Westpac Pacific Food: advance trade discounts are not income.
Three grocery store chains organized Westpac as a partnership to purchase and warehouse inventory. During the years at issue, Westpac entered into agreements with vendors, such as GTE Sylvania, America Greetings and McCormick, to buy inventory and receive cash in advance. Under each contract, Westpac agreed to buy a minimum quantity of merchandise and receive a volume discount (i.e., cash up-front). If Westpac purchased the agreed-on minimum amount of merchandise, it was entitled to keep the cash advance. If it failed to purchase said amount, it was obligated to repay a pro-rata portion of the advance.
Westpac, an accrual-basis taxpayer, treated the up-front cash payment as a liability for financial accounting purposes. For tax purposes, it did not include it in income when received; instead, it reduced its cost of goods purchased under the agreement by a pro-rata amount. On audit, the IRS took the position that such cash advances were required to be included in income in the year received.
The Tax Court agreed with the Service's position and held that Westpac was required to include the cash advances in income in the year of receipt. The court cited the broad definition of gross income used by the Supreme Court in Glenshaw Glass Co., 348 US 426 (1955), which includes "all income from whatever source derived," and found that Westpac had "unfettered use" of the advance payments and "actual command" over the money.
The Tax Court rejected Westpac's position that the amounts should be treated as trade discounts under Regs. Sec. 1.471-3(b) that reduce cost of goods sold. It stated that, to qualify as a discount under the regulations, an amount must arise contemporaneously with the purchase of specific goods. It also characterized the obligation to repay amounts if minimum purchases were not made as a contingent repayment obligation that would not operate to defer income recognition.
"Harry Homeowner" example: The Ninth Circuit began its opinion with remarks intended to demonstrate the folly of the Tax Court's conclusion. It noted that a child might think that one makes money for buying something when the child sees a parent receive change back from making a purchase, and a person may joke to a spouse that he or she made money from buying something on sale. The court stated, however, that "everyone knows these are merely amusing remarks, not real ways to make money."
The court simplified the facts in the case by providing what it called a "simple hypothetical" involving Harry Homeowner. In the example, Harry wants to buy some dining room chairs that a furniture store is offering at a 25% discount off the $2,000 regular price. Harry is a little short on cash and negotiates a deal in which the furniture store gives him a 20% discount as a cash advance instead of a 25% discount. This results in Harry receiving $400 "cash back" today, and paying $2,000 when the chairs are delivered. Under this hypothetical, Harry did not earn $400, because he has an obligation to purchase the chairs. Harry needs to sell the chairs for more than $1,600 to make money on the transaction. The example explains that the reason the $400 is not income is that (like a loan) the money is encumbered with a repayment obligation.
Analysis: The Ninth Circuit addressed the definition of gross income in Glenshaw Glass by stating that, "[o]ne may have 'complete dominion' over money but it does not become income until it is an 'accession to wealth.'" The court further explained that, for this reason, borrowed money is not income even though the borrower has "complete dominion" over the money. The court framed the issue as being bracketed by Supreme Court decisions. On one side is the decision in Indianapolis Power & Light Co., 493 US 203 (1990), and on the other are the decisions in Automobile Club of Michigan, 353 US 180 (1957), and Schlude, 372 US 128 (1963).
The court noted that Indianapolis Power & Light held that security deposits are not income because of the obligation to repay. The security deposits are analogous to loans because of the repayment obligation. In contrast, in Automobile Club of Michigan and Schlude, the amounts were not refundable and the money could be kept even if no services were provided. The Ninth Circuit concluded that the facts in Westpac were more similar to Indianapolis Power & Light than to Automobile Club of Michigan or Schlude. The cash-advance trade discounts were like security deposits, in that they were subject to repayment.
The court found that, because Westpac had to repay the money if the volume commitments were not met, it did not have an "accession to wealth" as required by Glenshaw Glass. (The Ninth Circuit found that Westpac made other promises as well, such as exclusivity and shelf space, but the volume purchase determined whether it had to refund the cash advance and how much it had to refund.) Just like Harry Homeowner, Westpac either had to buy goods or repay the money. Thus, the cash-advance discounts were like a loan or a security deposit, and were a liability rather than income when received. The court concluded that Westpac's "unfettered use" of the money did not result in income, because it was not an accession to wealth. Rather, it was merely an advance against an obligation, repayable if the obligation was not performed.
The Ninth Circuit concluded that Westpac did not get any richer when it received its volume discount in the form of up-front cash than Harry Homeowner did when he received the $400 from the furniture store. There was no accession to wealth when Westpac received the money, just an increase in cash assets offset by an equal liability for the advance trade discounts. As noted by the court, "[i]t remains exceedingly difficult to make money merely by buying things" Accordingly, it held that cash advances in exchange for volume purchase commitments, subject to pro-rata repayment if such commitments are not met, are not income when received.
FROM DAVID AUCLAIR, J.D., LL.M., WASHINGTON, DC
|Printer friendly Cite/link Email Feedback|
|Title Annotation:||GROSS INCOME|
|Publication:||The Tax Adviser|
|Date:||Feb 1, 2007|
|Previous Article:||Retail cash advances: loans or income?|
|Next Article:||Understanding form 1098-T.|