5, 1967 and April 5, 1968, which the California Church had
filed with the Registrar of Companies in the United Kingdom in order to conduct
its operations there. The balance sheets were headed:
*394 CHURCH OF SCIENTOLOGY OF CALIFORNIA
A company incorporated in the State of California, U.S.A. and registered
under Part X of the Companies Act 1948 on 29th March 1966 and not having a
share capital.
In March 1975 respondent audited the Church of Scientology of Hawaii (Hawaii
Church). This audit was immediately followed by a year-long audit of the
California Church's 1971-1974 tax years. During these audits respondent
reviewed letters, checks, receipts, and disbursement vouchers, some bearing
such names as Church of Scientology of California UK, Church of Scientology of
California WW, Church of Scientology Worldwide, Publications Org. WW, or HCO WW
as a name on the letterhead or as the endorsement or payee. A few letters and
receipts bore petitioner's name in bold print on the letterhead and the words
'a non-profit corporation in U.S.A. Registered in England' in fine print across
the bottom.
A few documents prepared by the IRS show that some of respondent's employees
knew that the United Kingdom Church was a branch of petitioner. The chief of
respondent's Foreign Operations Division in a memorandum to the chief of the
Audit Division, Honolulu District Office, dated November 18, 1966 stated:
The Hubbards attempted to organize a British corporation as a religious non-
profit organization, but the British tax authorities refused to grant the
corporation tax free status. They then organized the Los Angeles corporation
and they now carry on their British operations as a part of that corporation.
Respondent's representative in London reviewed the documents petitioner filed
with the Registrar of Companies in Great Britain. In a memorandum dated
November 18, 1974, transmitting these documents to respondent's Refund
Litigation Division, he concluded that the accounts of the United Kingdom
Church could be incorporated with petitioner's for tax purposes. At least two
other reports prepared by respondent's representatives show knowledge that the
California Church was registered to conduct operations in Great Britain. One of
these reports was distributed to a Scientology Task Force in December 1974. A
report prepared by Service personnel after auditing the Hawaii Church in March
1975 tentatively concluded that the Publication Org. WW, a Scientology
*395 organization operating in the United Kingdom, was a division of the
California Church.
Lewis J. Hubbard, Jr. served as respondent's advisory on Scientology matters
from middle or late 1974 until July 1977. During this period Lewis Hubbard held
the position of Staff Assistant to the Associate Chief Counsel (Litigation).
Lewis Hubbard directly oversaw the exempt function audit of the Hawaii Church
which took place in March 1975 (Hawaii audit) and served as the National Office
advisor during the year-long audit of petitioner's 1971-1974 tax years (1971-
1974 audit). Before overseeing the Hawaii audit Lewis Hubbard read a few
documents which either explained that the United Kingdom Church was a branch of
petitioner or perhaps made passing reference to this fact. He read the Foster
Report. He saw petitioner's certificate of incorporation which it filed with
the Registrar of Companies in the United Kingdom in order to operate there. He
also skimmed one transmittal memorandum dated November 18, 1974 from
respondent's London representative which opined that the United Kingdom
Church's accounts could be incorporated with petitioner's for tax purposes.
However, Lewis Hubbard did not recall reading that portion of the memorandum.
During the Hawaii audit, Lewis Hubbard questioned Joel Kreiner, a Church lawyer
and high-ranking Guardian official, about the status of the United Kingdom
Church. Kreiner told Lewis Hubbard that petitioner incorporated the United
Kingdom Church but it operated separately and independently. After overseeing
the Hawaii audit, Lewis Hubbard authored a report in which he tentatively
concluded that the Publication Org. WW was a division of the California Church.
Following the 1971-1974 audit, Revenue Agent Eugene Endo, on the advice of
Lewis Hubbard, changed some wording in a draft of his report of the audit. The
original version said that the audit disclosed that petitioner had seven
branches and then listed them. The final version again stated that petitioner
had seven branches but inserted the phrase 'California's submission outlined
the seven branches as follows: :' before listing them.
On most occasions when the subject arose, petitioner misled respondent about
the legal status of the United Kingdom Church. In 1967 respondent asked
petitioner to list its subordinate churches. Petitioner's reply letter did not
mention *396 the United Kingdom Church. [FN4] Again, during the 1971-1974
audit, respondent twice asked petitioner to list its divisions. Petitioner did
not mention the United Kingdom Church. Petitioner was dissatisfied with
respondent's report of the audit and so wrote its own report correcting what it
viewed to be respondent's errors. Petitioner's version did not list the United
Kingdom Church as a branch church. On the first day of trial petitioner and
respondent filed Stipulation of Facts (Set Number 3) listing the divisions of
the Church. The United Kingdom Church was not listed. [FN5] During the 1971-
1974 audit, respondent asked for an explanation of several FOLOs including the
FOLO in the United States (FOLO WUS) and the FOLO in the United Kingdom (FOLO
UK) and was told that FOLO WUS was part of petitioner but FOLO UK was part of
an overseas Church. Also when respondent asked for a list of petitioner's bank
accounts, none of the United Kingdom accounts were listed in petitioner's
response. The Church's report of the 1971-1974 audit, in discussing the United
Kingdom Church's alleged debt repayment to OTC, named several British
Scientology organizations and stated they were 'part of the corporate entity of
the UK Church.' Prior to trial, respondent subpoenaed the records of the United
Kingdom Church bank accounts used to deposit franchise payments. Objecting to
the subpoena, petitioner in open court said:
The accounts referred to there are not accounts of the Church of Scientology
of California and they are not in its custody and control. It is true that the
accounts bear the name Church of Scientology of California Worldwide but they
are actually accounts of the United Kingdom Church of Scientology which until
two years ago, as I understand it, was incorporated as the Church of
Scientology of California but never, ever was a part of the Church of
Scientology of California that's involved in this case.
Those accounts have had nothing to do with the Church of Scientology of
California involved in this case.
The United Kingdom Church was formally organized as a branch of petitioner in
1966 when the assets of the Scientology organizations in the United Kingdom
were conveyed to petitioner *397 which then registered to do business in the
United Kingdom as a foreign corporation under the Companies Act of 1948, 11
Geo. 6, Ch. 38. Tax considerations partly motivated the transfer. British
authorities would not grant tax-exempt status to local Scientology
organizations. Petitioner therefore took over the assets of those organizations
so that they could carry on under petitioner's tax-exempt mantle.
The United Kingdom Church purported to have its own board of directors.
Anthony Dunleavy, a high-ranking church official who served as a Commodore
Staff Aide during the docketed years, testified about his tenure on the board
preceding the docketed years. He gave three different versions of his term on
the board, changing dates as he was confronted with conflicting documentary
evidence. By the end of his testimony he had completely changed his initial
statement regarding the dates of his tenure. He was also evasive about who were
the prior members of the board. At first he claimed not to know who they were.
Then confronted by one of respondent's exhibits, he claimed his memory was
refreshed and listed the prior members. Testimony about board membership during
the docketed years was also conflicting, one Church witness naming one set of
members and another Church witness naming a different set except for one common
member. A few board minutes were placed in evidence. Two of these are
captioned 'Church of Scientology of California' and refer in their text to
officers of the United Kingdom Church as 'Directors of the Church of
Scientology of California.' The Franchise Office was a major division of the
United Kingdom Church. The board of the United Kingdom Church did not have
final authority for its management. Diana Hubbard, L. Ron Hubbard's daughter
and a Commodore Staff Aide, had the final authority.
The California Church and the United Kingdom Church shared responsibility for
the franchises. The California Church issued the franchise charters, [FN6] gave
them some legal advice, *398 served occasionally as an intermediate
collection point for franchise payments and ultimately established franchise
policy. For its part, the United Kingdom Church collected weekly tithes and
operating reports, distributed policy letters, and gave day-to-day operating
advice.
United Kingdom Church officials were signatories on the California Church's
accounts and vice versa. Mary Sue Hubbard was authorized to sign checks on
virtually all the United Kingdom Church accounts, including Church of
Scientology of California Rubric Worldwide Account Number 292236 at the Swiss
Bank Corporation in Zurich, Switzerland where franchise tithes were deposited.
Denzil Gogerly, who by all accounts was a member of the board of directors of
the United Kingdom Church during the docketed years, was sole signatory on
petitioner's accounts. He signed checks on SFO's and USGO's accounts. Jane
Kember, the highest ranking official in the United Kingdom Church's Guardian
Office, was also a sole signatory on petitioner's accounts. Herbie Parkhouse,
the Deputy Guardian of Finance in the United Kingdom Guardian Office, issued
checks on the United States Guardian Office account.
The Guardian Offices of both churches were also interconnected. Mary Sue
Hubbard at Flag was the chief executive for both offices. Furthermore,
sometimes both offices collaborated and jointly issued policy directives on
behalf of L. Ron Hubbard or the California board of directors.
For part of the docketed years the United Kingdom Church tithed to the United
States Churches of Scientology Trust. The trustors of this purported trust were
all Scientology Churches in the United States. Petitioner was a trustor.
The United Kingdom Church had several divisions. These were: Worldwide; the
Hubbard College of Scientology, St. Hill; the Hubbard College of Scientology
St. Hill Foundation; Advanced Organization United Kingdom; London Day; London
Foundation; Plymouth; Brighton; and Swansea. Worldwide in turn had several
departments: the Executive Council Worldwide, the Franchise Office Worldwide,
the Guardian Office Worldwide, and the Flag Operation Liaison Office, United
Kingdom (FOLO UK). In 1971 the United Kingdom Church underwent some
reorganization. The Executive Council Worldwide was officially disbanded. The
Hubbard College *399 of Scientology, St. Hill merged with the Hubbard
College of Scientology St. Hill Foundation. The FOLO UK split off from
Worldwide.
C. OPERATION TRANSPORT CORPORATION, LTD.
The Operation Transport Corporation, Ltd., was a L. Ron Hubbard and
petitioner. It's board of directors lacked bona findes. Panamanian corporation
incorporated by L. Ron Hubbard, Mary Sue Hubbard and Leon Steinberg on February
17, 1968. It was not organized as a non-profit corporation. No shares of stock
were issued.
OTC was a sham corporation controlled by L. Ron Hubbard, Mary Sue Hubbard and
Leon Steinberg were the original directors of OTC. They resigned immediately
after the corporation's formation and were replaced by Brian Livingston, Joyce
Popham and Barry Watson. All three of these individuals were Flag employees.
Joyce Popham was the secretary to L. Ron Hubbard's personal aide. Barry Watson
and Brian Livingston were Class-10 auditors and served on the Aides Council.
During the docketed years, these three individuals performed only one board
function. Sometime in the summer of 1972 they approved L. Ron Hubbard's
decision to transfer approximately $2 million from OTC bank accounts in
Switzerland to Apollo. That they even performed this function is questionable
since there are no minutes of the board meeting adopting a resolution
authorizing the transfer. A signature card for petitioner's account number 6919
at the Crocker-Citizens National Bank in Los Angeles, California underscores
the lack of substance of the OTC board of directors. It certifies that on
November 18, 1968 the board of directors of the 'O.T.S., Advanced Organization
Church of Scientology of California' authorized the signatories listed on the
card to sign checks on behalf of the corporation.
OTC purportedly performed banking services for Flag. However, the record shows
that OTC had no offices, officers, or employees and that Flag employees were
actually the ones who handled all of petitioner's financial activities. During
the docketed years petitioner deposited Flag division funds in accounts
maintained in the name of OTC. The signatories on the OTC accounts were all
Flag employees. Except for Joyce Popham, who apparently never wrote a check,
they had no connection with OTC. Besides keeping the checkbooks, Flag
*400 officials, not OTC personnel, directed the flow of funds into and out
of OTC accounts, receipted money for the support of Flag operations and
controlled and managed Flag expenditures. Furthermore, Flag officials did not
differentiate between Flag and OTC invoices and disbursement vouchers when they
recorded Flag receipts and expenses.
L. Ron Hubbard and Mary Sue Hubbard controlled OTC funds. L. Ron Hubbard
initiated the practice of depositing Flag funds in OTC bank accounts. Sometime
before the Apollo went to Corfu in August 1968, he directed a Flag official to
travel to Zurich, Switzerland to open bank accounts in the name of OTC. At that
time two numbered accounts were opened. They were account number 295,728 and
account number 295,728.1. During the taxable years in issue the major share of
OTC funds were banked in those accounts. There were other OTC accounts. L. Ron
Hubbard was a signatory on all the major OTC accounts. In the summer of 1972,
L. Ron Hubbard authorized the transfer of approximately $2 million in cash from
OTC accounts in Switzerland to the Apollo. The money was stored in a locked
file cabinet to which Mary Sue Hubbard had the only set of keys.
To avoid harassment, Flag officials on board the Apollo were instructed to
tell strangers they were employed by OTC and that OTC was a management company.
This cover story was first used in March 1969 when the Apollo was suddenly
asked to leave Corfu, Greece. It was formalized in a Flag Order dated December
24, 1970.
D. THE SEA ORGANIZATION
The Sea Organization was a fraternal organization of elite Scientologists. Its
membership consisted of persons who dedicated their lives to work fulltime for
Scientology. Sea Organization members signed a 'contract of employment'
pledging to work for the Sea Organization for a billion years. Sea Organization
members were frequently sent on missions to Scientology organizations
throughout the world to handle problems interfering with the effective
administration of the organization and the delivery of Scientology services.
Organizations mostly or entirely staffed by Sea Organization members were
called 'Sea Org. Orgs.' The following divisions of petitioner were Sea Org.
Orgs.: Flag, ASHO, AOLA, and *401 FOLO. The leadership of the Sea
Organization came from petitioner's Flag Division.
CHURCH POLICY
California Church officials administered the Church in accordance with written
policy directives called 'issues.' There were several different kinds of issues
classified by a combination of factors including author, period of
effectiveness, and designated audience. The most important issue was called a
Hubbard Communications Office Policy Letter (HCO PL or policy letter). These
issues were usually written by L. Ron Hubbard. Sometimes, however, they were
written by a high-ranking Scientologist with L. Ron Hubbard's approval or the
approval of the Aides Council (also known as the International Board). Policy
letters set basic administrative policy. They took precedence over all other
types of issues. Each policy letter was dated and had a legend showing its
designated area of distribution on the upper left-hand corner of the first
page. Policy letters were intended to remain in full force and effect until
officially cancelled or modified by another policy letter.
Initially policy letters were distributed individually in looseleaf form or in
packets called 'hat-packs.' Beginning in 1970 a Scientology organization in
Denmark began to compile the policy letters and publish them by subject matter
in a comprehensive set of volumes called the Organization Executive Course or
'OEC.' The project took years to complete. Individual volumes were published as
they were completed. By 1974 petitioner published the complete nine volume
work. Most of the policy letters in the OEC series contain information about
Church administrative practices but some contain instructions on religious
practice. As previously found, a typical Scientology church has seven operating
divisions. The OEC volumes are organized so that volumes 1 through 7 of the
series each contain policy letters relating to the management, operation and
activities of a corresponding division of a Scientology church. Volume 0 of the
OEC series is an introductory volume. It contains policy letters describing
basic staff duties and responsibilities and the rudiments of Church structure
and organization. The Management Series volume contains policy letters relating
to data collection, public *402 relations, personnel practices, operational
control, finances, executive duties, and the establishment of churches. The OEC
series does not contain every policy letter. The OEC volumes indicate in
brackets when a policy letter has been formally cancelled or amended. Some HCO
PLs fell into desuetude without being officially cancelled. [FN7]
There were other types of policy issues besides policy letters governing
petitioner's administrative practices. In addition to writing policy letters,
L. Ron Hubbard also wrote executive directives called L. Ron Hubbard Executive
Directives (LRH EDs). These communicated short-range orders and directions and
described current projects and programs. They were generally written for a
limited audience such as a specific organization, region or staff position. LRH
EDs were only valid for a year and then they automatically expired. Guardian
Orders were another type of issue. They set policy for the Guardian Offices and
Guardian staff of the Churches of Scientology including petitioner. Guardian
orders were issued by the authority of Mary Sue Hubbard or Jane Kember, the
Guardian Worldwide Guardian Orders did not expire automatically. Flag Orders
set policy for Scientology Sea Organizations including the following divisions
of petitioner: Flag, FOLO, ASHO, and AOLA. Most Flag Orders were written by L.
Ron Hubbard or with his approval. Flag Orders did not automatically expire at
the end of a fixed period.
Another type of issue was the Order of the Day (OOD). The commanding officer
of every church unit was supposed to write an OOD daily. This form of issue was
used to communicate newsworthy events, to promulgate daily schedules, and to
publicize plans and directions for current programs and projects. The first
section of the Flag Order of the Day was reserved for communications from L.
Ron Hubbard.
The front piece of each volume in the OEC contains a partial disclaimer
stating that the policy letters 'should be construed only as a written report
of * * * (L Ron Hubbard's) research and not as a statement of claims made by
the Church or the author.' Despite this disclaimer the California Church
clearly adopted and utilized the policy letters. Each California Church
*403 staff member had a folder of materials called a 'hatpack' describing
the duties of his position and the place his position occupied in the
organization's structure. The hatpack contained policy letters. Staff members
were expected to read the hatpack materials and were quizzed on their contents.
Sometimes the failure to follow a policy letter inspired a quiz on the hatpack
materials. California Church members also studied policy letters in work-
training courses they were encouraged to take. One course, the OEC course
offered by most of petitioner's branch churches, was entirely devoted to the
study of the OEC volumes. It required 2- 1/2 weeks of study for each volume.
The Franchise Office Worldwide distributed policy letters to franchise holders
for use in running the missions, and Flag distributed them to the local
churches for guidance. In the Flag Division every crew member received and was
required to read the Flag OOD and Flag Orders.
One of the guiding principles of Scientology is that most organization
problems arise from the failure to follow policy. True policy was strictly
limited to the written policy found in the official issues such as HCO PLs,
Flag Orders and Executive Directives. California Church members were taught
that if a directive was not in writing based on official policy, it was not to
be believed. California Church officials were expected to know the contents of
HCO PLs and to follow them. One high ranking official referred to policy
letters on an average of once a day for guidance. The failure to follow policy
was an offense for which a California Church member could be disciplined
particularly if the failure resulted in monetary loss or bad publicity. There
is no evidence in the record that this happened. California Church officials
did not always robotically implement policy. If a particular policy was
questionable, staff consulted higher officials, usually in writing, to
determine a more favorable course of action. Franchise holders providing
services to the public had more freedom to disregard policy directives than
petitioner's officials.
DISCRIMINATORY SELECTION
On January 2, 1957 respondent recognized petitioner as an organization
described in section 501(c)(3) exempt from income tax under section 501(a).
Petitioner's tax-exempt status was reconfirmed on November 16, 1964. In August
1965 respondent *404 examined petitioner's records for the taxable year 1963
and concluded that petitioner was a church; that petitioner received income by
selling books and E-meters and by providing spiritual counseling and training;
and that petitioner paid royalties to the L. Ron Hubbard Trustee Account for
the use of Scientology books and materials. After the examination, respondent
again confirmed the tax-exempt status of the California Church.
In 1966 respondent again reviewed petitioner's tax status by examining
petitioner's Annual Information Returns (Forms 990-A) for 1964 and 1965. The
record does not disclose what concerns prompted the examination. Following the
examination, respondent sent petitioner a letter on July 29, 1966 recommending
revocation of petitioner's tax-exempt status. The letter stated three bases for
the recommendation: (1) the California Church's income was inuring to the
benefit of Scientology practitioners; (2) the Church's activities were
commercial; and (3) the Church was serving the private interests of L. Ron
Hubbard and Scientology practitioners. The California Church was accorded the
right to protest the recommendation and to submit documents in support of its
protest. An informal conference was held in the Los Angeles District Office and
the proposed revocation was affirmed. A conference was then held in the
National Office on June 15, 1967 and again the proposed revocation of exemption
was sustained. One month later on July 18, 1967 respondent issued a formal
letter of revocation which repeated the same three grounds of revocation as had
been stated in the original recommendation. Respondent published the revocation
in the Internal Revenue Bulletin and removed petitioner from its cumulative
list of organizations qualifying under section 170 for deductible charitable
contributions. Petitioner was advised that it was required to file Federal
income tax returns.
Sometime in the fall of 1966 the Department of Justice asked respondent to
review the tax status of several Scientology churches including petitioner. The
request was made as the Department of Justice prepared to defend a case against
the Founding Church of Scientology (Founding Church) in the United States Court
of Claims. In that case, the Founding Church sued for refund of its Federal
income taxes which it had paid after its tax-exempt status had been denied. The
*405 exemption was denied on the grounds that the Founding Church was
organized and operated as a commercial venture benefiting private interests and
that Scientology did not serve a religious purpose. [FN8] Believing that
respondent's recognition of the tax-exempt status of other Churches of
Scientology was inconsistent with the defense of the Founding Church case, the
Department of Justice asked respondent to investigate the matter and rescind
recognition of all similar Churches of Scientology prior to the trial of the
Founding Church case.
In response to this request respondent reviewed the tax status of several
Scientology churches in addition to petitioner whose tax status was already
under review. In the spring of 1967, as the trial of the Founding Church case
approached, pressure to expedite proceedings relating to these churches
increased. In some cases, denial or revocation of exemption was proposed.
However, the record is silent with respect to what, if any, final adverse
action was taken against these churches, besides petitioner, prior to the trial
of the Founding Church case. Years later the tax status of some of these
Scientology churches was still under administrative review.
During 1966 and 1967 a few of respondent's agents spoke critically of
Scientology or circulated reports calling it a medical quackery; evil; a threat
to the community, medically, morally and socially; a pseudo-religious
organization; a grab-bag of philosophical voodooism; and a prey on the public
pocketbook. These comments were not made by agents in respondent's Exempt
Organizations Division--the division charged with reviewing petitioner's tax
status. However, agents in respondent's Exempt Organizations Division were
privy to memoranda containing these comments and to materials critical of
Scientology.
Although petitioner was advised that it was required to file Federal income
tax returns (Forms 1120), it refused to do so and continued to file Annual
Information Returns (Forms 990). During 1969 and 1970 Revenue Agent Woodrow
(Woody) Wilson examined petitioner's records for the taxable years 1964-1967 to
determine petitioner's tax liability and review its *406 tax status. A
second agent Robert Cluberton tried to audit petitioner's records for the
taxable years 1968 and 1969. Petitioner resisted this second audit claiming a
right to be free from successive audits until its protest of the 1964-1967
audit, including the denial of its tax-exempt status, was finally resolved.
On June 7, 1974 respondent mailed a notice of deficiency to petitioner for the
taxable years 1965 through 1967. The deficiencies were:
TYE Dec. 31-- Deficiency
1965 ....... $2,614.19
1966 ........ 5,041.03
1967 ....... 13,946.30
Petitioner filed a timely petition in the Tax Court for the 1965 deficiency.
In late 1976 respondent settled the case by conceding petitioner's tax-exempt
status for that year but without prejudice to any other year. Respondent also
decided not to litigate any cases against petitioner prior to the 1968 taxable
year and closed the 1966 and 1967 tax years on the basis of 'no change.'
Returning to 1974, respondent, by the end of the year, was occupied with a
number of Scientology matters. [FN9] Representatives of the California Church,
respondent and the Department of Justice met at a conference in Washington,
D.C. on February 14, 1975 to try to settle some of these matters without
resorting to litigation. No agreement about substantive issues was reached, but
the representatives did establish a procedure for handling some of the ever
mounting tax matters. First, the parties would temporarily suspend litigation.
Second, respondent would examine the Hawaii Church to determine whether it
qualified as a tax-exempt organization. Third, the ruling with respect to the
Hawaii Church would govern all Churches of Scientology organized and operated
in a similar fashion. Fourth, respondent would examine the California
*407 Church and any other church that differed from the normal pattern and
determine what effect, if any, these differences in operation or organization
had on the organization's qualification for tax-exempt status. [FN10]
The audit of the Hawaii Church was an exempt function audit covering the tax
years 1965 and 1966 through 1974. The audit lasted approximately 2 weeks.
Following the audit of the Hawaii Church the IRS asked the Church and several
similarly situated churches to submit determination applications, Forms 1023.
This was done and the IRS set up a special group to process the applications.
The Hawaii Church received a favorable ruling and so did several other Churches
of Scientology.
The audit of the California Church (1971-1974 audit) followed the Hawaii
audit. The examination began in June 1975 and continued through July 1976
covering the taxable years 1971 through 1974. Three experienced agents [FN11]
worked full time on the audit. Under IRS policy, cases involving a church are
classified as sensitive cases and automatically referred to the National
Office. Thus, from time to time the agents received advice and guidance from
Lewis Hubbard, an attorney in the National Office of respondent's Chief
Counsel.
The agents examined between 200 and 300 cartons of records, containing
approximately 2 million documents. The audit covered the following topics: (1)
petitioner's sources of income; (2) petitioner's corporate structure; (3) the
purposes of the California Church as stated in corporate documents; (4) the
administration of the Scientology trust fund; (5) compensation and benefits
paid or bestowed upon L. Ron Hubbard and his family; (6) the purposes and
amounts of petitioner's expenditures; (7) certain aspects of Church
administration including banking practices, recordkeeping and the
implementation of policy; and (8) Scientology religious beliefs and practices.
At the outset of the 1971-1974 audit, no thought was given to what procedure
would be used to obtain a ruling on the audit. As the audit drew to a close,
the National Office and the *408 District Office jointly decided that the
technical advice procedure was best since it afforded the California Church an
opportunity to comment on the facts and issues raised by the audit. [FN12]
In accordance with the technical advice procedure, Agent Eugene Endo prepared
a draft report of the audit. The draft report covered the following topics: (1)
a description of Scientology religious beliefs; (2) a description of
petitioner's corporate charter, by-laws and amendments thereto; (3) a
description of petitioner's pricing and sales policies; (4) an explanation of
the different memberships in petitioner; (5) an account of petitioner's
charitable and community activities; (6) a description of petitioner's
promotion methods; (7) a discussion of the role of policy letters in the
administration of petitioner's affairs; (8) a description of petitioner's
banking practices and management activities; (9) an analysis of petitioner's
income and certain expenses by Church branch; (10) an explanation of the
royalties paid to L. Ron Hubbard; (11) a description of OTC's relationship to
petitioner; (12) documentation of petitioner's failure to substantiate OTC
expenditures on behalf of petitioner; (13) an analysis of financial gains
accruing to OTC from currency conversions; and (14) a history and description
of the United States Churches of Scientology Trust.
The technical advice procedure was never fully implemented. The California
Church took matters into its own hands and sent the National Office Agent
Endo's draft report (Service audit report) which it had been given for comment
as a matter of courtesy before Agent Endo had a chance to complete it. The
Church also sent the National Office a copy of its own report (Church audit
report). The Church audit report *409 was written in the style of the
Service audit report in goodly measure adopting verbatim the text of the
Service audit report. However, there were textual differences, some noted and
explained in footnotes. According to Church officials, the purpose of the
Church audit report was to present a fair and accurate version of the
California Church's tax position. The National Office refused to accept this
'end-run' and referred the matter back to the Los Angeles District Office.
In accordance with the technical advice procedure, the examining agent and
Church officials met in the district office in October 1976 and tried to reach
agreement on a statement of facts and issues to present to the National Office.
Agent Endo reviewed the Church audit report, signified his agreement with the
factual content of certain footnotes in the Church audit report, but complete
agreement was never reached. [FN13] There remained significant differences in
the texts and the footnotes of both reports. The matter was then referred to
the National Office. [FN14] In January 1977 Church and Service representatives
met in the National Office to discuss the reports. Respondent never issued a
technical advice memorandum.
During 1977 petitioner and respondent engaged in settlement negotiations.
These negotiations were discussed in detail by counsel at a pretrial hearing
held on petitioner's Motion to Render the Notice of Deficiency Nugatory and for
Other Relief. At the conclusion of the hearing, the Court made findings about
the conduct of the settlement talks. The Court found (1) that there was a bona
fide dispute between the parties which was the subject of negotiations; (2)
that the notice of deficiency incorporates these legitimate grounds of
dispute; (3) that respondent was forced to issue the notice of deficiency to
protect the Government's interest in the revenue since petitioner would not
consent to extending the statute of limitations which was about to expire
before a settlement could be reached; and (4) that good-faith settlement
negotiations continued after the notice of deficiency was issued. The
*410 Court ultimately found that the determinations were at least
sufficiently reasonable to render the notice of deficiency valid and therefore
denied petitioner's motion.
During negotiations the parties came close to reaching a settlement of their
disputes over income inuring to OTC's benefit from currency conversions and
over alleged debt repayments from the Danish Kingdom and United Kingdom
Churches. Significant differences remained on at least three other issues: (1)
petitioner's recordkeeping system; (2) petitioner's reporting obligations; (3)
petitioner's failure to satisfy respondent that it was not implicated in
criminal activity to impede the IRS from performing its lawful functions.
Respondent's last offer was made on December 20, 1977. The scope of the offer
was limited to settlement of petitioner's 1970-1972 taxable years.
The notice of deficiency was drafted by Agent Endo. It was drafted sometime in
November, 1977 as the statute of limitations for the taxable years in issue was
about to expire. The notice was issued on December 28, 1977.
On March 5, 1980 this Court ruled that compliance with public policy is a
requirement for exemption from tax under section 501(c)(3). In a Memorandum Sur
Order dated April 1, 1980, this Court defined the scope of the public policy
requirement by stating 'this requirement is limited to compliance with well
defined public policy--such as may be reflected in a criminal or civil
statute.' Respondent's Trial Memorandum, filed October 3, 1980, catalogued a
series of petitioner's acts, policies and procedures which respondent intended
to prove to show petitioner's failure to comply with public policy. These acts,
policies and procedures included: (1) conspiracy to impede and obstruct the
Internal Revenue Service under 18 U.S.C. section 371; (2) abuse of the role
of religious confidant by auditors; (3) the infliction of psychic harm
including the loss of moral judgment through brainwashing accomplished by
auditing and other practices and procedures; (4) the use of blackmail and
intimidation to implement petitioner's 'fair game' policy; (5) the involuntary
dissolution of marriages and family ties through the enforcement of
petitioner's 'disconnect' policy; (6) involuntary detention and false
imprisonment; (7) the making of false statements to immigration authorities in
violation of 18 U.S.C. section 1544; (8) the *411 removal of large
amounts of currency from the United States without disclosure; (9) the false
registration of petitioner's fleet as private yachts used for pleasure when in
fact they were used for paramilitary training and commercial activities; and
(10) the drastic punishment of staff and members. By letter ruling dated
October 30, 1980, the Court precluded respondent from offering proof on many of
these issues and narrowed the evidence it would entertain on the remaining
issues to 'ACTS against others that violated civil or criminal law or were
contrary to well-defined public policy.' Respondent's Trial Memorandum also
stated two other major issues to be tried in addition to the public policy
issue: (1) whether part of the California Church's net earnings inured to the
benefit of L. Ron Hubbard and his family; and (2) whether petitioner engaged in
commercial activities such that it was not operated exclusively for religious
purposes.
Respondent also contended, in a letter to petitioner in connection with
petitioner's Motion to Render the Notice of Deficiency Nugatory and for Other
Relief, that (1) the Church's methods are akin to brainwashing; (2) the Church
employs tactics which are harmful to society; (3) petitioner is a cult; (4)
Scientology operations are partially a profit-making scheme; and (5) Church
policies and practices endanger the moral and physical health of citizens and
create trouble in families. [FN15]
During the years 1969 through 1975 respondent formed and maintained special
intelligence units to collect information about certain taxpayers, apparently
selected by essentially political criteria, to monitor their compliance with
the tax laws. Two of these units, the Special Service Staff (at first called
the 'Activist Organization Committee') and the Intelligence Gathering and
Retrieval Unit, were part of respondent's National Office. The third unit, the
Case Development Unit, was part of the Los Angeles District Office. All three
collected information about petitioner.
In July 1969 the IRS established the Special Service Staff (SSS) to insure
that dissident groups were not violating the tax laws. The SSS gathered the
centralized information about *412 taxpayers, frequently selected because of
their political activism, and disseminated this information to the district
office having jurisdiction over the particular taxpayer. As a result of SSS
operations, dissident groups were subject to more rigorous scrutiny for their
compliance with the tax laws. Also, all exempt organizations which were
scrutinized by the SSS were subject to special procedures for obtaining
approval of their applications for exemption from taxation.
Initially the SSS selected 77 organizations to monitor. On October 8, 1969 an
additional 22 organizations were targeted. These included the Founding Church
of Scientology. After the Founding Church was selected, the SSS received some
information about Scientology churches including petitioner. [FN16] When the
SSS ceased functioning in 1973, it had amassed close to 3,000 files on
organizations and approximately 8,500 files on individuals.
In 1973 respondent established a national intelligence program called the
Intelligence Gathering and Retrieval Unit (IGRU). This program differed from
other intelligence operations in that the IGRU gathered general intelligence
unrelated to a specific investigation of a specific allegation. Agents were
free to determine whom and what to investigate provided their investigations in
some way related to IRS investigative jurisdiction. In a number of districts,
IGRU agents collected intelligence having little relationship to enforcement of
the tax laws.
The Los Angeles District unit of IGRU classified petitioner as a 'tax
register.' In 1975 certain IGRU files in St. Louis were destroyed. One file
labeled 'subversives' contained materials only about Scientology. [FN17] The
IGRU was disbanded in mid-1975.
Between 1968 and 1974 the Case Development Unit staffed by two special agents
in respondent's Los Angeles Office gathered information they collected
concerned petitioner's religious operations and financial activities. Their
files, *413 however, contained a few reports linking petitioner or
Scientology with criminal activity including homicide, blackmail, guerrilla
training, break-ins, drug trafficking and the transportation of illegal
firearms.
ENTANGLEMENT
Over slightly more than a decade, respondent examined petitioner's records
four times. In 1965 respondent audited petitioner's 1963 tax year and, in 1969,
petitioner's 1964-1967 tax years. Between 1971 and 1973 Agent Cluberton
unsuccessfully tried to examine Church records for 1968 and 1969. The most
comprehensive audit began in June 1975. It lasted approximately 1 year and
covered petitioner's 1971-1974 tax years. Three or four agents worked full time
and others worked as needed. The auditors received and reviewed between two and
three million records. Most of these were original financial records such as
invoices, disbursement vouchers and cancelled checks since the California
Church did not keep business journals or books of account. The examiners also
reviewed policy issues, membership fees and descriptions, contracts for
services and employment, organizational charts, Scientology newsletters and
dissemination pieces, and similar records illustrating petitioner's
organization, activities and financial practices. The agents also inspected
petitioner's premises at three or four locations.
Respondent collected information about Scientology and petitioner. An index
prepared by the IRS in 1974 shows that respondent had over 6,000 documents
relating to Scientology in its files. Many of these documents were prepared by
the IRS and related to specific audits, investigations or lawsuits.
Approximately 2,000 of these documents were policy letters similar in kind, if
not identical, to the ones contained in the OEC volumes. Other documents
transmitted information from confidential sources on such diverse topics as
their personal experiences in the Church of Scientology, Scientology financial
activities, the administration of Scientology churches and the names of
Scientology members. Respondent's files also contained newspaper articles about
Scientology and pamphlets, magazines and newsletters published by Scientology
organizations, and a few books and brochures describing Scientology doctrine
and practices.
*414 The trial of this case lasted 51 days, spread over 12 months. Many
matters were covered: petitioner's corporate and management structure,
petitioner's fee structure, petitioner's banking practices, petitioner's
dissemination practices, petitioner's relationship to OTC, the administration
of the Scientology trust fund, IRS antipathy toward Scientology; petitioner's
efforts to obstruct the IRS, and Scientology beliefs and practices. Petitioner
called three witnesses -- Joyce Isaacson, Herbert Richardson, and Renee
Norton -- to provide background information about Scientology beliefs and
practices. On cross-examination respondent inquired of these witnesses whether
Dianetics formed part of the religious doctrine of Scientology and whether the
E-meter was used apart from auditing to conduct security checks as a condition
of employment. [FN18]
During the trial, respondent tried to prove that some of petitioner's
activities served a commercial purpose. Respondent tried to prove that
petitioner sent staff on missions to branch churches to increase profits, that
petitioner developed new courses and awareness levels for commercial reasons,
and that petitioner used commercial techniques to promote Scientology in order
to make money.
During the trial, respondent used policy issues to examine witnesses on such
subjects as petitioner's corporate and management structure, petitioner's
financial activities and petitioner's efforts to obstruct the IRS. Respondent's
reliance on policy issues generated collateral examination on the extent to
which policy issues had to be obeyed. while following this line of inquiry,
respondent questioned witnesses, past and present members of Scientology, with
respect to whether they were disciplined for failing to follow policy.
Respondent also inquired into petitioner's system of discipline and ethics in
pursuing his inquiry into petitioner's treatment of IRS personnel.
*415 CHURCH FINANCES
Petitioner mainly derived income from four sources: (1) auditing and
training; (2) sales of Scientology literature, recordings and E-meters: (3)
franchise operations; and (4) management services. Of these four areas, the
largest percentage of petitioner's income came from auditing and training. By
petitioner's own admission, auditing and training sales accounted for the
following percentages of total income:
AOLA ASHO LAO SFO UK
1971 91 68 85 81 70
1972 94 50 91 86 70
Petitioner exacted what it called a 'fixed donation' for its auditing and
training courses. With few exceptions, these services were never given for
free. [FN19] Auditing sessions were offered in fixed blocks of time called
'Intensives.' By petitioner's own admission the general rate of the fixed
donation for auditing was as follows:
12 1/2-Hour intensive ......... $625
25-Hour intensive ............ 1,250
50-Hour intensive ............ 2,350
75-Hour intensive ............ 3,350
100-Hour intensive ..... [FN20]4,250
At Flag, the fixed donations were 3 to 4 times higher. Additionally,
petitioner offered two specialized types of auditing for a higher fixed
donation:
Integrity Processing-- $750 per 12 1/2-Hour intensive
Expanded Dianetics-- $950 per 12 1/2-Hour intensive
*416 Petitioner offered its parishioners a 5-percent discount on the rate
of fixed donation if the donation was well in advance of the service.
Petitioner also offered 1-year members and lifetime members a 10-percent and
20-percent discount, respectively, on services. Apart from these discounts,
branch churches were not allowed to deviate from standard prices. [FN21]
There was a special fee arrangement for most staff members. In order to become
a staff member, a prospective employee had to sign an employment contract. The
terms of most employment contracts varied from week-to-week employment to
periods of 2- 1/2 or 5 years. Sea Organization staff members pledged to work
for a billion years. Contracted staff members, except the week-to-week
employees, were given free or discounted training and auditing. If, however, a
staff member breached his employment contract by leaving petitioner's employ
prior to the contract's expiration, the former staff member, termed a
'freeloader,' was contractually obligated to pay petitioner a sum equal to the
full cost of all services received or liquidated damages of $5,000. In order to
enforce this policy an organization that sent a staff member for training to a
higher organization was required to have the staff member sign a note in the
amount of $5,000 before commencing training. The signing of the $5,000 note was
intended to prevent a staff member from leaving after receiving higher
training. HCO PL December 14, 1969, 3 OEC 241, entitled 'ORG Protection,'
required that 'Such a Note * * * must be legally binding in that, if he breaks
his Contract, he is automatically in debt to the org for $5,000.' In order to
insure collection of such amounts, petitioner paid its agents a 10-percent
commission for each freeloader debt collected in full. *417 No effort was
made by petitioner to collect freeloader debts in court.
Individual applicants for training and auditing were required to execute two
documents. Under the first document, entitled the 'Pledge of Offering,' the
applicant pledged a specified amount as an offering to petitioner in exchange
for a limited amount of training or auditing directed toward the attainment of
a specified state of spiritual awareness.
Additionally, the applicant was required to execute a second document,
entitled a 'Legal Contract for Auditing and Training.' Under this document, the
applicant declared that he or she was a proper applicant for training, which
entailed among other things that the applicant was of legal age, that he or she
did not have any medical illness, that he or she did not have a record of
institutionalization, that he or she did not have a criminal record, and that
he or she was not addicted to drugs or alcohol. Furthermore, pursuant to this
contract, the applicant waived all rights of action against petitioner L. Ron
Hubbard arising from the receipt of the designated services except the right to
request a refund within 3 months of the last day of the services rendered.
Petitioner promoted Scientology services through free lectures, congresses,
free personality testing, handouts and advertisements placed in newspapers and
magazines and on the radio. Petitioner geared promotional activities to be
responsive to community concerns after taking surveys to ascertain community
needs and desires.
Two categories of staff-registrars and Field Staff Members--had the job of
establishing contact with the public to stimulate interest in Scientology
services. Registrars in the public division of petitioner's branch churches
kept track of new people who showed an interest in Scientology. The registrars
were trained in salesmanship. They encouraged new people to purchase
introductory Scientology courses. Once a new person showed a commitment to
Scientology through the purchase of a major Scientology service, responsibility
for his progress was turned over to registrars in the dissemination division of
petitioner's branch churches who monitored each parishioner's training and
auditing progress through a central file system. This second group of
registrars had the duty of *418 contacting people listed in the central
files by mail or in person and urging them to take higher Scientology services.
In addition to the actions of the registrars, petitioner used another group of
people known as Field Staff Members (FSMs), who also contacted individuals in
an effort to interest them in Scientology. These FSMs operated on a commission
basis. They were paid an amount equal to 10 percent of the fixed donation for
each person they successfully enrolled in a Scientology service. Additionally,
the FSMs received awards in the form of scholarship money for Scientology
courses based on their ability to make commissions.
Petitioner earned money from the sale of books, E-meters and recordings.
According to petitioner during the taxable years 1971 and 1972, AOLA, ASHO, SFO
and LAO alone generated in excess of $400,000 and $500,000, respectively, from
the sale of these items. By petitioner's admission, sales of these items
accounted for the following percentages of total income:
AOLA ASHO LAO SFO UK
1971 1 24 10 16 3
1972 5 49 7 14 3
ASHO PUBS, a division of ASHO, from 1971 onwards published and distributed
these items. As a distributor, it sold these items to other churches and
missions of Scientology as well as commercial bookstores for resale.
The major portion of the books distributed by ASHO PUBS were copyrighted by L.
Ron Hubbard. Through the year 1972, L. Ron Hubbard's collected works on
Dianetics, Scientology and closely related topics included two multi-volume
encyclopedic series and more than 50 other books and publications. [FN22] L.
Ron Hubbard also recorded more than 3,000 lectures dealing with Scientology
technology, administration and policies between the years 1950 and 1972. Tapes
for 509 of such lectures were regularly available to the public. Additionally,
petitioner sold E-meters which L. Ron Hubbard invented and on which he had a
patent.
Petitioner had an elaborate system of prices and discounts for books. In 1959
petitioner used the following formula to *419 price its books: It took the
printing cost and multiplied by 5. In 1965 this formula underwent a slight
change. The basic formula, 5 times the printing cost, stayed the same but to
this figure petitioner added 2 times the cost of postage to the furthest
church. This formula established a minimum price. During the docketed years,
the list price of books sold by petitioner through its bookstore ranged from a
low of $2 to a high of $225 or $300 for the OEC series. [FN23] Books could not
be given away. They had to be sold. Books sold to Scientology members were
discounted by 10 percent. Books sold to other Scientology churches, including
branches of petitioner, were discounted by 40 percent. Books sold to commercial
bookstores were also discounted in accordance with the following schedule:
1 Book ........... 25%
2 - 9 Books ...... 33/13 [sic]
10 - 49 Books .... 40
50 - 99 Books .... 41
100 - 249 Books .. 42
250 - 499 Books .. 43
500 Books ........ 45
The retail price of an E-meter during the tax years at issue was around $200;
however, discounts were available in accordance with the following schedule:
1. On individual purchases without any membership, full price, no discount.
2. International Membership holders -- 20% discount.
3. Bulk sales (10-40 meters) -- 35% discount.
4. Bulk sales (50 or more meters) -- 40% discount.
5. All contracted staff -- 40% discount.
Petitioner's third souce of income came from its franchise operations.
Petitioner's Franchise Programme was first introduced in the early part of
1959. Under the Franchilse Programme, interested auditors were granted
franchises which authorized them to use the names 'Applied Philosophy',
'Scientology', and 'Dianetics', along with the copyrights associated therewith,
in a certain district or territory. Additionally, *420 franchise holders
were granted 40 percent discounts on their purchases of books that they could
later resell to the public. In exchange, the franchise holder agreed (1) to
remit 10 percent of his or her gross income to HCO WW, and (2) to abide by the
policies governing franchises. The rates franchise holders could charge for
processing and courses were set by L. Ron Hubbard and made known to the
franchise holders in the form of policy letters. Franchises were strictly
forbidden from providing any free services.
In order to obtain a franchise, an interested person had to first file an
application for an interim franchise. Initially, these franchises were granted
directly by L. Ron Hubbard; however, during the tax years at issue, the
franchises were issued to the applicant by petitioner as agent for L. Ron
Hubbard.
A principal objective of the Franchise Programme was to involve members of the
public and push them up to upper level orgs, such as St. Hill, AOLA, ASHO and
Flag. [FN24] To this end, franchise holders were only permitted to offer lower
level courses and were encouraged to send their students to the higher level
orgs for more advanced training. For each student which the franchise holder
successfully referred to petitioner, he received a Field Staff Commission equal
to 10 percent of the amount the student spent at the higher level
organizations.
In conducting the Franchise Programme, petitioner placed a heavy emphasis on
statistics and the regular payment of the required 10 percent of gross income
to HCO WW. In this regard, the franchise holders were required to keep a set of
books and records and to submit weekly reports of the franchise holder's
activities, along with their weekly remittance of the required 10 percent of
gross income. Franchise holders who failed to submit the required 10 percent of
gross income on a regular basis ran the risk of losing their franchise.
During the tax years at issue, the franchises were administered by the
Franchise Office Worldwide, which was directed by the Franchise Offer. As part
of his responsibilities, the Franchise Officer sent the franchise holders
policy letters pertinent to running their franchises and collected the 10
*421 percent payments from each franchise. These payments were then reported
on the books of petitioner's United Kingdom Church under the designation
'Tithes.' The record is not clear how much income the Franchise Programme
generated. By petitioner's own records, the income from its franchising
operations during the tax years in question was as follows:
1970 ....... $288,672
1971 ........ 307,809
1972 .. [FN25]435,960
Petitioner's Flag Bureau generated a fourth source of income through the
provision of management services to Scientology organizations around the world,
including branches of petitioner. Flag collected a variety of statistics from
each local church and organization and used this data to develop programs for
improving local church administration. When a local church experienced
difficulty, Flag sent staff on assignments, called 'missions,' to help manage
the situation. The purposes of such missions were varied and included
straightening out financial mismanagement, increasing gross income, clarifying
job responsibilities, attracting new parishioners, and insuring excellence in
the delivery of services. Flag concentrated its attention on the organizations
that made the greatest contribution to Flag's financial support. The fee for
these management services was 10 percent of the corrected gross income of the
organizations and franchises that were not obligated to pay 10 percent to
Worldwide.
Flag collected statistics to track Scientology's worldwide growth and
expansion as well as individual and local church productivity. These statistics
were reviewed by Flag and used as a basis for the development of programs,
policies and procedures to increase the organization's growth and expansion. As
a basis for these statistics, each local church was required to follow a
standard method for reporting statistics to petitioner's Flag Bureau. Required
statistics included measures of output for each division within a church. This
statistic was called the 'Gross Divisional Statistic,' or 'GDS,' and was
specific to each division; for example, the GDS of the Dissemination Division
was gross income, while the GDS of the *422 Treasury Division was the amount
of credit collected and the amount of bills paid. Each church had an
organizational Information Center (OIC) which graphed and posted divisional
statistics. The OIC also transmitted certain statistics to Worldwide on a
weekly basis. Worldwide then transmitted (via Telex) accumulated statistics to
Flag, where they were graphed and posted in the Control Information Center
(CIC) and on the wall outside the Flag Treasury Division. These graphs
reflected overall Scientology income, Flag income, and LRH Comm. Statistic
Revised income, [FN26] as well as other income figures. In addition, each Flag
staff member had a graph of his job statistic posted next to his desk.
One of petitioner's articulated goals was to make money. This was expressed in
HCO PL March 9, 1972, MS OEC 384, which enumerated the Governing Policy of
Finance as follows:
GOVERNING POLICY
A. MAKE MONEY
B. Buy more money made with allocations for expense (bean theory).
C. Do not commit expense beyond future ability to pay.
D. Don't ever borrow.
E. Know different types of orgs and what they do.
F. Understand money flow lines not only in an org but org to org as customers
flow upward.
G. Understand EXCHANGE of valuables or service for money (P/L Exec Series 3
and 4).
H. Know the correct money pools for any given activity.
I. Police all lines constantly.
J. MAKE MONEY.
K. MAKE MORE MONEY.
L. MAKE OTHER PEOPLE PRODUCE SO AS TO MAKE MONEY.
A small sack of beans will produce a whole field of beans. Allocate only with
that in mind and demand money be made. * * *
Petitioner often used business terminology to describe its operations.
Churches were referred to as 'orgs.' Church missions were called 'franchises'
until 1971 when their designation in the United States was officially changed
to 'mission.' However, even after the name change, petitioner continued to
refer to the administrator of the missions as the Franchise Officer. Fees for
auditing were called 'prices' *423 rather than 'fixed donations,' and
petitioner frequently said its services were 'purchased,' 'bought,' or 'sold'
rather than 'donated,' 'offered,' or 'contributed.' HCO PL May 23, 1969 (Issue
III), 0 OEC 91-93, describing 134 measures to take to insure Church solvency,
exemplifies these patterns of speech. It states in part:
90. DEPARTMENT 17 (DEPT OF PUBLIC REHABILITATION): SELLS SCIENTOLOGY TO
GOVERNMENTS AND BROAD SOCIAL STRATAS (SIC).
92. Makes Scientology popular and the thing to do. * * *
107. DEPARTMENT 20 (DEPT OF ACTIVITIES): Guides in new body traffic. * * *
109. Sees that the Introductory Lecture and nonclassed courses use no words
that will be misunderstood and MAKES PEOPLE WANT TO BUY TRAINING AND PROCESSING
and offers it. * * *
124. DEPARTMENT 22 (DEPT OF FIELD RECRUITMENT, ESTABLISHMENT AND RECORDS):
Recruits, appoints and establishes FSMs, Groups and Franchises. * * *
128. Gets all commissions owed promptly paid to ENCOURAGE EARNING MORE
COMMISSIONS.
129. DEPARTMENT 23 (DEPT OF FIELD TRAINING): Trains the FSMs and Franchise
holders and MAKES THEM FINANCIALLY SUCCESSFUL.
130. TREATS THE WHOLE DEPARTMENT ACTIVITY AS SALESMEN ARE HANDLED BY ANY OTHER
BUSINESS ORG. (Emphasis added.)
This policy letter is not an isolated phenomenon. Even during the trial of
this case, the testimony of petitioner's church witnesses was heavily
punctuated with business terminology.
Petitioner performed charitable works. It provided assistance to prisoner's
ex-offenders, the elderly, the mentally ill, and drug addicts. It helped form
Narcanon, a drug-rehabilitation program. It organized a job referral service
for ex-offenders and it developed an educational program called Applied
Scholastics. On oCCsion, it also assisted the poor and sick.
*424 Petitioner performed christenings, funerals, and wedding ceremonies
free of charge. Petitioner's chaplains provided free marriage and family
counseling. Petitioner also provided a specialized form of auditing free of
charge called 'ARC break' auditing. This service was geared to help people in
crisis.
In his notice of deficiency, respondent determined that petitioner's seven
stipulated divisions (SFO, LAO, FOLO, ASHO, AOLA, USGO, and Flag) had the
following consolidated net incomes during the docketed years:
Income 1970 1971 1972
Gross receipts ................. $2,249,013.08 $3,301,143.73 $3,134,391.00
Advance payments ............... 373,222.37 788,704.96 1,198,763.86
Flag income .................................... 263,557.47 240,932.55
Payment Danish Kingdom Church .................. 77.92 53,609.76
Payment United Kingdom Church .................. 76,497.24 161,018.38
-------------- -------------- --------------
Total income ............. 2,622,235.45 4,429,981.32 4,788,715.55
Expenses
Per Form 990 ................... 2,438,646.65 4,242,124.02 4,178,876.05
Trust .......................... (28,930.34) (67,892.40) (77,986.62)
Charter Mission (disallowed) ... (982,415.39) (1,143,928.02) (1,400,015.99)
Flag expenses .................................. 1,238,466.30 1,036,108.56
-------------- -------------- --------------
Total allowable expenses . 1,427,300.92 4,268,769.90 3,736,982.00
Net income ............... 1,194,934.53 161,211.42 1,051,733.55
Petitioner does not contest the accuracy of these figures, but does disagree
with the tax treatment accorded them by respondent.
Petitioner collected advance payments from parishioners for auditing and
training services of $373,222.37 in 1970, $788,704.96 in 1971 an $1,198,763.86
in 1972. These were payments from people for whom no services were rendered
during the year the payments were received. It was petitioner's policy to
refund advanced payments upon request at any time before the services were
taken. There is no evidence in the record that petitioner kept the advance
payments segregated or placed restrictions on the use of these funds.
Petitioner used the cash method of accounting for its receipts except it
treated advance payments as liabilities.
*425 The Charter Mission expenses represented amounts transferred by
petitioner to OTC during the tax years. Petitioner deducted these payments as
expenses on its Forms 990. Respondent disallowed the deduction on the grounds
that the payments were not a business expense but constituted an internal
transfer of funds to the Flag Division. On brief, petitioner does not contest
the adjustment.
Petitioner deducted payments of $28,930.34 in 1970, $67,892.40 in 1971, and
$77,986.62 in 1972 to the Central Defense and Dissemination Fund. According to
petitioner these were payments to the United States Church of Scientology
Trust (the Trust).
Petitioner alleged that the Trust originated in 1962. However, there was no
trust document during the docketed years. The Trust was first memorialized by
Declaration of Trust on June 25, 1973. L. Ron Hubbard was the sole trustee of
the Trust during the docketed years.
During the docketed years no investments were made with trust funds. They were
deposited in several Swiss bank accounts: Rubric Trustee Account No. 272,893.6,
Church of Scientology of California Trustee Account No. 285,222, Church of
Scientology of California Trustee Account No. 285,222.1, L. Ronald Hubbard
Trustee Account No. 272,893.2 and L. Ronald Hubbard Trustee Account No.
272,893.3 at the Swiss Bank Corporation in Zurich, Switzerland. Funds were also
deposited in Account No. 015867.226 at the Swiss-Israeli Trade Bank, Geneva,
Switzerland. L. Ron Hubbard, Mary Sue Hubbard and Denzil Gogerly (a United
Kingdom Church official who administered the Trust) were all sole signatories
on the trust accounts. L. Ron Hubbard kept the trust checkbooks. Member
churches were required to remit 10 percent of their total income to the Trust
on a weekly basis.
In 1972, 4,222,015 Swiss francs ($1,119,678) [FN27] was withdrawn from the
trust accounts in Switzerland. petitioner's worksheets originally showed this
withdrawal as an inter-account transfer to OTS. This is crossed out and in
different handwriting the transaction is shown as cash held. According to
petitioner, this money was brought aboard the Apollo where it *426 was kept
in a locked file cabinet until 1975. Mary Sue Hubbard had the only keys to the
cabinet.
Membership in the Trust was restricted to churches of Scientology in the
United States. However, the Trust was administered in England by Denzel
Gogerly, a United Kingdom Church official, and the United Kingdom Church tithed
to the Trust until sometime in 1971. Financial statements for the Trust
covering the docketed years were belatedly prepared in 1973. They were prepared
in South Africa. They were prepared for the benefit of ten churches of
Scientology in the United States although the Declaration of Trust recites only
five member churches.
According to the financial statements finally prepared in 1973, the trust
accounts had the following net proceeds and accumulated funds for the docketed
years:
Accumulated
Year ended Net proceeds funds
Dec. 31, 1970 $86,170.80 $812,134.51
Dec. 31, 1971 254,084.71 930,400.08
Dec. 31, 1972 376,837.18 1,307,237.26
July 18, 1973 691,106.02 1,998,343.08
The purported purpose of the Trust was the defense of Scientology. During the
docketed years there was only one disbursement for such purpose in the amount
of $9,290.47. USGO expended substantially greater amounts for legal fees.
The United Kingdom Church was a branch of petitioner. According to
petitioner's records, the United Kingdom Church earned the following profits:
1970 1971 1972
Total receipts $892,783 $2,017,850 $1,815,509
Less: Total expenses (593,102) (1,221,433) (998,937)
--------- ----------- -----------
Net income 299,681 796,417 816,572
It was petitioner's policy to build large cash reserves and to deduct payments
to these cash reserves as business expenses. These reserves were mainly held in
OTC bank accounts. The year-end balances of the OTC bank accounts are shown in
the following table:
[Note: The following TABLE/FORM is too wide to be displayed on one screen.
You must print it for a meaningful review of its contents. The table has been
divided into multiple pieces with each piece containing information to help you
assemble a printout of the table. The information for each piece includes: (1)
a three line message preceding the tabular data showing by line # and
character # the position of the upper left-hand corner of the piece and the
position of the piece within the entire table; and (2) a numeric scale
following the tabular data displaying the character positions.]
*******************************************************************************
******** This is piece 1. -- It begins at character 1 of table line 1. ********
*******************************************************************************
OTC BANK ACCOUNTS
YEAREND (DEC. 31) BALANCE
Bank account
Bank number 1970 1971
(1) Swiss Bank 295,728 $1,721,748.46 $1,653,475.50
Corp.
(2) Swiss Bank 295,728.1 25,757.85 50,723.24
Corp.
(3) Swiss Bank 295,728.2 --- 98,743.80
Corp.
(4) Banque 081,920.4 --- 110,852.06
Marocaine
(5) du 10,5616.2 --- 1,330.93
(6) Exterieur 90,1924.0 --- 36,289.48
(7) " 90,1928.0 --- 8,425.93
(8) " 217.734.2 --- 11,937.44
(9) " 02.03.C.05616.5 --- ---
(10) Banco de 93,7470 20,577.44 1,433.57
Vizcaya
(11) Banco 15,855 --- 7,697.29
Unquijo
(12) Banco 23,718 --- 52,356.93
Espirito
Santo E
Comercial
de Lisboa
(13) 1st 20,48.007 --- 9,565.87
National
(14) Banco de Ellen Kayman 742.59 ---
Vizcaya
(15) Banco de 917290 2,340.66 ---
Vizcaya
(16) Banco 8631 1,814.72 ---
Hispano
Americano
------------------ --------------- --------------- ---
Total 1,772,981.72 2,042,831.54
1...+...10....+...20....+...30....+...40....+...50....+...60....+...70....+..
*******************************************************************************
******* This is piece 2. -- It begins at character 78 of table line 1. ********
*******************************************************************************
1972
$1,825,724.25
25.81
163,820.00
380,629.76
---
---
---
19,272.56
43,610.02
1,477.60
19,535.64
106,965.05
628.29
---
---
---
-------------------
[FN28]2,561,688.98
78.....+...90....+.
*427 During the tax years at issue, L. Ron Hubbard and Mary Sue Hubbard
received salaries from petitioner in the following amounts.
1970 1971 1972
L. Ron Hubbard $4,932 $9,368 $35,000
Mary Sue Hubbard 3,017 2,430 25,000
------ ------ -------
Total 7,949 11,798 60,000
Additionally, according to petitioner's own records, L. Ron Hubbard and Mary
Sue Hubbard received 5,125.11.4 pounds in fees from the United Kingdom Church
in 1970, 15,770.67 pounds in 1971, and 23,199.90 pounds in 1972. [FN29] Using
the *428 conversion rate of 2.4 suggested by petitioner's witness, these
amounts translate into $12,300.27 in 1970, $37,849.61 in 1971, and $55,679.76
in 1972. Thus, by petitioner's own admission, L. Ron Hubbard and Mary Sue
Hubbard received salary payments from petitioner totaling $20,249.27 in 1970,
$49,647.61 in 1971, and $115,679.76 in 1972.
In addition to the outright salary payments detailed above, during the years
at issue, L. Ron Hubbard, Mary Sue Hubbard, and their four children resided for
the most part aboard the Apollo. While aboard ship, petitioner paid the
Hubbard's living expenses which included free lodging, food, laundry, and
medical services. In 1970 Flag expended $31,720 for the benefit of the Hubbard
family.
L. Ron Hubbard received royalty payments in connection with petitioner's sale
of books and E-meters. These royalties were paid by ASHO and were computed on
the basis of 10 percent of the retail price of the publications and E-meters
distributed by ASHO PUBS. Parenthetically, we note that the retail price of
these items was determined by a formula developed by L. Ron Hubbard. Beginning
in August of 1971, all such royalties were paid on a weekly basis, while back
royalties attributable to periods prior to that time were paid intermittently
on later dates.
The amounts of royalties paid by ASHO to the account of L. Ron Hubbard during
the years 1971 and 1972 were as follows:
1971 .. $10,649.22
1972 .. 104,618.27
Additionally, as of April 29, 1972, there were unpaid back royalties of
$17,187.70 for the year 1971 which, along with all back royalties, were paid to
L. Ron Hubbard by the end of 1974. The majority of ASHO PUB's sales of E-meters
and books upon which royalties were paid to the account of L. Ron Hubbard were
to other Scientology churches including branches of petitioner.
It was a long-standing policy of petitioner that all works pertaining to
Scientology and Dianetics had to be copyrighted to L. Ron Hubbard. As a result
of this policy a number of publications copyrighted by L. Ron Hubbard were
actually written by others. For example, Ruth Mitchell wrote the book 'Know
Your People,' and Peter Gillum wrote the book 'How *429 to Be Successful';
however, both books were copyrighted by L. Ron Hubbard. Additionally, there are
many policy letters contained in the OEC series that were actually written by
paid employees of petitioner with L. Ron Hubbard's approval. Nevertheless,
despite the fact that L. Ron Hubbard did not personally author the entire nine-
volume set, he did receive royalty payments on the sale of this publication.
Petitioner expended funds to protect L. Ron Hubbard's patents and copyrights.
Sometime in the 1960s, Scientology organizations around the world began paying
L. Ron Hubbard 10 percent of their income in the guise of debt repayment. These
payments were variously referred to as 'LRH 10,' 'LRH RR,' AND 'LRH COMM.
STATISTIC (STAT.) REVISED.' THE RECORD IS PAMPERED WITH REFERENCES TO THESE
ALLEGED DEBT REPAYMENTS IN FBO CORRESPONDENCE AND POLICY LETTERS PREDATING THE
DOCKETED YEARS. IT IS CLEAR FROM THESE DOCUMENTS THAT THERE WAS NO SET AMOUNT
OF DEBT WHICH HAD BEEN NEGOTIATED BETWEEN L. RON HUBBARD AND PETITIONER OR ANY
OTHER ORGANIZATION BUT RATHER A CONTINUING OBLIGATION TO MAKE PAYMENTS BASED ON
TOTAL RECEIPTS.
Petitioner continued to funnel debt repayments to L. Ron Hubbard during the
docketed years. Between October 9, 1972 and December 28, 1972, USLO, also
called FOLO, receipted $19,324.41 in debt repayment from Scientology
organizations throughout the United States and Canada including branches of
petitioner. On petitioner's invoices (records of receipt), these payments were
designated 'LRH Repayments,' 'Founding Debt Payment' or 'Per HCO Policy Letter
7 Sept. 72.'
CONSPIRACY
Petitioner, its agents, and others willfully and knowingly conspired to
defraud the United States by impairing, obstructing, and defeating the lawful
functions of the IRS in the determination, assessment, and collection of income
taxes due from petitioner and from other Scientology organizations and
officials. The conspiracy began in 1969 and continued until approximately July
7, 1977 when the FBI, pursuant to a warrant, searched petitioner's premises for
evidence of the conspiracy and related crimes.
There is a written record documenting most of this conspiracy, some of it in
official Church publications, some in confidential *430 orders issued by
petitioner's Guardian Office, and some in correspondence between Scientology
officials. Prior to and during the course of the conspiracy, L. Ron Hubbard
issued policy letters and directives depicting the IRS as a danger to
Scientology, and threatening to make the IRS swim in circles. During 1969
personnel in petitioner's FBO network corresponded about plans to protect
petitioner's tax-exempt status by forging records to conceal petitioner's
relationship with OTC. Two confidential orders formulated by petitioner's
Guardian Office in 1972 and 1974, respectively, outlined plans to thwart IRS
investigations into the tax status of Churches of Scientology by burglarizing
Government offices and stealing Government documents. Reports sent to
petitioner's Guardian Office describe compliance with the confidential Guardian
Order issued in 1974.
In 1969 the IRS began an audit of petitioner's records to determine
petitioner's tax liability for the years 1963 through 1967. In the same year
top officials on petitioner's staff in the FBO network grew concerned that
petitioner's large payments to OTC, a foreign corporation not holding tax-
exempt status, would jeopardize petitioner's tax-exempt status. To disguise
these payments as debt repayment and to conceal the OTC sham, a cover story was
developed. [FN30] The theme of the coverup story was that OTC was a corporation
which provided training and consultation services to petitioner for a fee.
Petitioner planned several measures to implement this cover and some of them
were actually executed.
*431 On May 25, 1969 Vicki Polimeni, SBO and high-ranking official in the
FBO network, by dispatch orchestrated a plan to disguise payments AOLA and
other Advanced Organizations in Denmark and the United Kingdom made to OTC as
debt repayment. She ordered the FBO at AOLA and various other Advanced
Organizations to prepare and backdate weekly statements showing that each
Advanced Organization was making expenditures ON BEHALF OF OTC. [FN31] The FBOs
were directed to make these statements using Flag bill folders and Flag
summaries. However, the Polimeni dispatch directed the FBOs not to mention Flag
on the prepared statement. A mock statement itemizing Advanced Organization
expenditures on behalf of OTC was included in the dispatch as an example.
[FN32] The dispatch further explained that at the same time the FBOs were
preparing the statements, the SBO and others at Flag would prepare billings
from OTC to the Advanced Organizations using the statements to substantiate the
billings. The purpose of these statements and billings was to manufacture
evidence to show to the IRS which would disguise Advanced Organization payments
to OTC as debt repayment for services OTC had allegedly rendered. In fact OTC,
by petitioner's own admission, did not perform services for petitioner of the
type described in the mock statement.
As part of the coverup plan, the FBO International wrote the FBO at AOLA on
May 29, 1969 informing him that changes would have to be made to AOLA's
disbursement vouchers and invoices to OTC dating back to August 1968 to make
them support petitioner's tax story. (Petitioner's branch churches used
disbursement vouchers to record payments and invoices to record receipts.) On
June 1, 1969 the FBO International also directed the FBO AOLA to prepare new
signature cards and change the drawer's name on checks for account number 6919
used by AOLA but periodically maintained in the name of OTC at the Wilshire-
Westlake Office of *432 the Crocker-Citizens National Bank in Los Angeles.
This was done. Signature cards for this account show that between August 2,
1968 (when the account was established) and August 13, 1969 the account was
periodically held in the name of OTS or OTC, in combination with petitioner's
name or AOLA's name. However, beginning on August 14, 1969, account number 6919
was held in AOLA's name with no mention of OTC. Sometime in 1969 the drawer's
name was also changed on checks for account number 6919 from OTS to Church of
Scientology of California Advanced Organization of Los Angeles Reserve Account.
During the docketed years, petitioner advocated and practiced the use of
obstructionist tactics to thwart IRS investigations of petitioner and
affiliated churches. In 1970 petitioner's tax returns for the taxable years
1964 through 1967 were under audit. In June or July of that year Martin
Greenberg, the Church's accountant, told an assembled group of Scientologists
[FN33] that he purposely made the audit difficult. He said he gave the examiner
boxes of original records, disbursement vouchers and invoices in no semblance
of order with the intent of so hopelessly overwhelming and confusing the
examiner that he would be forced to give up the examination and accept
petitioner's version of the facts. In April 1972 Mr. Greenberg instructed a
member of the financial staff at an affiliated Church of Scientology to use
similar tactics if IRS agents ever came to her church to examine records. She
was told to give the IRS agent a bunch of records in a box in no semblance or
order, to place the agent in a dark, small, out-or-the-way room, to refuse to
give practical assistance like locating records, and to notify petitioner's
Guardian Office immediately of the agent's presence. Henning Heldt,
petitioner's vice president and the Deputy Guardian Finance in petitioner's
Guardian Office, gave this staff member similar instructions.
For approximately two years from May 1971 through February 1973, IRS Agent
Robert Cluberton tried unsuccessfully to audit petitioner's 1968 and 1969 tax
returns. [FN34] Part of the *433 audit's lack of success was attributable to
the IRS's failure to pursue vigorously the audit and part to petitioner's
refusal to cooperate. [FN35] Petitioner never allowed agent Cluberton access to
its financial records. On February 9, 1973 agent Cluberton served an
administrative summons on Henning Heldt, vice-president and director of
petitioner. The summons specified records and documents to be produced and
allowed a 10-day return. Heldt did not comply. On February 20, 1973 Heldt
appeared at the Los Angeles IRS office and handed Cluberton a letter stating he
had resigned as an officer of the California Church and therefore did not have
control of its records. Notwithstanding his resignation, Heldt continued to
exercise control over petitioner's financial records. By letter dated June 12,
1973 he authorized the Crocker-Citizens National Bank to release certain bank
statements to the bearer of the letter.
On or about October 26, 1971, petitioner filed an informational return, Form
990, for the taxable year 1970; on or about August 21, 1972, for 1971; and on
or about October 12, 1973, for 1972. All three informational returns were
prepared and signed by Martin Greenberg, certified public accountant. Reverend
Mulligan as president co-signed the 1970 return; Craig Beeney as secretary and
vice-president, respectively, co-signed the 1971 and 1972 returns. The returns
were signed under penalty of perjury. They do not contain financial information
for the United Kingdom Church of OTC.
During and after the docketed years, petitioner's Guardian Offices in the
United States and the United Kingdom planned and executed a scheme to
infiltrate the IRS, seize records pertaining to Scientology-related tax matters
pending before the IRS, and conceal petitioner's connection to these covert,
illegal activities. During this period the highest ranking Guardian was Mary
Sue Hubbard who held the position Commodore Staff Guardian. Jane Kember, the
Guardian Worldwide, was just under her in rank. In the United States during the
years 1970-1972, the highest ranking official in the *434 Guardian Office
was Robert Thomas, the Deputy Guardian United States (DG US). His senior staff
and their positions from 1970-1972 were as follows:
James Mulligan .. Deputy Deputy Guardian [FN36]
Joel Kreiner .... Deputy Guardian Legal
Craig Beeney .... Deputy Guardian Technology
Henning Heldt ... Deputy Guardian Finance
Arthur Maren .... Deputy Guardian Public Relations
Terry Milner .... Deputy Guardian Intelligence [FN37]
Martin J. Greenberg, whose title was CPA US, was an adjunct of the United
States Guardian Office during these years. He was petitioner's accountant.
Henning Heldt reviewed his work. By the end of 1972 the USGO had 40 staff
members. James Mulligan, Craig Beeney and Henning Heldt also served as officers
and directors of petitioner during the docketed years. Their positions and
dates of service were:
James Mulligan .. Director and president
(Jan. 1, 1970--Sept. 3, 1973)
Henning Heldt ... Director and vice president
(Feb. 23, 1971--Feb. 16, 1973)
Craig Beeney .... Director and secretary
(Feb. 23, 1971--Apr. 13, 1973)
In April 1972, petitioner's Guardian Office formulated a three-prong plan
designed to stop what it perceived to be an IRS attack on Scientology. The plan
was developed in response to several unfavorable tax rulings revoking the tax-
exempt status of Churches of Scientology in the United States. The plan called
for three separate intelligence operations: Operation Search and Destroy,
Operation Random Harvest, and Operation Paris. The purpose of Operation Search
and Destroy was to identify organizations and individuals furnishing
information to the IRS and secure information about them covertly and overtly
which could be used to discredit or 'Dead Agent' them. This plan appears to
have been a continuation of an earlier program since the Intelligence Bureau of
the Guardian Office was already in possession of files taken from
organizations *435 providing information to the IRS. [FN38] Care was to be
taken to prevent the Church of Scientology from being connected to the covert
component of the operation.
The purpose of Operation Random Harvest was to document criminal activity on
the part of the IRS. The purpose of the third intelligence program, Operation
Paris, was to identify IRS personnel handling Scientology tax matters and to
investigate their backgrounds and activities. A segment of the plan called for
recruiting a 'plant' to develop social and professional contacts with IRS
personnel and develop a cover to hide his affiliation with the Church of
Scientology. Significant information gleaned from Operation Paris was to be
forwarded to the Intelligence Bureau of the Guardian Office. The Deputy
Guardian Intelligence (DG Int US) was placed in charge of this project.
The Guardian Office later developed another plan to infiltrate the IRS and
appropriate documents. The plan is memorialized in Guardian Order 1361 dated
October 21, 1974. The plan was developed in response to the IRS's continuing
investigation of Scientology tax matters which petitioner viewed as an attack.
Part of this investigation covered petitioner's tax returns for 1964-1969. The
purpose of the plan was to root out damaging reports considered to be false in
the IRS files so that the IRS would forget about Scientology and direct its
attention elsewhere. The plan called for infiltrating IRS offices in Los
Angeles, Washington, D.C., and London; stealing files on Scientology and L. Ron
Hubbard; and developing a suitable cover story to disguise how the information
was obtained. The Deputy Guardian Information, U.S. ('DG Info US') was in
charge of implementing most of the plan.
Pursuant to Guardian Order 1361, the IRS offices in Washington, D.C., were
burglarized and documents relating to petitioner and other Scientology churches
were taken and forwarded to petitioner's Guardian Office. At one point
Scientology operatives had difficulty gaining access to IRS intelligence files.
They tried to solve this problem by having petitioner's attorney, Joel Kreiner,
a witness in this case, make a Freedom of Information request for these
documents believing the request would lead the IRS to place the filed in a
*436 central location for processing where they would be more accessible.
Operatives gained inside information about the 1971-1974 audit by monitoring
the offices of Lewis Hubbard and his assistant and then successor, Stephen
Friedberg. Their offices were monitored over a period of several months while
the 1971-1974 audit was in progress. At one point during this period,
operatives reported they had gained access to all of the materials on
Scientology kept in Lewis Hubbard's office including Chief Counsel's files.
They also gained possession of Stephen Friedberg's handwritten daily notes
which contained occasional references to the examiner's activities.
On December 11, 1979 several ranking officials in petitioner's hierarchy were
convicted in the United States District Court for the District of Columbia of
conspiracy to obstruct justice and to obstruct a criminal investigation in
violation of 18 U.S.C. section 371. They were Mary Sue Hubbard, the
Founder's wife and second in the executive chain-of-command during the docketed
years; Henning Heldt, petitioner's vice-president and Deputy Guardian Finance
during the docketed years; Duke Snider, petitioner's president from late 1975
through May 10, 1976 and USGO official; Gregory Wilardson, a USGO intelligence
official in the post-docketed years; and Richard Weigand, also a USGO
intelligence official in the post-docketed years. On the same day Mitchell
Hermann a/k/a Mike Cooper, a Guardian official employed by the Church of
Scientology in the District of Columbia, was convicted of conspiring to steal
Government documents including ones pertaining to the 1971-1974 audit. [FN39] A
year later, on December 19, 1980, Jane Kember and Morris Budlong were convicted
in the United States District Court for the District of Columbia of
burglarizing the Exempt Organizations Division of the National Office of the
IRS on three occasions in 1976 while the 1971-1974 audit was in progress. Jane
Kember, the Guardian Worldwide, was the highest ranking official in the United
Kingdom Church during the docketed years. Morris Budlong was an official in the
Guardian Office Worldwide in the post-docketed years.
In the spring of 1975, Guardian Office personnel came aboard the Apollo and
engaged in a project to falsify petitioner's *437 financial records. The
project was undertaken in anticipation of an IRS audit.
From June 1975 through July 1976 the IRS audited petitioner's records bearing
on its 1971-1974 tax returns. Following the audit, petitioner prepared a Church
audit report and maneuvered to have it serve as the operative statement of
facts to accompany a request for technical advice. Thereafter petitioner and
respondent entered into settlement negotiations which continued even after the
notice of deficiency was issued.
The California Church did not keep books or journals to record its financial
transactions. The examiners, therefore, worked from original records--checks,
disbursement vouchers and invoices. The California Church also gave the
examiners tax workpapers for the years 1971 and 1972 in lieu of general ledgers
or books of entry. During the course of the audit the examiners received over
300 cartons of records containing by conservative estimate two million
documents. The boxes were labeled by type of record and by year; for example,
'1971 disbursement vouchers,' but the labels did not always correspond with the
materials inside. The records were generally not in chronological order. The
checks were detached from their stubs. It took three or four examiners from one
to two weeks just to organize 49 boxes of records from the San Francisco
Organization. The Church's workpapers were not always prepared in accordance
with generally accepted accounting principles and were insufficient to
establish the information the California Church was required to report on its
returns.
During the audit the examiners tried to fathom the relationship between
petitioner and OTC. Several times they asked for canceled checks from the bank
accounts OTS maintained on behalf of the California Church. They were told
these might take several weeks to produce since foreign banks did not return
cancelled checks as a matter of course. The California Church concealed from
the examiners that it regularly received debit advices from the foreign banks
in lieu of cancelled checks, and it never produced the cancelled checks. As a
result, docketed-year disbursements totaling over $3 million from the Rubric
General Account No. 295,728 on which L. Ron Hubbard was a signatory were never
explained. The auditors made numerous requests for records to verify
*438 that OTC expenditures claimed to be made on petitioner's behalf were
actually expended on petitioner for an exempt purpose. The California Church
did not comply with some of these requests. In one instance the California
Church failed to substantiate a schedule of approximately 300 claimed
expenditures. The schedule was pared down to 20 items. The IRS never received
adequate documentation, e.g., cancelled checks or third party bills, to
substantiate even these 20 items.
During the audit and the ensuing negotiations, petitioner repeatedly
represented that OTC was a separate corporation from petitioner. Petitioner
represented that OTC was formed in 1968 to render financial services to the
Flag Division aboard the Apollo. Petitioner represented that OTC was a trusted
agent receiving and banking petitioner's funds and then expending them on
petitioner's behalf to support Flag operations. Petitioner represented that OTC
personnel performed these financial services. Petitioner further represented
that at the start of the agency relationship force of circumstances led
petitioner to deposit its funds in existing OTC bank accounts, a practice which
continued through the taxable years in issue. Petitioner also represented that
in 1972 over $2 million in cash belonging to OTC was transferred to the Apollo
and kept in OTC's custody until the end of 1974 when it was credited to
petitioner as partial payment of a debt OTC owed petitioner.
All of these representations were false. OTC was in form, but not in fact, a
separate entity from petitioner. Petitioner's personnel and not OTC personnel
kept the OTC checkbooks, directed the flow of funds into and out of OTC
accounts, receipted money for the support of Flag operations and controlled and
managed Flag expenditures. The OTC bank accounts were in reality opened and
maintained by petitioner. [FN40] Only petitioner's personnel were signatories
on the accounts. [FN41] Mary Sue Hubbard and L. Ron Hubbard were sole