Commissioner of Internal Revenue v. Indianapolis Power & Light Company – Oral Argument – October 31, 1989

Media for Commissioner of Internal Revenue v. Indianapolis Power & Light Company

Audio Transcription for Opinion Announcement – January 09, 1990 in Commissioner of Internal Revenue v. Indianapolis Power & Light Company

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William H. Rehnquist:

We’ll hear argument next in Number 88-1319, Commissioner of Internal Revenue versus Indianapolis Power & Light Company.

Mr. Wallace, you may proceed.

Lawrence G. Wallace:

Thank you, Mr. Chief Justice, and may it please the Court:

In this case the tax court, in a reviewed decision, and the court of appeals for the Seventh Circuit, rejected the position of the Commissioner of Internal Revenue previously upheld by the court of appeals for the Eleventh Circuit, that customer deposits required by a public utility to ensure payment of future bills are income to the utility upon receipt.

The case involves only the tax treatment of the deposit itself.

The question in this case does not affect the tax treatment of the utility’s earnings from third parties, such as banks through investment of the deposit monies.

The parties here–

Sandra Day O’Connor:

Mr. Wallace, do you concede that under the applicable utility regulations and general accounting principles, that these deposits have to be recorded as liabilities of the company?

Lawrence G. Wallace:

–Well, I concede that that is an accepted accounting practice which the company is following, insofar as I am aware that is the practice approved by the public service commission.

Whether or not it requires that, I am not aware.

But I certainly concede that that is an accepted accounting practice that is followed by the company in its financial accounting.

Sandra Day O’Connor:

Then, it seems strange then that the government would take the position that it does here on the taxability of these deposits.

What if the deposits were escrowed?

Would you be taking the same position?

Lawrence G. Wallace:

No, we would not.

The position depends on the fact that the monies come into the dominion and control of the utility company, and are not segregated from the other assets of the company, and are subject to its unfettered use.

Antonin Scalia:

Why does it depend upon that, Mr. Wallace?

I thought you were arguing, in one part of your brief at least, economic reality.

And I don’t think whether it is escrowed or not has very much different… very much to do at all with the economic reality of the matter.

Lawrence G. Wallace:

Well, under our tax system, and in particular for an accrual basis taxpayer, it has to have a right to the use of the monies within its own dominion and control.

The cases do establish that as a criterion for taxability.

Antonin Scalia:

I suggest that in establishing that, they are not looking to economic reality, which is what you argue we ought to look to for the rest of the case, and not to intent or to such… such other matters.

Lawrence G. Wallace:

Well, that is a form of economic reality, Justice Scalia, in that that means that the company can use the monies as its own, as it sees fit, to produce whatever earnings it can produce–

Antonin Scalia:

But you are taxing those earnings… you began your presentation by saying that is not at issue–

Lawrence G. Wallace:

–That is correct.

Antonin Scalia:

–whether… what happens to the earnings from them.

All that is at issue is whether when you get it it is income.

And it seems to me it makes no difference, when you are dealing with a massive public utility that has many assets, whether it goes into its own general pot or is put in escrow.

In either case, it seems to me, the company gets assured the payment of the bill that is going to be later presented.

The economic reality between those two situations does not seem to me distinguishable.

Lawrence G. Wallace:

Perhaps there would be a basis for making such an argument, but that is not the position the Commissioner has taken.

The Commissioner’s position is based on the receipt of funds within the dominion and control of the utility company.

The parties–

Harry A. Blackmun:

Mr. Wallace, you mentioned this was a reviewed decision.

Unanimous in the tax courts?

Lawrence G. Wallace:

–It was unanimous.

It was reviewed because the previous decision of the tax court in the City Gas case had been reversed unanimously by the court of appeals for the Eleventh Circuit.

So, all three lower court decisions that have addressed this have been unanimous, and somebody had to have been wrong.

Harry A. Blackmun:

Do you have any explanation why it has taken so long to get this case here?

One of the tax years here is 15 years ago, 1974.

Lawrence G. Wallace:

Well, these things do tend to get sorted out many years after the taxable years at issue.

The litigation, once it was under way, after the audit was made, moved forward.

The parties stipulated both the facts and the calculation of the tax consequences that would ensue for the years at issue should be Commissioner’s position prevail.

So,–

Harry A. Blackmun:

Well, it gets so that the interest sometimes exceeds the basic tax, and this certainly isn’t justice, normally.

Lawrence G. Wallace:

–Well, in any event the issue is now before this Court for resolution.

And under the Commissioner’s legal view, there are only two factual determinations in these stipulated facts recited by the tax court that are critical here, and indeed are dispositive under his legal view.

And in light of those two determinations, the remaining details of the way this program was administered become immaterial.

One is the one to which we have already adverted, that, and this is set forth on page 23a of our Appendix to the Petition in the tax court’s opinion, that the deposits were not segregated from the Petitioner’s general funds, the utility’s general funds, and were subject to its unfettered use and control.

And the other critical determination, set forth on page 20a of the same Appendix, is that the intended purpose of the deposits was to ensure payment of future utility bills by the customers required to make the deposits.

The Commissioner’s position originated in a 1972 revenue ruling which we cite that considered the implications for utility deposits of a series of three decisions rendered by this Court and of related lower court decisions.

Those decisions, and this Court’s previous decisions in the area, are unchallenged by the Respondent here, and of course unchallenged in the courts below.

Those decisions established that advanced payments for goods and services to be provided in the future, that an advance payment is taxable income in the year of receipt.

And the difficult question which was decided in this series of cases is the one suggested by Justice O’Connor’s question at the outset, whether that should be true for accrual basis taxpayers, whether to that extent the Commissioner had authority to set aside the accrual basis taxpayers’ accounting method and insist on conformity in this respect for the advance payments received on an annual accounting method.

And that was the decision made in various factual situations in the Auto Club of Michigan case, the American Automobile Association case, and finally in Schlude against the Commissioner.

And, as the court put it in the American Automobile Association case, the deferral of the advance payment for accounting purposes, and I am quoting now, doubtless presents a rather accurate image of the total financial structure is sound for financial accounting purposes, but fails to respect the criteria of annual tax accounting, and may be rejected by the Commissioner.

And in those decisions the court relied on Section 446(b) of the current code and its predecessor, Section 41 of the 1931 code, which gives the Commissioner authority when he determines that the taxpayer’s accounting method does not accurately reflect income to require, in his discretion, that the taxpayer use a method that does accurately reflect income.

Anthony M. Kennedy:

And your position is that the deposits here should be treated as advance payments, I take it?

Lawrence G. Wallace:

That is precisely our position.

Anthony M. Kennedy:

But the problem I have with that, or maybe it isn’t a problem… you tell me if I am wrong.

Anthony M. Kennedy:

If you have a 12-month cycle and you get an advance payment for the 12 months, then the utility, over the period of 12 months, recognizes 12 months of income, right?

It doesn’t recognize income in December, it recognizes two months of income in January.

Lawrence G. Wallace:

That… that is correct.

Anthony M. Kennedy:

All right.

But under your view, under the security deposit, you would recognize 13 months of income, because you have to accrue each month.

Lawrence G. Wallace:

Well, there is–

Anthony M. Kennedy:

And so it seems to me that the government is getting more under the security deposit theory than it would under the advance payment theory.

So you have bettered yourself.

Or is that wrong?

Lawrence G. Wallace:

–It operates precisely the way an advance payment operates.

Anthony M. Kennedy:

But an advance payment is attributable to a month.

And so for the month that it applies, you don’t accrue it.

Lawrence G. Wallace:

Well, that is correct.

And the advance–

Anthony M. Kennedy:

So you are getting an extra month.

Lawrence G. Wallace:

–Well, but the security deposit, when it would be applied against a month in which the customer defaults in his obligation, or when it is refunded, the taxpayer would get the same credit for it.

It would operate precisely the same–

Anthony M. Kennedy:

Well, at the very end of the cycle… at the very end of the cycle it works out, although, of course, at that point the utility now has a new customer and it starts all over again.

Lawrence G. Wallace:

–Well, that might not be the very end of the cycle.

The customer may default in January and the security deposit may be applied to pay that bill at that time, and the utility would get the credit for it.

Just as if it took an advance payment that was designated for the December bill, it would have to wait until the very end of the cycle.

I mean, that doesn’t really differentiate the economic effect of treating the security deposit the same as an advance payment when it’s intended for the same purpose.

And that is to assure payment of the income that the utility is concerned about in getting either the advance payment or the security deposit.

The security deposit amounts to a label on it, whereas here it is intended to secure the future payment of bills for goods or services to be provided.

But it is not meaningfully different from the advance payment that is collected on that same understanding.

Sandra Day O’Connor:

Mr. Wallace, what would you do with a security deposit that secures both the covenants in a normal security deposit and also could be applied to the last month’s rent, if unpaid… or services?

Lawrence G. Wallace:

Well, that is the difficult factual question that sometimes has to be determined in these cases, as the court of appeals for the Eleventh Circuit in the City Gas Company recognized–

Sandra Day O’Connor:

And what test would you propose be applied to one of these mixed applicability cases?

Lawrence G. Wallace:

–We agree completely with the court of appeals for the Eleventh Circuit in the City Gas Company, which agreed with the Commissioner’s position in that case, that the primary purpose of the particular deposit is determinative.

Here, there’s really no doubt about the purpose of the security deposit.

Lawrence G. Wallace:

It not only was a finding by the tax court, but under the rules of the Public Service Commission, it can be required only of customer after an objective inquiry into their credit worthiness, and only of the 5 percent, as it turns out, of customers with respect to whom the utility may be… have a basis for concern about payment of the future bills.

If it were a deposit to secure the property of the utility company it would be presumably required of all customers.

But those who are required to pay it are those who are determined to be credit risks.

Antonin Scalia:

Mr. Wallace, could you… I don’t understand how you reconciled the Commissioner’s Revenue Ruling 79-229 with what you are urging upon us here.

That’s discussed by the Respondent at pages 35 and 36 of his brief.

And what it sets for, essentially, is that the Commissioner has decided that when a livestock producer receives a payment, whether that payment will be considered to be income, and on the other side a deduction, or rather just a deductible… whether it be considered income for the prepayment of food for the cattle, or on the other hand a deposit, will be determined on the basis of the totality of the circumstances, not on the automatic sort of a rule that you are urging here.

How do you reconcile that with this case?

Lawrence G. Wallace:

Well, there are, as a matter of fact, many exceptions that have been developed in revenue rulings and in a revenue procedure that the Commission has adopted and in statutes that Congress has enacted, that allow deferral–

Antonin Scalia:

Statutes… Congress is allowed to be inconsistent.

I just want to talk about the Commissioner here.

Lawrence G. Wallace:

–that allow deferral of payments under which, you know, the possible full sweep of the holdings of this Court in the trilogy of cases I have mentioned has been receded from.

And this can be done permissibly through administrative practice or by Congress, and some of the administrative concessions have perhaps been made with a view toward preserving those victories to the extent they have been preserved.

Antonin Scalia:

If I understand you, you are acknowledging it is inconsistent.

Lawrence G. Wallace:

Well, there may be an inconsistency in the… in the sense that the Commissioner found that in that factual context it was necessary to make a different type of factual inquiry, and there would be different material questions.

There is, in our view, no inconsistency and no necessary symmetry between the way the Commissioner treats the recipient of the deposit and the way the tax laws treat the customer.

And I think that can be an unnecessary distraction.

If I may, for example, in an ordinary sales transaction, if a business purchases an airplane or a boat or a truck for use in its business, it may pay cash and the vendor may have to treat that as income when received.

But the purchaser may well be required to amortize the payment over a period of the useful life of the item that was purchased.

And that is true whether the vendor was an American company subject to federal income tax or whether a similar boat was purchased from a foreign company not subject to federal tax at all.

William H. Rehnquist:

But you wouldn’t treat… you wouldn’t treat the purchaser differently if it were a utility company as opposed to a livestock dealer.

You would apply the same standards to them, wouldn’t you?

Lawrence G. Wallace:

That is correct, and… but, what is required in each case is to determine what the purpose of the particular receipt is.

And here, when there is no doubt that the purpose was to secure in advance, to ensure the payment for goods and services to be delivered in the future, that is a basis for determining, whether it is a utility or a livestock producer; there is just a different context in which to make a factual inquiry.

That is the basis for determining that that is to be treated no differently from any other form of advance payment for future goods or services, when that is the reason that the money is received, and when the money is subject to the dominion and the control of the utility upon receipt.

William H. Rehnquist:

Mr. Wallace, the Seventh Circuit, as I understand it, took the position that you have to look at the facts and circumstances of each case, and they upheld the determination of the tax court.

Now, your complaint with that is that they should have followed a flat rule of some sort?

Lawrence G. Wallace:

Well, the facts and circumstances that they looked at, and that the tax court looked at, seem immaterial to us, and therefor will give rise, if each court is to look at them in each case, to erratic results that don’t reflect the economic reality of the situation.

William H. Rehnquist:

Well, do you… does your rule give one uniform result for all deposits required by utility companies from customers?

Lawrence G. Wallace:

It… it does once a determination is made that the deposit is primarily for the purpose of assuring payment for goods or services to be delivered in the future, and that the deposit is not required to be escrowed or otherwise segregated and kept from the dominion of the utility company.

The Seventh Circuit emphasized in its analysis that interest was to be paid on the funds here, which seems to us not to distinguish the case from an ordinary advance payment in which there often is a discount given to the customer for making the payment in advance.

Lawrence G. Wallace:

Interest simply recognizes the time value of money, and–

William H. Rehnquist:

Well, is there some one factor… factor in your analysis that is controlling, so that you could say it wasn’t a facts and circumstances test, or is it just you think there should have been different facts and circumstances considered, or perhaps a different result reached on the same facts and circumstances?

Lawrence G. Wallace:

–Well, any… any criterion that we look to can be considered to be facts and circumstances.

I have tried to explain why we think the criteria that we have mentioned are controlling and make the situation indistinguishable from an advance payment, in terms of either its economic effect or its intended purpose.

The facts and circumstances that are recited by the tax court and the court of appeals seem to us to be demonstrably immaterial in this case.

On many of the deposits interest won’t even be paid by the utility.

It is required to pay interest under the amended regulations only if it has held the deposit for 12 months.

And if the customer has terminated service before that time, or if the customer has paid its bills on time for nine months, it is required under the Public Service Commissions rules to refund the deposit before the 12 months has elapsed.

Antonin Scalia:

Suppose… suppose, Mr. Wallace, that I establish a scheme, I am a marketer of furniture, or whatever, and I establish a scheme where I let people make advance payments.

But those advance payments, just to guarantee them that they will get them back if I don’t come across with the goods later on when they are due, those advance payments are put into escrow.

Would I have to report as income those advance payments?

Lawrence G. Wallace:

I believe not, Mr. Justice.

I believe not.

I would like, if I may, to reserve the balance of my time.

William H. Rehnquist:

Please proceed, Mr. Stroble.

Larry J. Stroble:

Thank you, Mr. Chief Justice, and may it please the Court:

Since at least 1921 the Indianapolis Power & Light Company has collected customer security deposits as a security against potential bad debt losses, and it has collected them from certain of its customers.

These deposits have always been treated as current liabilities to customers for both financial regulatory purposes as well as for tax purposes.

Harry A. Blackmun:

Why were they not segregated?

Larry J. Stroble:

The rules for collection, refunding and payment of interest on these deposits is prescribed by the state Public Service Commission.

The Commission sets the guidelines for whether they… how they are collected and how they are to be treated after they are collected.

And the state rule essentially imposes no limitation on the liability… on the utility’s use of the funds.

Harry A. Blackmun:

You mean if they were segregated some state rule would be violated?

Larry J. Stroble:

No, they could have been segregated, but there was simply no reason to segregate them.

Harry A. Blackmun:

Then my question is why weren’t they segregated to avoid all this litigation?

Larry J. Stroble:

If… perhaps they would have been had that been an announced position in 1921, that they would be taxed if they were not segregated.

It is conceivable that the parties might have undertaken to set up such an arrangement.

Sandra Day O’Connor:

Well, does the company now escrow the funds?

Larry J. Stroble:

To my knowledge the company is continuing to follow the practice it always has and continues to follow exactly what the state Public Service Commission’s regulations prescribe.

Antonin Scalia:

I guess I am not following this.

Antonin Scalia:

Is it the… do you understand it to be the government’s position that if these funds had been segregated, although not escrowed, the tax would not have been payable?

I mean, if that is their position, you ought to advise your client that way.

That seems to me that is a pretty easy way to handle the problem.

Larry J. Stroble:

Well, that does seem–

Antonin Scalia:

But I didn’t understand that to be the government’s position, that all you had to do was segregate it.

Larry J. Stroble:

–Well, that seems to be what they have said in their brief.

Antonin Scalia:

Not escrowed, just segregated.

Larry J. Stroble:

We have never seen why segregation of these funds should be an important distinction.

Our position has been that these funds… these security deposits have many of the same ear marks as a loan, as a borrowing of money, because the security deposits are offset by an obligation to refund upon conditions which essentially lie within the control of the customer from whom they are collected.

It is a clear principle that the collection or the receipt of borrowed money is not taxable income.

And that is true even if the funds are not segregated or escrowed.

And there is a very clear reason why that is so.

Under our federal income tax system, as this Court has recognized in past cases, there must be an increase in wealth, an accession to wealth, before income is properly reportable.

That is just a fundamental and a common sense proposition of–

Byron R. White:

But if these sums were segregated, I take it it would be a indication that these funds were not available for just any use that the company wanted to make with… of them.

Larry J. Stroble:

–It would–

Byron R. White:

Whereas the loan proceeds, you borrow money to use for the general corporate purposes, I suppose.

Larry J. Stroble:

–Well, as in the case of a loan, the company does have to stand ready at any time to make a refund to a customer whenever the conditions that have been established are met.

The deposits are collected under the obligation that at such time as the customer shows that he is credit worthy, the funds have to be returned to the customer.

Byron R. White:

Yeah, but if the… if the company goes broke it may not have the money to refund these.

If the funds were segregated in a separate fund you wouldn’t be using them for other purposes.

Larry J. Stroble:

It’s… the Indiana Public Service Commission could have prescribed such a rule.

I think the–

Sandra Day O’Connor:

Well, the company could have followed such a policy, too, so it’s a peculiar argument.

Larry J. Stroble:

–The company could have accepted the funds and set them into a separate bank account.

Sandra Day O’Connor:

What sort of a test do you think should govern the taxability of these monies?

Larry J. Stroble:

We think that the test that should govern is essentially the tests that the tax court and Seventh Circuit applied: are the amounts in question–

Sandra Day O’Connor:

So you think it makes a difference whether interest is paid on it or not?

Larry J. Stroble:

–We think that the payment of interest is one factor that should be considered.

That the job of the courts, the lower courts and the tax court, is to determine whether the payment in issue has been received as a security deposit, so that it is securing the performance of a customer and it is returnable to that customer at such time as the deposit has served its purpose.

Larry J. Stroble:

Or whether, alternatively, the amount is an advance payment for goods and services, so that it has been received to buy future utility services.

Anthony M. Kennedy:

Well, an advance payment has to be returned if the service isn’t rendered.

Larry J. Stroble:

Justice Kennedy, that is exactly correct, but the situation in which it has to be returned is exactly the opposite of what we have here.

In the case of an advance payment, if the seller who has received the payments performs his obligations under the contract, namely delivering the goods, he gets to keep the payments he has received.

And it is on that basis that there is clear there has been an increase in wealth that justifies taxation.

In the case of a security deposit, if it is the customer that performs the secured obligations, then the amounts have to be returned to the customer.

So it is–

Anthony M. Kennedy:

But, the reality of the utility business is that you can’t pick and choose your customer.

You could… you could never elect that you just didn’t want to serve that customer.

Larry J. Stroble:

–There is an obligation to–

Anthony M. Kennedy:

And so that differs, makes a substantial difference between the security deposit in this industry and the security deposit in, say, a furniture business where you might decide that you are just not going to deliver.

Larry J. Stroble:

–I think that is a valid observation, that there is a difference between a regulated industry and the private commercial setting where many of the advance payment cases originally arose.

In the public utility setting, it is a state-mandated obligation that the utility serve the customer.

And the receipt of the security deposit is not the consideration that triggers that obligation to return goods and services.

Anthony M. Kennedy:

So, from a practical standpoint, it really is just an advance payment, isn’t it?

Other than the interest factor.

Larry J. Stroble:

Well, another reason why it is not the equivalent of an advance payment is that it is subject to a refund.

Anthony M. Kennedy:

Well, so is the advance payment if the customer elects to terminate the service.

Larry J. Stroble:

Well, I think in a normal advance payment situation the customer would want to make certain that it had assured what it was going to receive for its advance payment.

There would typically be an agreement that in exchange for this advance payment so many dollars of goods and services will be delivered at a certain time in the future.

Anthony M. Kennedy:

But, as we have already established, a utility always has to deliver services.

It can’t unilaterally discontinue service, absent nonpayment.

Larry J. Stroble:

But that is a obligation that is imposed independent of the deposit, or as a separate obligation that is not a countervailing or a mutual obligation that arises for the reason of having received this deposit.

Government once says that you have received the deposit, it should be treated as the equivalent of an advance payment, that the deposit should be treated as if it has bought future goods and services.

What we are saying is that the payment in question is not, the deposit is not the thing which triggers the obligation to supply services to the customer.

Antonin Scalia:

Mr. Stroble, are you sure that that is true.

It is true that with respect to most of its customers the utility has an obligation to provide services.

I would think however, that when the state regulating commission approved this requirement of an advance payment for certain people it is saying you don’t have to serve these people unless they make the advance payment.

I mean, isn’t that the deal?

Larry J. Stroble:

Well–

Antonin Scalia:

So, it’s general obligation to serve all comers is suspended with respect to some particularly economically shaky individuals.

Isn’t that right?

Larry J. Stroble:

–Well, the facts of the case as they were disclosed by the record is that the… this utility, except very rare cases, would supply service to any customer, would allow them to hook up to the system, would turn on the electricity and sell them electricity.

It was only at such time as that customer had failed to pay bills and had receive disconnection notices that a deposit would be requested.

Antonin Scalia:

Fine.

But at that point you couldn’t say that the customer was getting nothing for the advance payment.

He was getting further service.

The Commission, the utility had no obligation to provide any further service at that point, unless he made the payment.

Right?

Larry J. Stroble:

In most cases the record discloses that the customer who fails to make any payment, either a deposit or an actual payment on the delinquent utility bills, would be disconnected for failure to pay the utility bill.

Antonin Scalia:

So he is getting something for the payment, continuing service, which the utility would not otherwise have any obligation to provide.

Larry J. Stroble:

It is true that a customer who absolutely refused to pay a deposit could be disconnected from the system.

Antonin Scalia:

That is to say, all the customers from whom you demand these prepayments.

Larry J. Stroble:

But in that event… in that circumstance, I think we still have to ask the question is the deposit collected for the purpose of buying these future goods and services.

Or is it there as a standby… still there as a standby security device collected only for use in the event of an actual default by that customer?

Antonin Scalia:

Is what counts what it is collected for, and not at all what it is paid for?

Do you look at just one side of that?

I… It’s not a trick question, I don’t know the answer.

Larry J. Stroble:

I think you’re right.

I mean, I think the question is–

Antonin Scalia:

I mean, I am sure that he is paying it only to get more electricity.

Right?

To have your service continue.

It is clear from that side what he is doing it for, right?

Why do you think an advance payment is properly treated as income right then?

Larry J. Stroble:

–In the three cases which Mr. Wallace alluded to, the Automobile Club of Michigan, the Triple A case and the Schlude case, the Commissioner fought very hard for the proposition that there are circumstances under which the accrual method of accounting can be deviated from.

Under the all events test of the accrual method you would only recognize income as the utility services are provided, as the customer is billed, and at that point income would be recorded on the books, even though payment, cash payment, had not actually been received.

Those cases held that, at least in certain circumstances, it is appropriate to tax a party upon the receipt of prepayments for those goods and services.

It is in that situation that the government is permitted to deviate from the normal accrual method that otherwise governs taxability.

The reason is that in that situation the amounts in question are identifiable, or are identified with the future delivery of goods and services.

Larry J. Stroble:

As long as the seller provides those goods and services he gets to keep the money.

He is not under an obligation to refund the money.

And for that reason the increase in wealth has occurred.

Anthony M. Kennedy:

Well, he is under an obligation if he doesn’t furnish it.

Larry J. Stroble:

If he doesn’t furnish… if he doesn’t live up to his contract, then he has to return the, he has to return the deposit.

But as long as he lives up to his contract–

Anthony M. Kennedy:

Nevertheless, meanwhile he has returned it as ordinary income.

Larry J. Stroble:

–Yes, that… that’s correct.

Our position is that the distinction there is that in the case of a customer security deposit, if the customer performs as agreed, then the deposit does have to be refunded.

In other words, if each side performs their mutual obligations, the deposit is refunded to the customer.

And that is just the exact opposite of an advance payment, where the performance of each party’s mutual obligations results in the seller being entitled to retain the payment.

The Commissioner’s approach produces a serious problem that needs to be addressed, and it relates to this question of proper tax treatment of an accrual method taxpayer.

As we just noted, an accrual method taxpayer reports income as the goods and services are delivered and billed for, and at that point income is put on the books for tax purposes.

In the taxpayers case, in this utility’s case, income was recognized as the utility meter was read and as the customer was billed.

So as soon as the income was recognized an account receivable was then put on the books.

The advance payment rule says that depending on the facts, a prepayment of cash can be taxed at the time it is received, even though, under the normal accrual method, recognition of income would be deferred until the goods are actually delivered.

This was the holding of the three trilogy, so-called trilogy cases, of the late ’50s and early ’60s.

But what the Commissioner is doing here is taking what was an exception to the all events test, the prepayment rule, and basically applying that in tandem with the accrual method.

The result is a distortion of income, or a double counting of income, essentially along the lines that Justice Kennedy alluded to in Mr. Wallace’s presentation.

He is basically applying a cash method to the deposit, and an accrual method to the goods and services, simultaneously.

It is being imposed simultaneously on the same series of transactions.

Because what happens is the deposit is included in income when collected, and the utility, under its normal accrual method of accounting, is also required to report income as it delivers services to its customers.

Antonin Scalia:

Excuse me, you would have that same problem if it were, even if it were considered, whether it is considered a security deposit or a prepayment.

Wouldn’t you have the same problem?

Larry J. Stroble:

Well, I think there is a difference, and perhaps an example might help me better illustrate it.

Let us take the example of a taxpayer that collects a security deposit, such as we have here.

We’ll say it’s a $25 security deposit.

So it is collected in year one.

Antonin Scalia:

I am sorry.

I asked you the wrong question.

Antonin Scalia:

Suppose it were concededly a prepayment.

You have no doubt, you receive it as a prepayment.

Larry J. Stroble:

Yeah.

Antonin Scalia:

Wouldn’t the same thing happen?

Larry J. Stroble:

I don’t think so.

Antonin Scalia:

I mean, that is just a function of what happens when you get a prepayment.

Larry J. Stroble:

I don’t think so, because what happens in that case is the utility receives a prepayment for a given utility service, it would have no reason to send out a bill to that customer or to accrue any additional income, because it has already received the payment, with those identifiable goods and services.

In other words, if a customer says this is a prepayment for goods and services, I would not then separately bill that customer for those services, and I wouldn’t accrue any additional income.

Antonin Scalia:

You wouldn’t report that payment until the services were provided 12 months later?

Larry J. Stroble:

Well, if it was a true prepayment, as you has posited in your example–

Antonin Scalia:

And you’re on an accrual basis.

Larry J. Stroble:

–And I’m on the accrual basis, under the trilogy cases I would report that as income at the point I collected it, no question.

Antonin Scalia:

At the point you collected it.

Larry J. Stroble:

But I would not then again accrue income as I delivered those services to that customer.

That’s, I think, the problem that is developing in this case, is–

Antonin Scalia:

Well, you don’t accrue it when you, at the end, at the twelfth month.

What happens at the twelfth month is, if you do deliver the services, you return the money and you get a deduction for the return of the money, which in effect offsets the accrued income you are receiving that month.

It works out.

Larry J. Stroble:

–That seems to solve the problem as long as we contain everything within a given taxable year.

Antonin Scalia:

That’s right.

So the only real problem is that you get a double charge the first month, which is evened out at the end, but you get a double charge… which is in the government’s advantage.

But I am saying that always happens to an accrual… to an accrual taxpayer whenever you get an advance payment.

So it doesn’t prove your case.

All it says is if it is an advance payment, yeah, that ought to happen.

But that still leaves you with the question of whether it is an advance payment or not.

Larry J. Stroble:

If it is an advance payment, then it would normally be identifiable with some goods and service that would permit the taxpayer to avoid that second, that accrual, that separate accrual and the double counting that would occur in the first year.

If it is not an advance–

Anthony M. Kennedy:

Whereas a security deposit is carried on indefinitely and might not relate to the first year, so the government tends to maximize income to a greater extent under security deposits than with advance payments.

Larry J. Stroble:

–Exactly.

The government is picking up, in the one example, 13 months in a 12-month period, or in my example, the government is accruing, basically double counting the income for a given period of service.

Anthony M. Kennedy:

Of course, I guess the government could argue it’s the way we structure the hypothetical, it’s the way we are assuming the advance payment is designated.

We are assuming it is designated for the twelfth month.

Larry J. Stroble:

It seems that an advance payment has to be designated to some particular identifiable good or service.

I mean, I think that is part of the problem from the accounting standpoint, and ultimately this is a question of whether the utility’s income is being clearly reflected.

An advance payment would be something that you could identify with a good or service to be delivered in the future.

But a deposit is not intended to be a prepayment.

It is intended to sort of stand by as a security device.

Consequently, we have no way of identifying it with some future periods utility service when it is collected.

And for that reason the normal accrual accounting rules apply in accounting for our utility service delivery in the future.

That strikes us as really an over reaching, really getting the best of both worlds.

The best of the cash method and the best of the accrual method, overlaid on top of one another, and a distortion of the taxpayer’s income, which is directly contrary to the advance payment rules that… and to the security deposit rules, which ultimately govern this case.

This other area that we see the Commissioner over reaching in, essentially trying to take an advantage that is not a fair advantage, is to criticize the facts and circumstances test, which the tax court and the Seventh Circuit utilized here, as being too vague.

And then, when addressing the treatment of the person who pays a deposit, providing that a facts and circumstances analysis is the only way to determine a proper tax treatment.

As Justice Scalia mentioned in Revenue Ruling 79-229 dealing with a cash-basis farmer, the question is whether a given amount is a deductible advance payment or, on the other hand, is it a non-deductible deposit.

John Paul Stevens:

Mr. Stroble, although Mr. Wallace didn’t make the point, doesn’t that case, or that ruling deal with cash-basis taxpayers?

Larry J. Stroble:

It deals with the question whether a cash-basis taxpayer should be–

John Paul Stevens:

But then does it have any bearing on how we treat accrual-basis taxpayers who get income up front?

Larry J. Stroble:

–I think it does in an environment where we say we are going to make an exception to the normal accrual method and tax the receipt of the cash as a prepayment, if it really is a prepayment.

So in that sense the Commissioner is using a form of cash method when he tries to accelerate the taxation at a point earlier than it normally would be recognized under an accrual method.

So I think in that sense the treatment of a cash–

Antonin Scalia:

But you don’t object to that?

You–

Larry J. Stroble:

–If it is a true advance payment, we wouldn’t object to it.

Antonin Scalia:

–You don’t object to it.

But you are saying it is applying a form of non-accrual accounting to the accrual taxpayer.

Larry J. Stroble:

It is.

And the treatment of a cash basis deposit payor, or deposit payee, has relevance.

The real question is, in that Revenue Ruling, is this particular sum a deposit or is it an advance payment?

And the ruling states that whether a particular expenditure is a deposit or a payment depends on the facts and circumstances of each case, which is exactly what the tax court and the Seventh Circuit said here.

And the ruling goes on to say that when it can be shown that the expenditure is not refundable, and is made pursuant to an enforceable sales contract, then in that case it will not be considered a deposit.

Larry J. Stroble:

So those are the very points that we think are important in trying to evaluate the taxability of the person that receives the deposit.

John Paul Stevens:

But does the ruling say the converse?

That if it is refundable it will be treated as–

Larry J. Stroble:

In, it enumerates four or five factors that are to be looked at, and clearly the question of whether it is refundable and whether or not it is part of an enforceable sales contract for specific goods and services are key factors in making that determination.

I think the Commissioner would allow a consideration of the overall set of circumstances to try to arrive at that decision, but clearly, the refundability becomes a key point.

We think that really it shouldn’t make any difference which side of the coin you are looking at, as long as the issue is does the deposit serve as a true security deposit or does it serve as a… an advance payment for goods and services.

The approach used by the Seventh… by the tax court and the Seventh Circuit are faithful to the general principle recognized by this Court, that it is only amounts which really produce some form of increase in wealth which should be taxable, and that as long as the amount is offset by an obligation to refund, that increase in wealth has not occurred.

And it is only a review of the total relationship between the parties that a fair evaluation can be made of whether there has been a sufficient transfer of rights to justify taxation.

The Commissioner’s approach is essentially an arbitrary per se rule that disregards the most critical facts to be considered in making that determination.

The result of using the Commissioner’s approach is to distort income, to mischaracterize and misaccount for the actual earning of income, which should be the purpose of good tax accounting.

For those reasons we believe that the Seventh Circuit and the unanimous tax court properly evaluated the facts before it, and concluded that these were true security deposits, and not some form of disguised advanced payment.

Unless there are any questions–

William H. Rehnquist:

–Thank you, Mr. Stroble.

Mr. Wallace, do you have rebuttal?

Lawrence G. Wallace:

Yes, Mr. Chief Justice.

This Court’s trilogy of decisions were decided by divided votes in favor of the government, five to three, five to four and five to four.

As I think much of the exchange has illustrated, there was a substantial and coherent position expressed in the dissenting opinions in those cases–

John Paul Stevens:

Mr. Wallace, can I interrupt you just a second on those three cases?

It seems to me that if those, if you had lost those three cases a fortiori you would lose here.

Lawrence G. Wallace:

–Yes, Mr. Justice.

John Paul Stevens:

Now, isn’t it true that those cases basically said that we will make an exception from normal accrual accounting procedures for payments received in advance, as in those cases.

So what we have here is whether–

Lawrence G. Wallace:

That is correct.

John Paul Stevens:

–we construe an exception broadly or narrowly.

Lawrence G. Wallace:

Well, that is correct.

And those cases are not challenged here, and Congress has tinkered with the results in Sections 455 and 456 of the code, and has adopted other rules where it saw fit to do so for prepaid subscription income for newspapers and magazines, and for dues to non-profit membership organizations, such as the auto club.

But otherwise has left them in effect.

And once what admittedly was a coherent position taken in dissent is behind us in those three cases, it seems to me that the coherent position now in applying the implications of those three cases to the utility’s situation is the position that has been taken in the Commissioner’s Revenue Ruling.

Otherwise, you get into what the court of appeals here admitted was functionally similar situations being treated differently, such as getting an advance payment of the twelfth month’s rent, or getting a deposit equivalent to the twelfth months rent that will be returned after twelve months of rent has been paid.

Why… there is no possible reason why those two situations should result in different tax consequences.

Lawrence G. Wallace:

And the tax court and the court of appeals, by enumerating a number of factors to be looked into, has invited an inquiry into whether a prepayment to secure the payment of future income differs from an advance payment of that future income, when there really is no meaningful difference between the two inquiries.

And it is hard to see how any of these factors bear on them.

And that is not going to be a criterion for even-handed administration of the tax laws.

When the so-called security deposit is given to assure the payment of the future income, it is a receipt of that income.

And the only question is the timing of its recognition, and that was settled in this Court’s trilogy of cases, that the Commissioner did have authority to insist that when that income is received in advance by the accrual basis taxpayer, he has to recognize it at that time.

Antonin Scalia:

Mr. Wallace, there is no significant economic difference between, let’s assume a security deposit not for payment of future rent, but for not destroying the property, which you acknowledge is not taxable immediately.

Correct?

Lawrence G. Wallace:

That is never converted into income.

Antonin Scalia:

All right.

Well, but there is really no economic difference between that and between the tenant buying the landlord insurance against the tenant’s destruction.

And if the tenant did that, I assume that would be income to the landlord, wouldn’t it?

If the landlord required the tenant to pay for an insurance policy that would cover any destruction by the tenant.

So, you know, if you play the economic reality game, all sorts of things would be income that aren’t income.

And I… I am just not impressed with the fact that the economic realities are thus and so.

That doesn’t seem to me the way the tax code is played.

Lawrence G. Wallace:

Well, but the code does not give controlling significance to labels that are meaningless, either, when the same payment is being made between two parties to a transaction and it is called one thing or another.

That, the code does not do, and I think it would not lead to even-handed administration of the tax laws for the decision here to invite that approach to the issue.

William H. Rehnquist:

Thank you, Mr. Wallace.

The case is submitted.