Westpac Pacific Food v. Cir ( 2006 )


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  •                     FOR PUBLICATION
    UNITED STATES COURT OF APPEALS
    FOR THE NINTH CIRCUIT
    WESTPAC PACIFIC FOOD; SAVE                
    MART SUPERMARKETS, INC., TAX
    MATTERS PARTNER,                                  No. 02-71041
    Petitioners-Appellants,
    v.                                 Tax Ct. No.
    12400-99
    COMMISSIONER OF INTERNAL                            OPINION
    REVENUE,
    Respondent-Appellee.
    
    Appeal from a Decision of the
    United States Tax Court
    Argued and Submitted
    September 15, 2004—San Francisco, California
    Filed June 21, 2006
    Before: James L. Oakes,* Andrew J. Kleinfeld, and
    Consuelo M. Callahan, Circuit Judges.
    Opinion by Judge Kleinfeld
    *The Honorable James L. Oakes, Senior Circuit Judge of the United
    States Court of Appeals for the Second Circuit, sitting by designation.
    6885
    6888               WESTPAC PACIFIC FOOD v. CIR
    COUNSEL
    Thomas F. Carlucci, Foley & Lardner, LLP, San Francisco,
    California, for the appellants.
    Audrea R. Tebbets, Department of Justice, Tax Division,
    Washington, D.C., for the appellee.
    OPINION
    KLEINFELD, Circuit Judge:
    We must decide whether cash paid in advance by a whole-
    saler to a retailer, in exchange for a volume commitment, is
    “gross income” under 
    26 U.S.C. § 61
    . In the grocery trade,
    these are called “advance trade discounts.”
    It is hard to think of a way to make money by buying
    things. A child may think buying things is how one makes
    money: he sees his father give a clerk a single piece of paper
    money, and receive in exchange the goods purchased, several
    pieces of paper money, and a number of coins. And a person
    may jokingly say to a spouse “I made $100 today” after buy-
    ing something on sale for $100 off. But everyone knows these
    are merely amusing remarks, not real ways to make money.1
    1
    About the only obvious way to make money by buying things is to buy
    back one’s own debt at a discounted rate, as when a corporation purchases
    its outstanding bonds at less than par. See United States v. Kirby Lumber
    Co., 
    284 U.S. 1
    , 2 (1931).
    WESTPAC PACIFIC FOOD v. CIR                      6889
    The facts outlined below sound more complicated than they
    are, so imagine a simple hypothetical. Harry Homeowner goes
    to the furniture store, spots just the right dining room chairs
    for $500 each, and says “I’ll take four, if you give me a dis-
    count.” Negotiating a 25% discount, he pays only $1,500 for
    the chairs. He has not made $500, he has spent $1,500. Now
    suppose Harry Homeowner is short on cash, and negotiates a
    deal where the furniture store gives him a 20% discount as a
    cash advance instead of the 25% off. This means the store
    gives him $400 “cash back” today, and he pays $2,000 for the
    four chairs when they are delivered shortly after the first of
    the year. Harry cannot go home and say “I made $400 today”
    unless he plans to skip out on his obligation to pay for the
    four chairs. Even though he receives the cash, he has not
    made money by buying the chairs. He has to sell the chairs
    for more than $1,600 if he wants to make money on them.
    The reason why the $400 “cash back” is not income is that,
    like a loan, the money is encumbered with a repayment obli-
    gation to the furniture store and the “cash back” must be
    repaid if Harry does not perform his obligation.
    This case is that simple, except that it involves a little more
    math and a lot more money. The taxpayer promised to buy a
    lot of items and received cash in advance as its discount on
    its future, high-volume purchases. Using accrual accounting,
    the taxpayer treated the up front cash discount as a liability
    when it was received, just like a loan. As goods were sold, the
    taxpayer applied the discount pro rata to the full purchase
    price it paid.2 The net effect was that Westpac reduced its cost
    2
    The government argues that there is no evidence that Westpac was
    actually purchasing the goods at the full list price. We give this argument
    very little credence. The Tax Court — and each party to the various con-
    tracts — consistently treated the advance “payments” as discounts on the
    volume Westpac agreed to purchase. Further, Westpac actually repaid the
    pro rata portion of the advance discount on the contracts for which it did
    not meet the volume requirement. In short, nothing in the record supports
    the government’s argument that the up front money was a payment for
    entering into the contracts or anything other than an advance discount.
    6890              WESTPAC PACIFIC FOOD v. CIR
    of goods sold and increased its reported profit (and thus its
    taxable income). The taxpayer reported pro rata amounts
    without matching sales as miscellaneous or other income.
    The government concedes, and the Tax Court agreed, that
    Westpac’s method was consistent with generally accepted
    accounting principles. “Revenue is usually recognized when
    the earning process is complete and an exchange has taken
    place.”3 Nevertheless, the Tax Court concluded that the cash
    discount received in advance was income, noting that tax
    principles do not serve the same purposes as accounting prin-
    ciples, such as reflecting to shareholders how their company
    is performing.
    A company would indeed have a major problem if it
    accounted to its shareholders as the Tax Court would have it
    account to the government. Were a company to get very sig-
    nificant amounts of up front cash discounts on its obligation
    to purchase goods in the future and tell stockholders and pro-
    spective stock purchasers that it had “made” this much “in-
    come,” investors would be sorely disappointed to learn that all
    the money had to be paid back if their company did not sell
    all the goods it had promised to sell in the future. The com-
    pany would be like Harry Homeowner claiming to have
    “made” $400 when he received his cash advance discount on
    the four chairs. Harry might have to spend the night on the
    couch, but the CEO could spend the night in jail.4
    FACTS
    Three grocery store chains — Raley’s, Save Mart, and Bel
    Air — organized the taxpayer, Westpac, as a partnership to
    purchase and warehouse inventory. Westpac is an accrual
    basis taxpayer.
    3
    Martin A. Miller, Comprehensive GAAP Guide 1990 § 36.51 (1989).
    4
    See, e.g., 15 U.S.C. § 78j(b).
    WESTPAC PACIFIC FOOD v. CIR               6891
    During 1990 and 1991, Westpac made four contracts to buy
    inventory and receive cash in advance: (1) lightbulbs from
    GTE Sylvania; (2) Hallmark cards from Ambassador; (3)
    bows, wrapping paper, and other products from American
    Greetings; and (4) spices from McCormick. Under each con-
    tract, Westpac promised to buy a minimum quantity of mer-
    chandise and received a volume discount in the form of cash
    up front. If Westpac bought too few lightbulbs, spices, greet-
    ing cards, etc., then it was obligated to pay back the cash
    advance pro rata. Conversely, Westpac’s obligation to repay
    the cash advance was extinguished if Westpac purchased the
    required volume. Westpac made other promises as well, such
    as exclusivity and shelf space, but the volume purchased
    determined whether it had to refund the cash advance and, if
    so, how much it had to refund.
    GTE Sylvania Contract
    In July of 1990, Westpac made a deal with the Sylvania
    Lighting division of GTE Products Corp. to (1) make GTE
    Sylvania its exclusive lightbulb supplier for Westpac and its
    member stores for four years; (2) “aggressively and regularly”
    advertise and promote GTE Sylvania’s products; (3) dedicate
    on average at least 12 lineal feet of shelf space to GTE Syl-
    vania’s products in its member stores; and (4) purchase $17
    million in lightbulbs during the term of the agreement. Given
    Westpac’s volume purchase commitment, GTE Sylvania
    agreed to pay Westpac $1.1 million as an “unearned advance
    allowance.” GTE Sylvania paid this to Westpac by check, and
    agreed to pay Westpac another $200,000 on the first, second,
    and third anniversaries of the agreement, provided that GTE
    Sylvania was satisfied with Westpac’s warehouse distribution
    arrangement. The contract refers to the total $1.7 million in
    payments as the “Westpac Allowance” and contains the fol-
    lowing clause:
    Upon termination of this Agreement, Westpac will
    reimburse GTE Sylvania on a pro-rated basis for any
    6892            WESTPAC PACIFIC FOOD v. CIR
    portion of the Westpac Allowance advanced to
    Westpac but not earned due to the failure by West-
    pac to purchase at least $17.0 million in lamps.
    During Westpac’s 1991 tax year, GTE Sylvania paid the first
    $200,000 to Westpac.
    Westpac could not resell enough lightbulbs to meet the
    minimum volume the contract called for, so it terminated the
    arrangement in October of 1994. Westpac’s termination letter
    acknowledged its obligation to pay back a pro-rated portion
    of the Westpac Allowance, and it repaid $861,857 to GTE
    Sylvania in December.
    Ambassador Contract
    In August of 1990, Westpac agreed to buy more than $61
    million worth of greeting cards and like items from Ambassa-
    dor, and Ambassador agreed to pay Westpac $4,572,000 up
    front as a volume discount. The contract provided for pro rata
    reimbursement of the cash advance if Westpac did not meet
    its volume commitment. The parties agreed on an addendum
    in 1994, increasing Westpac’s volume commitment and obli-
    gating Ambassador to additional cash advances.
    In 1997, Westpac and Ambassador discussed termination
    because of Westpac’s inadequate purchasing volume, and
    Ambassador sent Westpac a letter stating how much of the
    cash advance Westpac would be required to repay upon termi-
    nation. This letter included a table listing (1) the amount of
    advances Westpac had received under the contract; (2) the
    volume of purchases Westpac had achieved through Decem-
    ber of 1996; and (3) the pro rata repayment amount for the
    advances, which corresponded to the percentage of the vol-
    ume Westpac had promised to purchase. The parties ulti-
    mately decided against terminating the contract.
    WESTPAC PACIFIC FOOD v. CIR               6893
    American Greetings Contract
    In January of 1991, Westpac’s assignor, Save Mart, and
    American Greetings agreed that American Greetings would
    supply counter cards, tray packs, wraps, bows, and similar
    products. The company would give American Greetings the
    exclusive right to supply these goods, a designated amount of
    shelf space, and would continue the arrangement until it had
    spent $17,970,000 on American Greetings products. Ameri-
    can Greetings initially agreed to provide credits and dis-
    counts, but the agreement was later changed to $1,250,000
    cash up front “in lieu of periodic volume discounts.”
    On this deal, too, the volume requirement was not met and
    the contract was terminated by mutual consent. Although the
    contract did not have an explicit provision for pro rata reim-
    bursement of the up front, cash payment, both parties recog-
    nized the repayment obligation, evidently because of the
    customs of the grocery trade. American Greetings calculated
    Westpac’s pro rata repayment obligation at $406,243, and
    Westpac paid it. The check stub read “repayment of contract
    adv[ance].”
    McCormick Contract
    In March of 1991, Westpac and McCormick & Co. agreed
    that McCormick would supply spices, extracts, seasonings,
    and such, and Westpac would buy at least $50 million worth.
    McCormick provided Westpac $1 million in product without
    charge and $5 million cash up front, with additional cash pay-
    ments to be made as Westpac met periodic volume goals. The
    contract obligated Westpac “to repay any unearned prepaid
    allowances on a pro rata basis” in the event Westpac failed
    to satisfy the entire $50 million volume purchase commit-
    ment. Nothing in the record reflects that this contract was ever
    terminated or that Westpac made any pro rata repayments.
    6894               WESTPAC PACIFIC FOOD v. CIR
    Westpac’s Tax Reporting
    In accord with standard accounting principles, Westpac
    accounted for the up front cash as a liability at the time it
    received the cash.5 The cash advance got translated into tax-
    able income through Westpac’s inventory accounting. As
    Westpac purchased the goods for which it had the volume
    obligations, it subtracted pro rata portions of the advance
    cash discounts from what it paid. This had the effect of reduc-
    ing the cost of goods sold (and increasing the taxable profits
    from sales) by the amount of the cash advances attributable to
    the goods sold.
    The government took the position that Westpac and Save
    Mart under-reported over $5.5 million in gross income for
    1990 and over $4.9 million for 1991 because they did not
    report the cash advances as gross income. Westpac filed a
    petition for readjustment and the government opposed it.
    Relying on Commissioner of Internal Revenue v. Glenshaw
    Glass Co.,6 the Tax Court held that the cash advance dis-
    counts were “income” under section 61 of the Internal Reve-
    nue Code.7 Westpac timely filed this appeal.
    The sole issue before us is whether advance trade discounts
    constitute gross income when received. We hold that they do
    not and reverse the Tax Court.
    ANALYSIS
    There are no disputed findings of fact in this case, just the
    question of law: whether “advance trade discounts” subject to
    5
    See Charles T. Horngren & Walter T. Harrison, Accounting 1134
    (1989) (“Unearned revenues are liabilities because the business that
    receives the cash owes the other party goods or services to be delivered
    later.”).
    6
    CIR v. Glenshaw Glass Co., 
    348 U.S. 426
     (1955).
    7
    
    26 U.S.C. § 61
    .
    WESTPAC PACIFIC FOOD v. CIR            6895
    repayment if volume requirements are not met are income
    when received. We review the Tax Court’s decision on ques-
    tions of law de novo.8
    A.     Waiver
    [1] The government argues that Westpac waived the argu-
    ment that the advances were not income because that is not
    the argument Westpac made to the Tax Court. We have exam-
    ined Westpac’s trial brief to the Tax Court and cannot agree.
    Westpac stated the issue as whether “the advance trade dis-
    counts received by Petitioner [should] be recognized as
    income for federal income tax purposes” in the year received,
    or, as the government claimed, “as the associated inventory
    was sold.” The government argues that Westpac’s argument
    to the Tax Court focused on when the cash was income rather
    than whether, but that is too fine a distinction. Westpac has
    never denied that its income tax should be higher to reflect the
    cash received in advance. Rather, Westpac maintains that the
    advance trade discounts are not income when received but
    adjustments to the cost of goods sold. Either way, the central
    question is when Westpac has to recognize the income for tax
    purposes, so Westpac’s argument on appeal was sufficiently
    preserved.
    B.     Is A Discount in the Form of A Cash Advance Income
    When Received?
    [2] There appears to be no circuit court authority on point,
    but the Supreme Court authorities bracketing the question
    compel our answer: Cash advances in exchange for volume
    purchase commitments, subject to pro rata repayment if the
    volume commitments are not met, are not income when
    received.
    8
    Milenbach v. CIR, 
    318 F.3d 924
    , 930 (9th Cir. 2003).
    6896                WESTPAC PACIFIC FOOD v. CIR
    [3] The statutory definition of gross income is expansive.9
    Commissioner v. Glenshaw Glass Co. held that punitive dam-
    ages received by a successful litigant were “income” because
    they were “accessions to wealth, clearly realized, and over
    which the taxpayers have complete dominion.”10 The govern-
    ment argues that the cash advances in this case fit that defini-
    tion because Westpac had “complete dominion” over the
    money. It did not have to put the cash in a trust account and
    could spend the money as it chose. But that leaves out sine
    qua non of income: that it be an “accession to wealth.” One
    may have “complete dominion” over money but it does not
    become income until it is an “accession to wealth.” That is
    why borrowed money is not income, even though the bor-
    rower has “complete dominion” over the cash.11 “Because of
    this [repayment] obligation, the loan proceeds do not qualify
    as income to the taxpayer.”12
    The Supreme Court decisions bracketing this case are CIR
    v. Indianapolis Power & Light Co.13 on one side, and Automo-
    bile Club of Michigan v. CIR14 and Schlude v. CIR15 on the
    other.
    [4] Indianapolis Power held that utility customers’s secur-
    ity deposits are not income to the utility because of the obliga-
    tion to repay the money when service ended.16 The decision
    9
    
    26 U.S.C.A. § 61
    (a).
    10
    See Glenshaw Glass, 
    348 U.S. at 431
    .
    11
    See CIR v. Indianapolis Power & Light Co., 
    493 U.S. 203
    , 207 (1990)
    (Explaining that “it is well settled that receipt of a loan is not income to
    the borrower.”).
    12
    CIR v. Tufts, 
    461 U.S. 300
    , 307 (1983).
    13
    CIR v. Indianapolis Power & Light Co., 
    493 U.S. 203
     (1990).
    14
    Automobile Club of Michigan v. CIR, 
    353 U.S. 180
     (1957).
    15
    Schlude v. CIR, 
    372 U.S. 128
     (1963).
    16
    Indianapolis Power, 439 U.S. at 211-12.
    WESTPAC PACIFIC FOOD v. CIR               6897
    analogizes the security deposits to loans because of the repay-
    ment obligation.17
    [5] Automobile Club of Michigan holds that prepaid mem-
    bership dues are income when received, despite the associa-
    tion’s obligation to provide membership services — maps,
    tire repair and the like — during the subsequent year.18 The
    reason was that pro rata application of the dues to each month
    “bears no relation to the services” the club had to perform.19
    Drivers do not call AAA once a month to repair a flat or send
    a map, and AAA is entitled to keep the membership dues
    regardless of whether the member ever requests any goods or
    services. Schlude held that cash paid to a dance studio for
    ballroom dancing lessons was income when received, not
    when the lessons were provided.20 The Court applied Automo-
    bile Club of Michigan, because the money was not refundable
    and the studio could keep it even if the student did not show
    up for dance lessons.21
    [6] This case is like Indianapolis Power, not Automobile
    Club of Michigan or Schlude. The cash advance trade dis-
    counts are like the security deposits in that they are subject to
    repayment, and unlike the membership dues in that the recipi-
    ent cannot keep the money regardless of what happens after
    receipt. Westpac could only retain the full, up front trade dis-
    count if it met the volume requirements. Like the security
    deposit, the cash advance is subject to repayment. The only
    difference is that the repayment amount in this case may not
    be the full amount advanced by the vendor, but that is because
    the repayment amount is reduced pro rata to the extent West-
    pac fails to fulfill its volume commitment.
    17
    See id. at 208.
    18
    Automobile Club of Michigan, 
    353 U.S. at 712-13
    .
    19
    Id. at 712.
    20
    Schlude, 
    372 U.S. at 137
    .
    21
    See 
    id. at 130
    .
    6898                 WESTPAC PACIFIC FOOD v. CIR
    [7] Because the taxpayer here has to pay the money back
    if the volume commitments are not met, it is not an “accession
    to wealth” as required by Glenshaw Glass. Westpac either has
    to buy a specified volume of goods for more than it would
    otherwise pay or pay back the money, just like Harry Home-
    owner. Thus the cash advance discounts are, like a loan or
    customer security deposit, liabilities rather than income when
    received.
    The Tax Court found that Westpac’s accounting for the
    cash advances as affecting cost of goods sold complied with
    generally accepted accounting principles, but correctly held
    that accounting rules are not necessarily controlling for tax pur-
    poses.22 The regulations require that inventory accounting
    conform to best accounting practices and clearly reflect
    income.23 But that does not go far enough to transform the
    cash into “income” in the face of Indianapolis Power. We
    cannot agree with the government that Westpac’s “unfettered
    use” of the money makes it income, because it was not an
    accession to wealth. Rather, it was merely an advance against
    an obligation, repayable if the obligation was not performed.
    [8] Our decision in Milenbach24 is more analogous to this
    case than Schlude or Automobile Club of Michigan. In Milen-
    22
    See American Automobile Ass’n v. United States, 
    367 U.S. 687
    , 693
    (1961) (“[t]o say that in performing the function of business accounting
    the method employed by the Association ‘is in accord with generally
    accepted commercial accounting principles and practices’ . . . is not to
    hold that for income tax purposes it so clearly reflects income as to be
    binding on the Treasury.”).
    23
    See 
    26 C.F.R. § 1.471-2
    (a):
    (a) Section 471 provides two tests to which each inventory
    must conform:
    (1) It must conform as nearly as may be to the best
    accounting practice in the trade or business, and
    (2) It must clearly reflect the income.
    24
    Milenbach v. CIR, 
    318 F.3d 924
     (9th Cir. 2003).
    WESTPAC PACIFIC FOOD v. CIR            6899
    bach, a Los Angeles entity loaned the Oakland Raiders $6.7
    million, repayable only out of revenue from the luxury suites
    to be built in the future, to induce the team to move to Los Ange-
    les.25 Even though it was a non-recourse loan with no certain
    repayment date, and even though the Raiders neither built the
    suites nor made any payments, we held that the $6.7 million
    was not income because the repayment obligation was genu-
    ine.26 The case at bar is easier than Milenbach because the
    cash advances here are more plainly subject to repayment in
    calculable amounts by a set date. Westpac not only had a duty
    to repay the discounts, it actually did repay them when it did
    not meet the volume commitments. When Westpac did buy
    the required volume of goods, it paid list price rather than a
    discounted price, and realized the income for tax purposes.
    [9] It works out about the same as with Harry Homeowner:
    He has to sell the chairs for more than he paid in order to
    make money on them. Westpac had to sell the lightbulbs, rib-
    bons, greeting cards, and such for more than they paid in
    order to make money on them. It remains exceedingly diffi-
    cult to make money merely by buying things. Westpac did not
    get any richer when it received its volume discount in the
    form of cash up front than Harry Homeowner did when he got
    the $400 from the furniture store. There was no accession to
    wealth when Westpac got the cash, just an increase in cash
    assets offset by an equal liability for the advance trade dis-
    counts.
    REVERSED.
    25
    See 
    id. at 929
    .
    26
    See 
    id. at 931
    .