U.S. Freightways Corp. v. Commissioner of Revenue

• Decision Date: 06 November 2001
• Docket Number: No. 00-2668,00-2668
• Citation: 270 F.3d 1137
• Parties: (7th Cir. 2001) U.S. Freightways Corp., f.k.a. TNT Freightways Corp., and Subsidiaries, Plaintiff-Appellant, v. Commissioner of Internal Revenue, Defendant-Appellee
• Court: U.S. Court of Appeals — Seventh Circuit

Page 1137

270 F.3d 1137 (7th Cir. 2001)

U.S. Freightways Corp., f.k.a. TNT Freightways Corp., and Subsidiaries, Plaintiff-Appellant, v. Commissioner of Internal Revenue, Defendant-Appellee.

No. 00-2668

United States Court of Appeals Seventh Circuit

Argued January 18, 2001

Decided November 6, 2001

Appeal from the United States Tax Court. No. 459-98--Arthur L. Nims, III, Judge.

Before Bauer, Manion, and Diane P. Wood, Circuit Judges.

Diane P. Wood, Circuit Judge.

This is an appeal from the United States Tax Courts decision affirming the Commissioners determination that U.S. Freightways Corp. (Freightways) improperly deducted certain expenses during the 1993 tax year. Although we acknowledge that even after United States v. Mead Corp., 121 S.Ct. 2164 (2001), we owe some deference to the Commissioner's interpretation of his own regulations, we conclude here that the lack of any sound basis behind the Commissioner's interpretation, coupled with a lack of consistency on the Commissioner's own part, compels us to rule in favor of Freightways. Because the Tax Court did not reach the Commissioner's alternative argument that Freightways' method of accounting for the expenses in question did not clearly reflect its income, we remand for the limited purpose of allowing that court to consider this issue in the first instance.

I

This case was tried before the Tax Court on stipulated facts. Freightways is a long-haul freight trucking company that operates throughout the continental United States. In 1993, it had a fleet of 14,766 trucks and was growing. Every year it is required to purchase a large number of permits and licenses and to pay significant fees and insurance premiums in order legally to operate its fleet of vehicles. These items are referred to collectively as FLIP expenses in the record, and we will follow that convention. During the 1993 tax year, Freightways' FLIP expenses totaled $5,399,062. None of the licenses and permits at issue was valid for more than twelve months, nor did the benefits of any of the fees and insurance premiums paid extend beyond a year from the time the expense was incurred. But because the various FLIP expenses were incurred at different times during the tax year, Freightways enjoyed the benefits of a substantial portion of them in more than one tax year. According to Freightways' own accounting, $2,984,197, or approximately 55%, of the FLIP expenses it incurred in 1993 actually benefitted the company during 1994.

Despite the subsequent tax year benefits of its FLIP expenses, Freightways, which otherwise uses the accrual accounting method for bookkeeping and tax reporting purposes, deducted the entire $5,399,062 in FLIP expenses on its 1993 federal income tax return. This had been its com mon practice for a number of years. After auditing Freightways' tax return, the Commissioner concluded that Freightways should have capitalized its 1993 FLIP expenses and deducted them ratably over the 1993 and 1994 tax years. Freightways disputed this conclusion and petitioned the Tax Court for a redetermination of the IRSs proposed judgment. The Tax Court sided with the Commissioner, concluding that under the relevant provisions of the tax code, Freightways, as an accrual method taxpayer, was required to capitalize these expenses. Given this holding, the court declined to reach the Commissioners alternative argument that Freightways' use of the accrual accounting method did not fairly reflect its income.

II

Whether a taxpayer is required to capitalize particular expenses is a question of law, and our review is therefore de novo. See Heffley v. Commissioner, 884 F.2d 279, 282 (7th Cir. 1989). In order to place the issues in context, we begin by addressing the Tax Court's resolution of the case. The court recognized that whether Freightways could properly deduct its FLIP expenses in full depends on whether they are ordinary and necessary business expenses as defined by I.R.C. § 162(a), or capital expenditures covered by § 263(a). Citing INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992), the court explained accurately, that the essential reason behind the need to distinguish between currently deductible expenses and those that are subject to capitalization is "to match expenses with the revenues of the taxable period to which they are properly attributable, thereby resulting in a more accurate calculation of net income for tax purposes." 503 U.S. at 84. Some mismatching is inevitable: it is not necessary to count every pencil on hand at the end of a tax year to determine whether it will be useful in the next tax year and, if so, to treat it as a capital asset. The critical consideration in determining whether an expense should be treated as a capital expenditure is whether the expenditure produces more than an incidental future benefit or, as the Treasury Regulations put it, whether a benefit for the taxpayer extends "substantially beyond the tax year." See, e.g., Treas. Regs. § § 1.263(a)-2, 1.461-1(a)(2).

This means that, but for the accident that Freightways' expense year does not correspond with its tax year, there would be no problem in treating the FLIP expenses as current. The licenses and fees Freightways purchased conferred a 12-month benefit on the company; if it had incurred those expenses on January 1 of each year and they had all expired on December 31 (the tax year for Freightways), no one would have argued that capitalization was required. But for reasons unrelated to taxation, that is not the way the FLIP expenses worked. The Tax Court's task was thus to unravel the tax implications of this quirk, which turn on the lines that must be drawn conceptually between deductible expenses and capital expenditures.

Turning to the question whether Freightways' FLIP expenses were deductible in full in the year they were incurred, the Tax Court understood Freightways to be arguing that it should be allowed to deduct its FLIP expenses in full under a "one-year rule" permitting the deduction of any current expense with a benefit that extends less than 12 months into the subsequent tax year. The application of this principle would rid the Commissioner's position of its intrinsic arbitrariness: under a one-year rule, nothing would turn on the accident of the date during a year when a one-year expenditure was made. The worst case (from the Commissioner's standpoint) one could imagine of a mis-match between the year of payment and the year of benefit would be the one in which a taxpayer bought all its licenses on December 31 of year 1 and deducted their entire cost in that year, even though the entire benefit accrued in year 2. (The worst for the taxpayer might be a case in which the license was purchased on February 1 of the first year and expired on January 31 of the next year, if the Commissioner regarded a full month as "substantial" enough to require capitalization.) The Tax Court rejected Freightways' reliance on a one-year rule for two reasons. First, it questioned whether such rule was, in fact, well established in the case law. Second, it found that Freightways had a "more fundamental problem," namely the fact that "even if such a 1-year rule were widely recognized, it would be inapplicable to an accrual method taxpayer." On these two grounds, and without further explanation, the court affirmed the Commissioner's deficiency judgment.

III

This is a difficult case because the language of the Code, the regulations, and the presumption in favor of capitalization to varying degrees support the Commissioner's position, but the rationale for distinguishing between immediate expenses that should be deducted from a single year's income and longer term expenses that are suitable for amortization strongly cuts in Freightways' direction. Furthermore, as we explain below, the Tax Court's alternative ruling that any judge-made "one year rule ought not logically to be available to accrual taxpayers" is not supportable. Because so much turns on the degree of deference we owe to the Commissioner in these circumstances, we begin with a brief discussion of that subject and then turn to the merits of the case.

A.

At the most general level, this case turns on which of two provisions of the Code itself should apply to Freightways' situation: section 162(a), which permits the deduction of ordinary and necessary business expenses, or § 263(a), which calls for the capitalization of all other expenditures. The Commissioner has issued notice-and-comment regulations that elaborate on the way this choice should be made. As we noted above, those regulations provide that expenditures producing nothing more than an "incidental" future benefit are eligible for current year deductions, while expenditures whose benefits extend "substantially" beyond the tax year must be capitalized. See Treas. Regs. § § 1.263(a)-2, 1.461-1(a)(2). But this is not a case where the regulations themselves fully answer the question before us. Instead, another layer of interpretation has been laid on top of the regulations: the Commissioner has informed the courts throughout the course of this litigation that the term "substantially" as used in the regulations should be interpreted to cover anything that extends more than a few days, or perhaps a month, into the second tax year. This is so regardless of the implications for the capitalization decision of the other factors normally used to draw the line between ordinary and capital expenses.

In the ordinary case, our focus is on the deference we must give to a regulation itself. After Mead, we know that we give full deference under Chevron v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984), only to regulations that were promulgated with full notice-and-comment or comparable formalities. See Mead, 121 S. Ct. at 2171. We also know that deference to agency positions is not an all-or-nothing proposition; more informal agency statements and positions receive a more flexible...