Recent judicial decisions and IRS advice have dealt with the claim-of-right doctrine. Generally, when a taxpayer receives income under a claim of right, the income must be included in the taxpayer’s gross income (the amount giving rise to the tax cost). If the taxpayer later determines that it did not have a rightful claim to such income and repays an amount in a later tax year, the taxpayer may be entitled to a deduction (the amount giving rise to the tax benefit). If the tax benefit afforded by the deduction is less than the tax cost—that is, if the tax rate or other tax attributes differ between the year of receipt and the later year—the taxpayer may find relief under Sec. 1341.
This item discusses four recent judicial decisions and administrative pronouncements addressing Sec. 1341. Unfortunately, because the factual situations underlying the recent decisions are dissimilar, the cumulative result can be confusing for practitioners and taxpayers.
Pennzoil-Quaker State Co.
The Federal Circuit denied Pennzoil Sec. 1341 relief in Pennzoil-Quaker State Co., 511 F3d 1365 (Fed. Cir. 2008), rev’g 62 Fed Cl 689 (2004). Pennzoil’s suppliers sued the company, alleging price fixing to artificially lower the price Pennzoil paid for oil products. Pennzoil settled the lawsuit, paid the suppliers, and deducted the payments on its returns for the years at issue. Later, Pennzoil amended those returns and requested a refund of overpaid taxes under Sec. 1341. The IRS denied Pennzoil’s request for refund, and Pennzoil filed suit in the Court of Federal Claims.
Pennzoil based its claim on the following arguments:
- Pennzoil had overstated its income from product sales in prior years (the income originally reported was greater because its cost of goods sold (COGS) was artificially low);
- Pennzoil was allowed a deduction for the settlement payments because it did not have a right to the overstated income in a later year; and
- The inventory exception (which disallows Sec. 1341 relief) applies only to sales returns, allowances, and similar items, as stated in Regs. Sec. 1.1341-1(f)(1), not to Pennzoil’s settlement payments.
The Court of Federal Claims held that Pennzoil was eligible for Sec. 1341 relief.
On appeal by the government, the Federal Circuit reversed the decision of the Court of Federal Claims. The Federal Circuit determined that Pennzoil failed the judicially created “same circumstances” requirement and that, in addition, it was barred from relief under Sec. 1341 by the “inventory exception.”
Under the same-circumstances requirement, in order for a taxpayer to be eligible for Sec. 1341 relief, the taxpayer’s obligation to restore amounts previously included in income must arise out of the same circumstances, terms, and conditions of the transaction from which the income was originally derived (Blanton, 46 TC 527 (1966)). Pennzoil’s item included in income (the understated COGS) did not arise out of the same circumstances as the obligation to make payment (the settlement of a suit with Pennzoil’s suppliers) for three reasons:
1. The Federal Circuit found that Pennzoil’s item of income (the understated COGS) did not qualify as an allowable deduction, contrary to the requirements of Sec. 1341(a)(2).
2. For purposes of the item-included requirement of Sec 1341(a)(1), Pennzoil treated the settlement payment as COGS, while for purposes of the deduction-allowable requirement in Sec. 1341(a)(2), it treated it as a settlement payment. The court stated that this was a fatal conceptual defect in Pennzoil’s claim.
3. The Federal Circuit determined that Pennzoil failed a judicially created “restoration requirement,” which, as interpreted by the Federal Circuit, requires repayment of the item of income to the party from which the income was derived (see Chernin, 149 F3d 805 (8th Cir. 1998); Regs. Sec. 1.1341-1(a)). Since the inflated income from the sale of Pennzoil’s products was repaid not to Pennzoil’s customers (the parties from which the inflated income was derived) but to its suppliers, the Federal Circuit held that Pennzoil could not invoke Sec. 1341 relief for its settlement payments.
Under the inventory exception, Sec. 1341 relief is not available for any deduction related to an item of income that resulted from the sale of inventory. Pennzoil argued that the exception applies only to a deduction in the current year in the nature of sales returns and allowances. The Federal Circuit disagreed, holding that the exception applies when the item of income in the prior year resulted from the sale of inventory. Therefore, because the item of income included in the prior year arose out of the underpayment of COGS, the inventory exception applied.
The Third Circuit denied Alcoa Sec. 1341 relief in Alcoa, Inc., 509 F3d 173 (3d Cir. 2007). Alcoa’s operations between 1940 and 1987 produced waste byproducts that caused environmental contamination at several of its disposal sites. As a result of the enforcement of subsequently enacted environmental laws, Alcoa spent funds in 1993 to remediate the contamination. Alcoa argued that the remediation costs were eligible for Sec. 1341 relief.
For purposes of the decision, the Third Circuit assumed the remediation costs were included in Alcoa’s COGS computation for the years at issue. Alcoa argued that because the remediation costs were part of its COGS, the money “unspent” on them in the earlier years resulted in an overstatement of gross income. Although the court did not reach a conclusion as to whether an understatement of COGS was an item of income, it noted that on this point, “Alcoa’s artful argument . . . exploits technicalities at the expense of common sense” (Alcoa, 509 F3d at 178 n. 6).
The Third Circuit’s denial of Sec. 1341 relief rested on Alcoa’s failure to satisfy the same-circumstances requirement because the environmental remediation obligation did not arise from the same circumstances “as the initial failure to spend additional funds on environmental clean-up” (id. at 179–80). The change in environmental laws, the court found, was a new circumstance that created new obligations unrelated to the amounts not spent by Alcoa in the earlier years.
The court also found that Alcoa failed the restoration requirement, noting that to restore something means to “give it to the person who either once had it or should have had it all along” (id. at 182). Alcoa was entitled to the funds it received as sales revenue, and no other entity had a better claim; thus, “Alcoa’s expenditure of funds in 1993 was not the restoration of particular moneys to the rightful owner” (id. at 180). The Third Circuit concluded, “In sum, only the most torturous reading of section 1341 could equate Alcoa’s expenditures to clean up its sites with restoring moneys to the rightful owner” (id. at 183).
The Third Circuit decision in Alcoa did not address the inventory exception even though, as in Pennzoil, the taxpayer argued that the understated COGS was the item of income included in an earlier year. The lower court in Alcoa, however, did note the issue but did not make a finding with regard to the application of the inventory exception because Alcoa initially failed to satisfy the statutory requirements for Sec. 1341 relief. See Alcoa, Inc., 406 FSupp2d 580, 584 (W.D. Pa. 2005) (adopting the reasoning and result in Reynolds Metals Co., 389 FSupp2d 692 (E.D. Va. 2005)).
Chief Counsel Advice (CCA) 200805021, published February 1, 2008, concludes that Sec. 1341 relief is not available to a taxpayer that made additional oil lease royalty payments under a settlement agreement if the royalty payments constitute additional inventory cost. Note that the advice did not decide if the payments were a disgorgement of income or additional inventory costs.
The advice finds, however, that to the extent the payments constituted additional inventory costs, Sec. 1341 relief is not available because there is no item of income. According to the advice, gross income, for purposes of Sec. 1341, is defined by Regs. Sec. 1.61-1, under which gross income means total receipts, not income reduced by the COGS. The advice rejects the lower court’s finding in Pennzoil that for purposes of Sec. 1341 gross income means gross receipts less COGS and finds that the taxpayer lacks not only an item of income but also an allowable deduction. Because the settlement payments—assumed to be additional inventory costs—are not deductible, the requirement of Sec. 1341(a)(2) that the taxpayer be entitled to a deduction cannot be met.
The advice concludes that the inventory exception bars Sec. 1341 relief. Because the taxpayer’s royalty settlement would be an “obligation to pay additional royalties and the resulting deduction is directly related to the inclusion of the item in gross income,” the inventory exception applies. The advice applies a different definition of income for purposes of the item of income determination (gross receipts (Regs. Sec. 1.61-1)) and the inventory exception (total sales less COGS (Regs. Sec. 1.61-3)). It does not specifically address whether the inventory exception is limited to sales returns, allowances, and similar items.
Published February 22, 2008, CCA 200808019 may be the most taxpayer-favorable resolution of the recently released guidance. In this advice, the taxpayers had entered into a settlement agreement under Section 16(b) of the Securities Exchange Act of 1934 and disgorged their short-sale profits to a corporation. The taxpayers applied for a tentative refund based on Sec. 1341 relief.
The advice turns on whether the taxpayers had an unrestricted right to the profits on the short sales or whether the “claim of wrong” doctrine applies. The claim-of-wrong doctrine limits Sec. 1341 relief if the taxpayer obtained the income in a fraudulent or illegal manner (Yerkie, 67 TC 388 (1976)). The advice concludes that the claim-of-wrong doctrine does not prevent Sec. 1341 relief because “there was a bona fide legal issue” as to the taxpayers’ Section 16(b) liability and they “had an appearance of an unrestricted right to the income in question.”
The advice concludes that the taxpayers satisfied the restoration requirement even though they paid the corporation, not the party that purchased the stock. Specifically, “disgorgement of income need not be to the party who was the original payor of the income. It is only necessary that the taxpayer pay the disgorged income to its rightful owner. See Example at Treas. Reg. § 1.1341-(1)(h).” The advice also concludes that the taxpayers satisfied the “establishment requirement” by showing that the deduction arose out of the taxpayers’ legal obligation to disgorge the income from a trial court judgment and a settlement during the appeals process.
The recently issued circuit court cases and IRS advice do not coalesce around any particular issue, potentially leaving taxpayers and practitioners with the same level of uncertainty that existed before. With seemingly more questions than answers regarding the scope of Sec. 1341, the Ninth Circuit is poised to issue its opinion in Texaco, Inc. & Subsidiaries, Dkt. No. 06-16098. The case—in which the sole question for the court is the scope of the inventory exception—is on appeal from the district court’s unreported, taxpayer-favorable order (Texaco Inc. & Subsidiaries, 96 AFTR2d 2005-5151 (N.D. Cal. 6/16/05) (taxpayer’s settlement of customer overcharges)). The district court found that the inventory exception’s language was ambiguous and that the taxpayer’s narrow interpretation of the inventory exception was supported by the regulations, legislative history, and case authority. Perhaps the upcoming Ninth Circuit decision will resolve some uncertainty.
Mary Van Leuven ia a Senior Manager at Washington National Tax KPMG LLP in Washington, DC
The information contained in this Tax Clinic is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser. The views and opinions expressed are those of the authors and do not necessarily represent the views and opinions of KPMG LLP.
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