Westpac Pacific Food v. C.I.R.

• Decision Date: 21 June 2006
• Docket Number: No. 02-71041.,02-71041.
• Citation: 451 F.3d 970
• Parties: WESTPAC PACIFIC FOOD; Save Mart Supermarkets, Inc., Tax Matters Partner, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

451 F.3d 970

WESTPAC PACIFIC FOOD; Save Mart Supermarkets, Inc., Tax Matters Partner, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 02-71041.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted September 15, 2004.

Filed June 21, 2006.

Thomas F. Carlucci, Foley & Lardner, LLP, San Francisco, CA, for the appellants.

Audrea R. Tebbets, Department of Justice, Tax Division, Washington, D.C., for the appellee.

Appeal from a Decision of the United States Tax Court. Tax Ct. No. 12400-99.

Before JAMES L. OAKES,^* KLEINFELD, and CALLAHAN, Circuit Judges.

KLEINFELD, Circuit Judge.

We must decide whether cash paid in advance by a wholesaler 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 buying something on sale for $100 off. But everyone knows these are merely amusing remarks, not real ways to make money.¹

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 discount." 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 obligation 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 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 principles, 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 significant amounts of up front cash discounts on its obligation to purchase goods in the future and tell stockholders and prospective stock purchasers that it had "made" this much "income," 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 company 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.

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 contract, Westpac promised to buy a minimum quantity of merchandise and received a volume discount in the form of cash up front. If Westpac bought too few lightbulbs spices, greeting 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 Sylvania'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 following clause:

Upon termination of this Agreement, Westpac will reimburse GTE Sylvania on a pro-rated basis for any portion of the Westpac Allowance advanced to Westpac but not earned due to the failure by Westpac 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 Ambassador, 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 obligating 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 termination. 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 December of 1996; and (3) the pro rata repayment amount for the advances, which corresponded to the percentage of the volume Westpac had promised to purchase. The parties ultimately decided against terminating the contract.

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. American Greetings initially agreed to provide credits and discounts, 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 reimbursement of the up front, cash payment, both parties recognized 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 payments 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 commitment. Nothing in the record reflects that this contract was ever terminated or that Westpac made any pro rata repayments.

Westpac's Tax Reporting

In accord with standard...