Media for Commissioner v. Hansen
Number 380, Commissioner of Internal Revenue, Petitioner, versus John R. Hansen and Shirley G. Hansen, and Number 381, Commissioner of Internal Revenue, Petitioner, versus Burl P. Glover.
Mr. Rothwacks, you may proceed.
May it please this Court.
Numbers 380, 381 and 512, the Baird case, are all income tax cases.
They involve the so-called Dealers Reserve issue.
They are three cases in a long line of litigation extending, since 1940, on this important issue.
And they have all been litigated against a background of a consistent administrative practice since 1931, which supports the position which the Commissioner takes before this Court.
Since 1931, of course, there had been two enactments of the Internal Revenue Code.
Congress has not seen fit to enact any provisions in support of the position which the taxpayer dealers advocate before this Court.
Now these cases, all of them, involved dealers who are on an accrual basis of accounting.
They sell goods on credit.
They receive, from their customers, contracts and other retail paper which embodies the customer’s obligation, an obligation to pay a full-time deferred balance.
Now, this contract is entered into between the dealer and the purchaser.
The finance company is not a part or party to that contract.
The dealer may retain the contract, he may retain the notes, or he may sell them.
And in all of these cases, he did indeed sell them to one or more finance companies.
Having sold the obligations of his purchasers to finance companies, the dealer was then paid a certain amount of approximately the face value of the paper in cash by the finance company, and the remaining portion was paid in the form of a credit that was entered on the finance companies’ books as a liability of the finance company.
And eventually, as we shall make more clear in the development of our argument, eventually, the amounts of those credits were paid to the dealers either in cash or in the discharge of the dealer’s obligations to the finance companies.
Now, the question that is raised here in all of these cases is an important one.
It’s important, not only from the purpose from the viewpoint of maintaining the integrity of the accrual basis of accounting, it’s also important from a practical point of view.
Now, the taxpayers’ representatives will, no doubt, urge upon this Court why is the Government seeking to report — to have the dealers report the amounts that were credited in the dealer’s reserve accounts when they were credited, when, eventually, they will report them when they get paid or when their obligations to the finance company are discharged?
As I said before, the question is not only of great academic importance in connection with the integrity of the — maintaining the integrity of the accrual principle, but if this Court were to accept the position advocated by the taxpayers, the effect of it would be, not only with respect to the thousands of automobile and trailer dealers throughout the country, to take them off the pay as you go basis and unto a, more or less, rollback basis, but it would also give the green light to hundreds, if not thousands, of other credit businesses all over the country to do precisely the same thing.
Now, there are two simple controlling principles in these cases.
The first is — and this Court has stated it many times, the first is that, while a cash basis taxpayer reports income on an actual or constructive receipt of the cash, there is a difference in the accrual basis of accounting.
An accrual basis taxpayer must report his income and pay the tax on it upon the fixation of his right to receive the income and not upon actual or constructive receipt of income.
And the fact that the payment may be deferred, the fact that the agreement between the parties may contemplate that, while the amount is fixed, while the obligation is presently fixed, payment may be made in the future is irrelevant and immaterial to the accrual basis of accounting.
And in —
William O. Douglas:
Is that an exemption in the body of regulation and —
Yes, it is, Your Honor.
It — it arises, I believe, under the regulations that were promulgated pursuant to Sections 41, 42 and possibly 43 of the Internal Revenue Code.
William O. Douglas:
But they — they are not printed here, are they?
They — they are not.
They are not.
But they have been so clearly and so often enunciated by this Court and by other courts that we didn’t feel it necessary to print that.
We’ll be very glad to do it.
This Court said, for example, in the Spring City case.
In that case, this Court will remember that the taxpayer was on the accrual basis.He sold goods on an open account in 1920.
His customer went into bankruptcy in that year.
In 1923 and 1924, he received dividends from the receiver in bankruptcy.
The taxpayer reported his income, in — in 1923 and 1924, the amounts which he received from the receiver.
This Court said “No.”
This Court said he was required to report the amounts as income in 1920 because keeping accounts and making returns on the accrual basis, this Court said, as distinguished from the cash basis, important that it is the right to receive and not the actual receipt that determines the inclusion of the amount in gross income, and when the right becomes fixed, then the right accrues.
And the second controlling principle in these cases, related somewhat to the accrual accounting principle, is that every taxpayer under our revenue system, regardless of the accounting method that he uses, is required to compute his income and to report his income on the basis of an annual, as distinguished from a transactional, basis.
In other words, the fact that an income producing transaction such as the sale of an automobile or trailer on credit, as in these cases, extends over a period of more than one year, as they did in these cases.
It does not affect the requirement but under our tax system, the computation of the income for tax purposes must show the net result of all of the taxpayer’s transactions in a given year rather than the net result of any particular transaction which may extend beyond that period.
Now, the facts in each of the cases in 380, 381 and 512 are of course somewhat different.
But while there are factual differences, we maintain that in their broad significant aspects, they do present a workable common picture which we may use to determine the application of the controlling principles which I have just enunciated.
Now, generally speaking, in these cases, the taxpayers were dealers who sold automobiles or trailers on credit.
They entered into negotiations with their customers.
They arrived at a time before balance with their customers.
They took the contract or the note of the customer which reflected the full-time balance less the amount that was paid in cash or the trade-in value of the car that was offered.
And that was the obligation of the customer, the purchaser, to pay to the dealer.
There’s no indication in this record at all, in any of the records in these cases, except to the extent that the finance company may have supplied forms for the convenience of the taxpayers that the finance company participated in any way in the negotiations between the dealer, on the one hand and his customer, on the other, nor was the dealer under any obligation at all to sell his contract or notes either to the finance company to which he actually did sell or to any other finance company.
Now, the fact is, of course, that he did sell the contract.
He did sell the notes under agreements which were either oral or written.
In some instances, the notes were transferred with recourse, in some instances, without.
The contracts vary —
Charles E. Whittaker:
Charles E. Whittaker:
Did I understand you to say, in some instances, they will be transferred without recourse?
Yes, that is true, Your Honor.
Charles E. Whittaker:
But under the contract (Inaudible) obligations?
Well, the — the notes, in some instances, were transferred without — without recourse but the contracts, the contracts would provide guarantees running from the — after the sale of the note to the — to the finance company.
The contracts between the — between the dealer and the finance company would provide guarantee, certain guarantees running from the dealer to the finance companies.
Charles E. Whittaker:
In other words, they’re separate collateral agreements?
Well, they were — they were separate agreements.
lf Your Honor is referring to — now to the transaction between the dealer and the finance company, yes, they were separate agreements, separate transactions, and the Courts of Appeals in the Seventh Circuit in the Baird case, in the Sixth Circuit in the Schaeffer case and last week, in the Wiley case have so held.
Now, on the sale of the notes —
The sale of what?
I didn’t hear you.
That the transactions were separable transactions.
That the one transaction was that between the dealer and his customer in which the customer gave the dealer the contract and the note which embodied the full-time deferred balance.
Then, there was a separate transaction between the dealer and the finance company in which in a contract which was either written or oral, the dealer sold the note or sold the contract to the finance company and there were certain obligations under the contract running from the finance company to the dealer and from the dealer to the finance company.
We’ll come to those later.
In view of the Seventh Circuit (Inaudible)
Yes, Seventh and —
You mention at the outset there were, obviously, must be minor factual differences among the cases that we have here.
Are there any important differences between these cases and the cases decided by the Seventh Circuit and the Sixth Circuit?
We don’t think so.
We don’t think that there are any important differences that — on our rationale and the rationale of the Wiley case last week in the Sixth Circuit, there are no important differences among these cases.
I may, at this point, interpolate by saying that one of the amicus briefs in these cases, filed by counsel in the Wiley case, does suggest that there may be an important difference in a situation where the dealer sells the obligation of his customer to the finance company and the finance company credits what is referred to as a holdback which, I take it, is part of the — what would normally be the purchase price, if there were no service charge or finance charge added on to the original note between the dealer and his customer.
The position of counsel in the Wiley case was that where — where the credit, which was entered by the finance company on its books in favor of the dealer, reflected something other than this so-called holdback, namely, a finance charge, then another principle obtained.
And in the Wiley case, which was handed down on April 24 and which was argued just 10 days ago, I believe, or two weeks ago, the Wiley case, in effect, held that the factual differences that were pointed out by counsel are not sufficient to distinguish this case in principle from the ruling in the Schaeffer case which it had previously decided.
Now, what I have given so far is, admittedly, a generalized picture of what transpired in these cases.
And while this Court will, of course, look to the records, it may be helpful on this opening presentation to at least give the highlights of the pertinent facts with respect to the records in each of these cases.
Now, in Hansen, Number 380, we find practically everything that we’re looking for at Record 39, joint Exhibit 5E, and that’s — contract, at the top of the page, a conditional sales contract between a dealer and his customer.
And the dealer sells and the customer buys a car for a total time price which, among other things, includes a finance charge and which results in an obligation called the “Time Deferred Balance” which is the amount reflected as the customer’s obligation to the dealer in the conditional sale contract.
But then, at the —
Where — where in the record you’ll find it?
At Record 39, Number 380.
Now, at the bottom of the page on this form which was provided by GMAC, the dealer then sells and — and as I said before, he was not obliged to sell.
As a matter of fact, the testimony of the taxpayer makes this seemingly clear.
He was asked, Record 33, “You are free either to hold these conditional sales contracts or sign them, depending upon what you wanted to do.”
The answer was “What do you mean hold them?”
Question, “Hold them personally, assuming you had sufficient cash.
I’m not saying that you did.”
The answer was “Yes, I could have held them if I — if I had my own contracts made up.”
He was asked whether he could have signed them to any other finance company and the answer to that was yes.
So, nothing of any consequence turns in taxpayer’s favor on the mere fact that the conditional sale contract from the dealer to the finance company happens to be on the same sheet of paper as the completely separate contract between the dealer and the customer.
Now, in the contract between the dealer and the finance company, the dealer sells to GMAC its right, title and interest to the — within contract and the dealer, in turn, guarantees full payment of the amount remaining unpaid hereon and covenants that if default be made in the payment of any installment, then to pay the full amount unpaid to GMAC.
The purpose of this reserve, as the Tax Court found and as indeed, Mr. Hansen himself testified, was to protect GMAC against any loss that might arise from the repossession of any automobile in case of default in payment.
Charles E. Whittaker:
I think the agreement simply spells out what the parties sold to each other and the purpose of the — the purpose of the contract, it seems — would seem to us, could be ascertained from the testimony of the party entering into the contract.
Charles E. Whittaker:
Is this a way to make clear what I had in mind that they found at least two points of the contract, one is the contract between the seller and the buyer of the car, and the other part of it is a form for constable use in the event of the sale of securities evidenced in deferred payment.
And in some instances, you have occurred document to render notes or maybe a chattel mortgage or something he could use.
Isn’t that what — is that not right?
Well, that’s — that’s another way of stating, I think, the same thing, Your Honor.
The important point from the Commissioner’s point of view is, as we will develop the argument later on, that these are separate transactions, that they are not telescoped into a single transaction.
And this is the point of view that was adopted in the Baird, Schaeffer and Wiley cases.
Now, in the Glover case, we have a very short record and practically everything that is of use to us in this case is found in the stipulation at Record 20.
In that case, the taxpayer sold new and used cars on credit.
He received notes from his purchasers.
The record doesn’t show the composition of the notes.
However, the record does show an agreement between C.I.T., which was the finance company and the dealer, and that agreement provided that the paper executed by the dealer — by the customer to the dealer was to be sold to the finance company without recourse except as to commercial cars, that the finance company would pay the dealer 97% of the face value of the notes and would credit — would set up credit on its books to the extent of the remaining 3% that C.I.T. would pay to the taxpayer out of the reserve everything in excess of 3% of the total outstanding balance on the notes, three times in every 12-month period if the taxpayer was not then indebted to it.
And that in the event C.I.T. stopped buying paper from Glover, then C.I.T. could hold and apply the credits until all the paper was liquidated.
The dealer’s obligations under this contract with C.I.T. was to purchase — to repurchase the — the repossessed cars and if it failed to do so, to make good to C.I.T. for any loss that it was — was incurred by C.I.T. and to pay a proportionate amount of the amount that was credited to the reserve in the event any purchaser prepaid on his obligation.
C.I.T. would refund the part of the service charge.
The obligation of the dealer was to pay a proportionate part of that refund out of the amounts in the credits.
In the Baird case, we have a dealer who, in the main, sold trailers.
William O. Douglas:
Is that the Seventh Circuit case?
This is the Seventh Circuit case, also, other commodities.
He sold on — this was a partnership which sold on conditional sales contracts and received notes from its customers.
It sold its notes to three finance companies.
One of them was a bank.
And in every instance, the paper was either endorsed with recourse or the partnership independently guaranteed payment to the finance companies.
The finance companies paid over 95% to 97% of the amount of the customer’s obligation and credited the remainder to the dealer’s reserve account in favor of the partnership.
Now, it’s important to noted that here, as in the other cases, the finance companies carried the accounts as liabilities and that the annual balances in the reserves — in the credit in reserves which they carried were not at all reflected in their income.
It was provided, as between the partnership and the finance companies that, in any event, the credits would be paid to the partnership after all of the customer’s obligations had been fulfilled, in other words, after all the notes have been paid.
There were also other provisions for accelerated payment.
For example, in the first — one of two contracts with one of the finance companies, Midland it was provided that when the reserve fund exceeded 10% of the balance of the total outstanding obligations of customers, the excess would be paid over by the finance company to the dealer automatically.
Furthermore, it was agreed between the dealer and the finance companies that the credits entered on the finance companies’ books in favor of the dealer could be charged with any unpaid balance owing by the customer, could be charged with repossession losses suffered by the finance companies, could be charged with any default by the partnership on its independent guarantees to the finance company and also, could be charged with a matured financial obligation of any nature, running from the partnership to the finance companies of any nature not necessarily related to the sale of the automobile or trailer by the dealer to his customer.
Now, we think that this brief review of what we consider to be the salient facts in this case demonstrates that, basically, there was a common mode of dealing in these cases.
First, a sale of a commodity between dealer and customer, the signing of a contract, the issuance of paper.
Secondly, the sale of a contract or paper to a finance company not under any legal obligation to do so whatsoever.
Thirdly, the finance company would pay part of the value of the contract or note that it bought and would set up the balance as a credit to the dealer.
And the credit — the balance was to be paid in due course pursuant to arrangements that were made between the dealers and the finance companies.
Now, on this common analysis of the facts, the courts have said that there are two ways of looking at the transactions, two ways of looking at what happened in these cases.
In the Baird case, which is the Seventh Circuit case, and in Schaeffer and by necessary implication, the Wiley opinion which was handed down on April 24, the courts have said that we’re dealing here with two separate and distinct transactions, first, the sale of the commodity to the purchaser at a time-deferred balance, second, the sale of a paper to the finance company.
On the other hand, the Hansen case spells out another theory.
This was announced, I think, in the Texas Trailercoach, that what is involved here is a single three-party transaction.
Now, the two transaction hypothesis was used by the courts to support taxability of the amounts that were credited to the reserves when the credits were made.
The one transaction, three-party hypothesis has been used by the courts to support the contrary conclusion.
Now, while we think that the better reason theory is the reasoning of the Sixth and Seventh Circuits, we, nevertheless, believe, and we’ll attempt to demonstrate, that it doesn’t make any difference what theory is used.
The tax incidence remains the same.
Now, what is there to support the two transaction theory in these cases?
First, it was the dealer, not the finance company that actually sold a car or trailer.
The purchaser’s contract was with the dealer, not with the finance company.
The note executed for the contract obligation was payable to the dealer, not to the finance company.
The dealer was under no legal obligation whatsoever to sell the contract or any note.
He could have financed any deal himself if he had had the ability.
As the Seventh Circuit said in the Baird case, in a typical case, the dealer completed the transaction of the sale of a trailer at the time the down payment was made and the purchaser executed and delivered to it notes and a chattel mortgage or a conditional sales contract.
The dealer, thus, acquired a complete and forceable right to receive the remainder of the purchase price at the times specified in the — in the retail paper.
In the Schaeffer case, which is the Sixth Circuit case, the Court was even more emphatic.
It said that the first transaction, the transaction between the dealer and the customer, was the controlling factor in the case.
And the Sixth Circuit said that in taking the purchaser’s note and conditional sale contract, the dealer acquired an asset in the nature of an account receivable with respect to which there was no contingency whatsoever.
As between the dealer and the purchaser, the entire amount of the contract obligation approved to the dealer.
If such account receivable became uncollectible in the future in whole or in part, the question then was one of taking a deduction under an applicable statute.
But the income accrued to the dealer before the transfer was made to the finance company, and the subsequent transfer did not change the legal effect of the prior completed transaction.
William O. Douglas:
There might be circumstances where buying would never get the 5%, might it not?
I don’t think so, Your Honor, for this reason.
Was Your Honor thinking in terms —
William O. Douglas:
Of the reserve.
— of the prepayments?
William O. Douglas:
Of the reserve of the 5%.
Well, we think not for this reason, that the dealer would either get the amount in cash or it would get it in discharge of its obligations to the finance company by virtue of its own contractual setup with the — with the finance company.
William O. Douglas:
The endorsement of the paper, you mean?
The endorsement of the paper for one thing but — and — and more, the agreements to — to guarantee the payment of the — of the full amount of — of the note or the contract by the purchaser and to say the — the finance company harmless in the event of a repossession.
And in — in the Baird case, in the Baird case, went into further.
In the Baird case, the contract called for the credits to be applied against any indebtedness of any kind of the — of the partnership dealer to the — to the finance company, whether or not it arose in connection with the sale of a trailer or —
What would happen, actually, if he didn’t get paid the full amount of the reserve in such a way that it did?
Did he deduct it later on?
We — we assumed that he would be entitled to a deduction.
This is in the very nature of the accrual system of accounting.
In other words, if there was a fixed right to the income and we say, for example, when the — when the dealer — when the customer rather, executed his note to the purchaser as the courts in the Baird and Schaeffer cases have said.
The dealer had then an enforceable right to the full amount of that — of that note.
Now, any — any dealer who sells commodities on — on credits and — and includes in the — in the amount of the price to be paid by — by the customer, a — a finance charge, accrues the — accrues the amount.
The — the accrual isn’t — isn’t defeated, isn’t negated, isn’t — isn’t undermined in any way if, after he has dealt with his customer, he decides to go to a bank and — and discount the paper, discount the note.
It’s interesting — it’s interesting, Mr. Justice Harlan, in connection with your question that in a case in which the Government’s position was not sustained, the Court of Appeals opinion on the Hansen case, the — the Hansen opinion says, at least, it doesn’t seriously question the correctness of the conclusion that the full amount, which is credited to the reserve but which was reflected at a prior time in the contract or obligation, is income when the sale is made and when the credits are made because this is practically simultaneously.
The Hansen opinion said that we have no quarrel with the theory of the Tax Court’s position.
Had the dealer financed the sales himself or elected to sell the contract as a separate transaction, the result reached below would be correct.
Now, if we look to the conclusion of the dealer-purchaser transaction as giving rise to the taxable event, which is what the Sixth and Seventh Circuits have said, it seems fairly clear that insofar as the dealer is concerned, there are no uncertainties with respect to the ultimate payment of the obligation which would bar accrual because the only uncertainty, the only uncertainty is the one that is inherent in every debtor-creditor relationship, namely, that it may turn out that the debtor may not be able to pay.
But it’s, of course, fundamental, fundamental under our accrual basis of accounting that an accrual basis taxpayer who receives payment in the form of a promissory note or any other shows of an action, which appears to be collectible, cannot refuse to accrue the amount of the obligation simply because it might not prove to be collectible when due.
If such a concept were adopted, it would indeed undermine the entire theory of accrual accounting in regard to commercial transactions.
Now, returning for a moment to the hypothesis espoused by the Hansen opinion, in effect, what the Hansen opinion does is to telescope, to telescope everything that transpired and to say “We look not to the amount of the note, not to the amount of the contract as between dealer and purchaser, but we look only to the credits that were entered by the finance company after sale of the obligation or the note.”
And in effect, the Hansen opinion says, although not in these words, that looking to the transaction in this way, we find that there are such grave uncertainties that the dealers will receive any payment at all, that the credits are really contingent credits and not accrued income.
Now, let us ask ourselves, what is the nature of the uncertainties as to the payments out of the reserves?
In the first place, whatever they were, whatever they were, they certainly were no greater than the uncertainty of payment would have been if the dealer had retained the purchaser’s contract or had retained the notes himself.
The real uncertainty in both situations, and I stressed this, the real uncertainty in both situations was that the purchaser would fail to make payment on the notes.
And as far as the dealer is concerned, he has added nothing to his risk by disposing of the retail paper instead of holding it himself.
The same risk is there, and it’s no more than the normal risk of any commercial seller who has sold on credit rather than for cash.
In the second place, the records in these cases show no basis at all for concern on the part of the dealers that the credits would not, in due course, be paid over to them.
If we look to the Hansen record, we find that Mr. Hansen testified at Record 31 that there were only some prepayments, that there were some loses from abnormal depreciation before repossession, and that the bad debts charged on his books had nothing to do with the credit sales of automobiles.
In the Glover record, which is sparse indeed, nothing is shown as to purchaser’s defaults or prepayments.
But on the other hand it is shown that the taxpayer had total bad debt expenses of only some $13,000 out of more than $3 million of gross retail sales.
In the Baird case, at Record 19, is the conclusion that most of the trailer purchasers were paying their notes when due.
Furthermore, there’s nothing in these cases, nothing in the — in the records in any of these cases to show that the finance companies would not be in any position to pay over the credits at the appropriate times.
In the Hansen and Glover cases, there isn’t a slightest indication in the record that there was any possibility that GMAC and C.I.T. could not perform when it came time to perform and in the Baird case, indeed, it was stipulated that during the years here involved, the finance companies were in such good financial condition that they were able to pay any accounts which might have been due and payable to the partnership out of the dealer reserve.
And finally, even if the dealers were not paid in cash out of the reserves, we submit that they would have had their obligations to the finance companies discharged by offsets against the credits and so, would have realized income in that fashion.
As the Baird opinion says, ultimately, only two things could happen to the funds in the dealer’s reserve accounts.
Either the amounts would be paid in cash or they would be used to satisfy the dealer’s other obligations to the finance companies.
And the Sixth Circuit said in the Schaeffer case, looking to the hypothesis upon which the Hansen case is predicated, there was nothing contingent about the dealer’s legal right to the amounts credited in the reserve account.The only contingency that existed was how much of the — the amounts would be paid in cash and how much would not be paid in cash but would be applied by the finance company to the payment of the dealer’s legal obligations to it under the contracts between the dealer and the finance companies.
Now, we think that when properly analyzed, the taxpayer’s real grievance in these cases is that a tax must be paid without the funds upon which the tax is levied being available for the payment of the tax.
But as the Hansen opinion itself pointed out in this case, this may often be the result, it said, of the accrual accounting just as it may be the result of the operation of the doctrine of realization and of the doctrine of constructive receipt.
And secondly, taxpayer’s real grievance may be in these cases that they are entitled to some relief because, as stated in the Baird case, they find themselves at the mercy of the finance companies.
We think that the Circuit Court of Appeals for the Seventh Circuit has given the correct answer to this plea.
Congress has the power to lay and collect income taxes.
If the application of the income tax law to persons situated, as taxpayers say they were, require a special consideration, then it’s for Congress to say so, not the courts.
Our duty is to ascertain what the law is and apply it to this case.
And to that conclusion, the Commissioner says “Amen.”