Westpac Pacific Food: advance trade discounts are not income.

• Author: Auclair, David

In Westpac Pacific Food, 451 F3d 970 (9th Cir. 2006), rev'g TC Memo 2001-175, the Ninth Circuit addressed whether advance trade discounts are required to be included in income in the year of receipt. In reversing the Tax Court, the court held that such discounts, subject to repayment if volume commitments are not met, are not income when received.

Facts

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.

Tax Court

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.

Ninth Circuit

"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...