Uncertainty governs advance trade discounts.

• Author: Walberg, Glenn

EXECUTIVE SUMMARY

* The Ninth Circuit held that advance trade discounts were not income when received by a taxpayer because the taxpayer had an obligation to repay the discounts and therefore did not have an accession to wealth.

* The Third Circuit held that a taxpayer's advance trade discounts were income when received because the taxpayer controlled whether it was entitled to keep the discounts.

* Rev. Proc. 2007-53 allows qualifying taxpayers to account for certain advance trade discounts for federal income tax purposes in the same way that they are accounted for in the taxpayer's financial statements

* In substance, an advance trade discount is an adjustment to the purchase price of goods and should be treated for tax purposes as a reduction of inventory costs.

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This article discusses the conflicting opinions on advance trade discounts from the Third and Ninth Circuits, IRS guidance on advance trade discounts in Rev. Proc. 2007-53, and the merits of treating advance trade discounts as purchase price adjustments instead of as income or loans.

Taxpayers often find advance trade discounts troubling. These payments, which sellers make to buyers in exchange for the buyers' promises to make certain volume purchases of goods in the future, frequently impose repayment obligations for buyers that fail to perform as promised. These repayment obligations prevent advance trade discounts from cleanly falling within commonly held notions of income or loans. Perhaps, as discussed below, this difficulty indicates that they represent neither.

Two appellate courts and the Service have recently addressed advance trade discounts; however, they have created more confusion than clarity. In Westpac Pacific Food, (1) the Ninth Circuit, reversing the Tax Court, found that a repayment obligation prevented an advance trade discount from creating an accession to wealth and therefore concluded that it did not constitute gross income when received. In Karns Prime & Fancy Food, Ltd., (2) the Third Circuit affirmed the Tax Court and held that a taxpayer must recognize an advance trade discount as gross income when received because the taxpayer's ability to keep the payment, as long as it fulfilled its purchase commitment, established the taxpayer's complete dominion over such payment. Days before the filing of the Karns opinion, the Service issued Rev. Proc. 2007-53 (3) and announced that it would follow Westpac insofar as it would allow taxpayers to follow their financial reporting treatment for certain advance trade discounts.

In light of these developments, taxpayers receiving advance trade discounts now face split circuit opinions and taxpayer-favorable guidance from the Service. This article explains the opinions and guidance, considers the possibility of the Service revoking Rev. Proc. 2007-53 after the government's victory in Karns, looks at the implications of having conflicting decisions in two circuits, and discusses the alternative of treating advance trade discounts as purchase price adjustments.

Ninth Circuit's Analysis in Westpac

In Westpac, the Ninth Circuit considered the advance trade discounts received by a partnership (Westpac) organized by three grocery store chains. Westpac entered into four contracts that resulted in Westpac's receiving up-front cash payments for volume discounts in exchange for Westpac's respective promises to purchase certain dollar amounts of products annually from each of four vendors. Westpac also agreed to repay the advance trade discounts pro rata to the extent it failed to satisfy its purchase obligations. Westpac did not satisfy its minimum purchase obligations under two contracts and made the required repayments to the appropriate vendors.

In preparing its tax returns for the years during which it received the cash payments, Westpac took a portion of those payments into account in determining its taxable income. The amount accrued by Westpac for a tax year reflected the pro-rata portion of the advance trade discounts attributable to goods purchased during that year under Westpac's purchase obligations. Westpac subtracted that portion from its cost of goods sold in order to reflect the discount, which had the effect of increasing Westpac's gross income.

The IRS adjusted Westpac's gross income to include the entire amount of the cash payments in the years they were received, and the Tax Court upheld the adjustments. The Tax Court reasoned that, considering Westpac's unfettered use of the cash and the broad definition of gross income under Sec. 61, the advance trade discounts constituted income recognizable when received because Westpac had actual command over the payments.

The Ninth Circuit reversed the Tax Court's decision in Westpac. The appellate court determined that the issue was whether Westpac must report an advance trade discount, subject to repayment, as income if it had not satisfied its associated purchase commitments by the time it received the payment. Even under the broad definition of gross income, the court concluded that Westpac's advance trade discounts could not constitute income as long as the repayment obligations remained outstanding.

The Ninth Circuit acknowledged, as did the Tax Court, the broad definition of gross income from the Supreme Court's decision in Glenshaw Glass Co. (4) In that decision, the Court characterized gross income as accessions to wealth over which a taxpayer has complete dominion. The Ninth Circuit, however, disagreed with the Tax Court's holding that under this definition Westpac's mere unfettered control over the cash receipts meant that it had to recognize income. The court found that this approach lacked any consideration of whether Westpac had an accession to wealth. To illustrate the point, the court explained that a taxpayer could exercise complete dominion over loan proceeds but still not recognize income because its repayment liability would offset the receipt of loan proceeds without affecting the taxpayer's wealth.

The court concluded that Westpac experienced no accession to wealth when it received the cash payments subject to repayment. It noted that Westpac could only keep those payments to the extent it fulfilled it purchase obligations and, despite holding the cash, "Westpac either has to buy a specified volume of goods for more than it would otherwise pay or pay back the money." (5) In either situation, Westpac assumed a liability that offset the value of the cash and hence realized no change in wealth.

The Ninth Circuit in Westpac therefore refused to characterize an advance trade discount as income where the taxpayer concurrently assumed an obligation to either make future purchases or repay the discount. Regardless of the taxpayer's degree of control over the proceeds, the court found no accession to wealth where the arrangement created a repayable advance against the taxpayer's obligation.

Third Circuit's Analysis in Karns

In Karns, the Third Circuit reached the opposite conclusion, creating a split between the circuits. In that case, the taxpayer (Karns) had sought $1.5 million of funding for capital improvements at its grocery stores. Karns therefore approached its principal supplier about a loan, and the supplier agreed to provide the requested financial assistance. Under an established practice with its strategic customers, the supplier required that Karns sign a promissory note and agree to annually purchase...