Avon Products, Inc. v. U.S.

• Decision Date: 08 October 1996
• Docket Number: No. 96-5003,96-5003
• Citation: 97 F.3d 1435
• Parties: -6682, 96-2 USTC P 50,525, 20 Employee Benefits Cas. 1969 AVON PRODUCTS, INC. and U.S. Subsidiaries, Plaintiff-Appellant, v. The UNITED STATES, Defendant-Appellee.
• Court: U.S. Court of Appeals — Federal Circuit

Page 1435

97 F.3d 1435

78 A.F.T.R.2d 96-6682, 96-2 USTC P 50,525,

20 Employee Benefits Cas. 1969

AVON PRODUCTS, INC. and U.S. Subsidiaries, Plaintiff-Appellant, v. The UNITED STATES, Defendant-Appellee.

No. 96-5003.

United States Court of Appeals, Federal Circuit.

Oct. 8, 1996.

Robert Feldgarden, McDermott, Will & Emery, Washington, DC, argued, for plaintiff-appellant. With him on the brief was Christopher Kliefoth.

Kenneth L. Greene, Tax Division, Department of Justice, Washington, DC, argued, for defendant-appellee. With him on the brief were Loretta C. Argrett, Assistant Attorney General, Gary R. Allen, Chief, Appellate Section, and John A. Dudeck, Jr.

Before RICH, NEWMAN, and BRYSON, Circuit Judges.

BRYSON, Circuit Judge..

This appeal stems from a dispute over the appropriate tax treatment of employee profit-sharing payments made by the Mexican subsidiary of a United States taxpayer, Avon Products, Inc. The Court of Federal Claims granted summary judgment for the government on the ground that the subsidiary had improperly deducted certain payments in the year in which the payments were made rather than in the year in which the employees' services were rendered. Avon Prods., Inc. v. United States, No. 94-485 T, 1995 WL 579706. We conclude that the government is not entitled to summary judgment on that issue, and we therefore vacate the judgment in favor of the government and remand for further proceedings.

I

Avon is an accrual-basis corporate taxpayer whose taxable year follows the calendar year. Avon's Mexican subsidiary, Avon Cosmetics, S.A. de C.V. Mexico (Avon Mexico), is required by Mexican law to pay its employees a percentage of its profits each year within five months of the close of its taxable year. Those employee profit participation payments (or EPP payments) are central to this dispute because of their impact on the foreign tax credit made available to Avon by section 902 of the Internal Revenue Code, 26 U.S.C. § 902.

Under section 902, a U.S. taxpayer is entitled to a credit for foreign taxes paid by a foreign subsidiary. The portion of the foreign tax that can be taken as a credit by the U.S. taxpayer is a function of the dividends paid by the foreign subsidiary to the parent divided by the subsidiary's after-tax accumulated profits. If the subsidiary pays dividends to its parent equal in amount to its after-tax accumulated profits, the parent is entitled to a 100 percent tax credit for the foreign taxes paid by the subsidiary. If the subsidiary pays no dividends to its parent, the parent is entitled to no foreign tax credit.

Between 1967 and 1981, Avon Mexico made its EPP payments for each year within the first five months of the following year, either in early March or in May. For the years in which the EPP payments were made in early March, the Internal Revenue Service allowed the payments to be deducted from Avon Mexico's profits for the prior year. For the years in which the EPP payments were made in May, the IRS did not allow the deduction to be taken from Avon Mexico's profits in the prior year, but required the deduction to be taken in the year in which the payments were made.

In 1980, Avon Mexico did not pay a dividend to Avon, and thus Avon was unable to claim a foreign tax credit for that year. Avon determined, however, that it could increase its total foreign tax credits if it could deduct the EPP payments for both 1980 and 1981 from Avon Mexico's profits for 1981. In an effort to achieve that end, Avon Mexico waited until March 26, 1981, to make the EPP payments for 1980. Avon claimed that because the EPP payments for 1980 were made after March 15 in the year after they were earned, those payments constituted deferred compensation, not current compensation, and they were therefore deductible in 1981, the year of payment, under section 404(a)(5) of the Internal Revenue Code, 26 U.S.C. § 404(a)(5). Avon Mexico then made the EPP payments for 1981 before March 15, 1982, so that the EPP payments for 1981 would also be deductible in 1981. Avon claimed that because those payments were made before March 15 in the year following the year in which they were earned, they constituted current compensation, not deferred compensation, and they were therefore deductible in 1981, the year of accrual, under section 162 of the Internal Revenue Code, 26 U.S.C. § 162.

The IRS did not challenge the deduction in 1981 of the payments made before March 15, 1982, but it disallowed the deduction in 1981 of the payments made on March 26, 1981. The IRS contended that because Avon was an accrual-basis taxpayer, the deduction of the EPP payments for each year had to be taken in the year in which the obligation accrued. According to the IRS, the Mexican statute established Avon Mexico's liability at the moment the 1980 taxable year closed and the deduction of the 1980 EPP payments therefore had to be taken in 1980, not 1981. After the agency reassessed Avon's 1981 tax liability and Avon paid the deficiency, Avon filed an action for a refund in the Court of Federal Claims. Following cross-motions for summary judgment, the court upheld the agency's decision and denied the refund.

II

Several sections of the Internal Revenue Code provide the statutory background against which the issue in this case arises. Section 162(a) permits taxpayers to deduct "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." 26 U.S.C. § 162(a). Section 446(a) requires that taxable income "shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books." 26 U.S.C. § 446(a). Section 446(c)(2) permits a taxpayer, such as Avon, to use accrual-method accounting. 26 U.S.C. § 446(c)(2). Under that accounting scheme, the taxpayer is normally entitled (and required) to take a deduction in the year in which the expense accrues, not in the year in which the expense is actually paid. Thus, an accrual-basis taxpayer is usually required to take a deduction for an ordinary business expense in the year in which the obligation to pay and the amount of the payment have become final and definite. Security Flour Mills Co. v. Commissioner, 321 U.S. 281, 286, 64 S.Ct. 596, 598, 88 L.Ed. 725 (1944).

In accordance with those principles, current compensation paid to employees by an accrual-basis taxpayer is deductible in the year of accrual. Deferred compensation, however, is treated differently. Section 404 of the Internal Revenue Code creates a special set of tax rules to govern deferred compensation. Certain deferred compensation arrangements, referred to as "qualified plans," enjoy favorable tax treatment under section 404. See 26 U.S.C. § 404(a)(1)-(4). All other forms of deferred compensation do not.

Section 404 has a broad reach. It applies to "stock bonus, pension, profit-sharing, or annuity plan[s]," 26 U.S.C. § 404(a); it applies to "compensation ... paid or accrued on account of any employee under a plan deferring the receipt of such compensation," id.; and, even where there is no such "plan," it applies to any "method or arrangement of employer contributions or compensation which has the effect of a stock bonus, pension, profit-sharing, or annuity plan, or other plan deferring the receipt of compensation," 26 U.S.C. § 404(b).

For types of deferred compensation other than qualified plans, section 404 provides that a payment by the employer is not deductible in the year in which the obligation to make the payment accrues, but in the year in which the payment is includible in the employee's gross income. 26 U.S.C. § 404(a)(5). The general rules governing deductions taken by accrual-basis taxpayers therefore do not apply to deferred compensation under section 404.

III

Avon argues that because it postponed including its EPP payments until March 26, 1981, those payments constituted "deferred compensation" within the meaning of section 404 and therefore were properly deducted in 1981, the year in which they were made. In response, the government contends that nothing Avon did in this case took it outside the normal rules applicable to an accrual-basis taxpayer--that an expense is deductible only in the year of accrual, regardless of when the accrued expense is actually paid.

The government makes three arguments in support of that thesis. First, it contends that Avon Mexico's EPP payments were not made pursuant to a "plan" and therefore do not fall within section 404. Second, it maintains that even if the EPP payments qualified as a form of compensation within the meaning of section 404, the payments were not "deferred" within the meaning of that statute, because they were made within a reasonable period of time after the close of Avon Mexico's 1980 taxable year. Finally, it argues that Avon's treatment of the EPP payments for 1980 constituted an impermissible change in the company's method of accounting and must be disapproved for that reason as well.

A

We first address the government's argument that section 404 does not apply to the EPP payments at issue in this case because the payments were not made pursuant to a "plan deferring the receipt of ... compensation," as required by section 404(a). If accepted, that argument would have the perverse consequence that a payment of accrued compensation made more than a short time after the close of a taxable year pursuant to a plan of deferring compensation would not be deductible in the prior taxable year, but a payment of accrued compensation made on a date arbitrarily chosen by the employer (i.e., not pursuant to a "plan" of deferral) could be deducted in the prior taxable year, even if the payment were made long after the close of that taxable year.

Both the language and the legislative history of section 404 persuade us that the statute does not compel this odd result. Rather, both indicate that the principles of section 404 governing the...