Oak Industries, Inc. v. Commissioner, Docket No. 37866-84.
| Decision Date | 29 January 1987 |
| Docket Number | Docket No. 37866-84. |
| Parties | Oak Industries, Inc. and Subsidiaries v. Commissioner. |
| Court | U.S. Tax Court |
Avram Salkin, Bruce I. Hochman, and Charles P. Rettig, 9100 Wilshire Blvd., Beverly Hills, Calif., for the petitioner. Steven Mather, for the respondent.
Memorandum Findings of Fact and Opinion
Respondent determined deficiencies in petitioners' income tax for the years 1974, 1977 and 1978 in the respective amounts of $15,533, $75,376 and $593,613. Before trial jobs credit, WIN credit, investment tax credit and research credit carryback issues were severed for the purpose of trial, briefing and opinion. A foreign tax credit issue for 1977 and investment tax credit issues for 1977 and 1978 have been settled.
The only issue for decision in this case is whether petitioners should have included in gross income their distributive share of subscriber security deposits received by National Subscription Television during 1977 and 1978.
Some of the facts have been stipulated and are so found. The stipulations and exhibits attached thereto are incorporated herein by reference.
Petitioners filed consolidated income tax returns for 1977 and 1978. At the time the petition in this case was filed, petitioners' principal place of business was in Rancho Bernardo, California.
By partnership agreement dated November 28, 1975, petitioner Oak Television, Inc. and Chartwell Communications Group agreed to conduct an over-the-air subscription television (hereinafter referred to as STV) operation. The partnership originally chose the business name World Pay Television but later changed the business name to National Subscription Television (hereinafter referred to as NST). Petitioner Oak Television was entitled to 51 percent of NST's income, gains, deductions, losses and credits, and the Chartwell Communications Group was entitled to 49 percent of such items.
Chartwell Communications Group was a California limited partnership. Its sole general partner was Chartwell Communications, Inc. whose only stockholder was A. Jerrold Perenchio. Perenchio served as managing partner for NST, responsible for programming, marketing, advertising and the general day-to-day business of the enterprise.
Before broadcasting began on April 1, 1977, NST developed equipment that enabled a broadcasting studio to transmit an over-the-air scrambled signal to the home of a subscriber without the use of cables or wires. Petitioners also developed an electronic decoder box that enabled subscribers to receive an unscrambled signal in their homes. Each decoder box was given an address and could be turned on or off from the studio initiating the scrambled broadcast.
It was necessary for NST to obtain authorization from the Federal Communications Commission (hereinafter referred to as FCC) before it could transmit its signal. In applying for FCC authorization, NST was required to submit the decoder box to the FCC for analysis and to submit an explanation of its business plan setting forth the financing of the operation, proposed programming and a list of the individuals who would be involved in the operation. At the time that NST filed its application, there were no FCC regulations concerning maximum monthly charges or maximum charges for security deposits. Nor were any such regulations subsequently adopted by the FCC.
From April 1977 until after September 30, 1981, NST used the decoder in an STV operation in the Los Angeles area under the fictitious name "On TV." A decoder was installed in the home of each subscriber. During 1977 and 1978, NST collected $64.95 from each subscriber upon installation. The subscription agreement in effect at that time allocated the $64.95 to a $39.95 "installation charge" and a $25 "security deposit."
The decision to charge $25 as a security deposit was based on a number of factors. NST wanted to assure that the decoder boxes were returned when STV service was terminated to protect its $100 to $125 investment in each box and to prevent nonsubscribers from tampering with boxes in order to receive programs without paying for the STV service. Because the FCC would not allow NST to sell its decoders, NST sought to set a meaningful amount that would induce subscribers to return the boxes.
Before commencing its operations, NST engaged several independent survey firms to provide assistance in deciding how much to charge for the deposit. In addition to performing surveys in shopping centers and supermarkets, the survey firms conducted over 20 focus groups to determine the reaction of potential subscribers to different amounts that might be charged for subscription deposits.
As the attorney representing NST before the FCC, Robert Cahill discussed the refundable subscription deposit with FCC representatives on more than 50 occasions. Although the FCC did not have any formal regulations restricting the amount that NST could charge as a deposit, NST was required to set forth information relating to the deposit on the FCC application for authorization. Cahill advised Perenchio that, in his opinion, the FCC authorization might be delayed or even denied if NST required a deposit of more than $25.
When a subscription deposit was received, NST's books reflected an entry of a debit of $25 to cash and a credit of $25 to a liability account called "Subscriber Security Deposits." The entire $25 deposit was placed in NST's general account and was not segregated or placed in a trust account at any time. No interest was paid to the subscriber on the deposit. Until and unless it came time to refund the deposit, petitioner's use of the deposited funds was unrestricted. Within a few days after installation of the decoder, NST billed the subscriber for the first month's charge of $17.42. The subscriber then received a bill each month requiring him to pay $17.42 in advance for the STV service. The $17.42 monthly billing included a $7 charge for the decoder rental plus a 6 percent sales tax.
From April 1, 1977, until early 1979, NST's collection department caused a subscriber's reception to be turned off when the collection representative determined that a substantial delinquency had occurred. In January, 1979, NST began shutting off the subscriber's service if any portion of the monthly billing was unpaid for 90 days after the billing date.
The subscription agreement provided that the subscriber and NST each had the right to terminate the STV service upon written notice and that upon termination the subscriber would pay all monthly fees due and surrender the decoder to NST. Under the terms of the agreement, upon termination of the STV service, NST would offset the deposit to be refunded against three charges: (1) the subscriber's account balance due to NST, (2) repair costs incurred by NST for decoder damage caused by the subscriber, and (3) costs incurred by NST for the subscriber's breach of the subscription agreement.
When STV service was terminated, NST would compute the final amount owed by the subscriber. If a balance was due, NST would apply the $25 deposit against the balance and refund the excess to the subscriber. If no amount was due, NST would refund the entire $25 deposit plus any overpayments. No money was refunded until the decoder was returned to the warehouse and tested.
A sample study of refunds to customers was performed using all refunds made during the months of July 1978 and December 1978. These two samples are representative of NST's actual refund history.
The subscription agreement in effect from 1977 until 1979 contained a liquidated damages clause requiring the subscriber to pay $350 for each decoder not returned upon termination of the STV service. The agreement also required the subscriber to pay for damage caused by tampering with the decoder.
If the decoder was returned with only minor damage, the subscriber was usually not billed. NST would bill the subscriber for the full amount specified in the liquidated damages clause if a decoder was returned with signs of tampering or with major damage rendering it unworkable or if the decoder was not returned at all. NST brought many actions in small claims court against subscribers who failed to either return the decoders or to pay liquidated damages. Initiation of the small claims litigation encouraged many nonresponsive subscribers to return their decoder boxes. This litigation also resulted in recovery of money damages.
Before resorting to small claims litigation, NST made many efforts to recover decoders including the use of dunning letters, telephone contacts, postage paid mail-in boxes, and in-house and outside collection services. NST did not pursue small claims litigation if the decoder was returned in working order but there was a balance due on the subscriber's account. Instead, NST would turn bad accounts over to collection agencies after the decoders were returned.
During 1977 and 1978 NST paid $105.30 for each of the first 50,000 decoders and $125 for each decoder in excess of 50,000. The price of a decoder on the "black market" ranged between $100 and $500.
Many of the decoders used by NST during 1977 and 1978 were leased on net leases from United Medical Leasing Company, Inc. (hereinafter referred to as UML) and Walter E. Heller & Company (hereinafter referred to as Heller). These leases were capitalized leases and were principally financing arrangements between NST and UML and Heller.
The leases required a security deposit in the form of restricted certificates of deposit. The interest on the certificates of deposit inured to the benefit of NST. Each year one-seventh of the principal amount of the restricted certificates of deposit was released to NST to coincide with the reduced obligation of payments due from NST on the 7-year lease. By the end of the lease when the decoders were due to be returned, the restricted certificates of deposit had...
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