Claim of right relief under Code Sec. 1341(a)

Appeals Court overturns oil company’s large claim of right refund
Texaco v. U.S. (CA 9 6/13/2008) 101 AFTR 2d ¶ 2008889

The Court of Appeals for the Ninth Circuit has reversed a district court award of an over $100 million refund claim to a large oil company, which had sought claim of right relief under Code Sec. 1341(a) because it was required to pay out pursuant to a settlement agreement sums that it had previously included in its gross income. The district court agreed with the taxpayer and ordered the government to pay the refund. The Ninth Circuit has now reversed, finding that the inventory exception in Code Sec. 1341(b)(2) barred the taxpayer from using Code Sec. 1341(a).

Background. Under the claim of right doctrine, income received without restrictionmust be reported in the year received, even if there’s a possibility it may have to be repaid in a later year. If it is repaid, the repayment is deductible in the year paid. However, various factors may prevent the taxpayer from receiving enough benefit from the deduction to offset the tax paid on the receipt of the income.

Code Sec. 1341 provides relief to taxpayers who received income in one year under the claim of right rule and were required to make refunds in another year at a time when the tax benefits of the repayment were less than the tax paid in the earlier year. It corrects the inequity by a reduction in the tax for the year in which the repayment is made. In essence, the amount of the tax reduction is equal to the amount the taxpayer would have saved if he had never received the income and never made the repayment, except for the loss of interest or other compensation for the use of his money.

For a claim of right relief to apply: (1) an “item” must have been “included in gross income for a prior taxable year (or years),” (2) “because it appeared that the taxpayer had an unrestricted right to such item,” (3) a “deduction” must be “allowable for the taxable year,” (4) “because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item or to a portion of such item,” and (5) “the amount of such deduction” must exceed $3,000. (Code Sec. 1341(a))

Under the inventory exception, Code Sec. 1341(a) does not apply to any deduction allowable with respect to an item that was included in gross income by reason of the sale or other disposition of stock in trade (or other property of a kind which would properly have been included in the inventory of the taxpayer if on hand at the close of the prior tax year) or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business. (Code Sec. 1341(b)(2))

Facts. Texaco was engaged in an integrated petroleum business. Between ’73 and ’81, it sold crude petroleum and refined petroleum products at prices that exceeded the price ceilings set by federal price regulations. Texaco included these overcharges as gross income on its corporate tax returns for the years ’73 through ’81. The Department of Energy (DOE) took various administrative actions against Texaco which eventually resulted in a consent degree requiring Texaco to pay $1,250,000,000 plus interest. Texaco made the payments and deducted the settlement amount on its federal income tax returns as ordinary and necessary business expenses. In February 2001, Texaco filed Refund Claims for the years ’88, ’90, ’91, and ’92, claiming that the tax benefit of the ordinary and necessary business expense deductions should have been calculated in accordance with Code Sec. 1341(a). IRS denied the refund claims on the ground that the Code Sec. 1341(b)(2) inventory exception rendered Code Sec. 1341(a) inapplicable.

In January 2004, Texaco filed a complaint against the U.S. in the District Court for the Northern District of California. On cross-motions for summary judgment, the district court determined that Code Sec. 1341(b)(2) did not preclude Texaco from seeking tax treatment under Code Sec. 1341(a), reasoning that the statute was ambiguous and sources outside the text of the statute supported Texaco’s argument that Code Sec. 1341(b)(2) only prohibited the use of Code Sec. 1341(a) computation for “sales returns, allowances and similar items.”

Failed argument. Texaco argued that there is a “syntactical” ambiguity in Code Sec. 1341(b)(2), and that the phrase “by reason of the sale or other disposition of [inventory]” modifies the phrase “deduction allowable with respect to an item which was included in gross income” in such a way that “the question that must be answered is whether the deduction in the current year is allowable “by reason of the sale or other disposition of [inventory].” It then argued that “by reason of the sale or other disposition of [inventory]” should be limited to “sales returns, allowances, and similar items.”

The Ninth Circuit said that, even if such a construction were grammatically possible, it would not be reasonable. First, Code Sec. 1341(a) clearly states that its general rule applies when “an item was included in gross income for a prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such item.” Accordingly, the Court said that there is no reason to interpret “included in gross income” in Code Sec. 1341(b)(2) as referring to anything other than the prior tax year or years. Moreover, the proposed interpretation would eviscerate Code Sec. 1341(b)(2) because a Code Sec. 1341(a) deduction is always based on calculations arising from a prior tax year and not on whether an item was included in gross income in the current year.

Second, the Court stressed that there is nothing in the statute that limits the definition of “sale or other disposition of stock in trade” to “sales returns, allowances, and similar items.” Texaco argued that such a limitation arises from Reg. § 1.1341-1(f). The Ninth Circuit, however, held that this reg does not limit Code Sec. 1341(b). It said that the reg says no more than that “sales returns and allowances and similar items” are examples of situations where the inventory exception applies; they do not delimit the exception.

Third, the Court said that Texaco’s proposed interpretation of Code Sec. 1341(b) would reduce the final sentence of the section to surplusage. The final sentence of Code Sec. 1341(b)(2) provides that the bar to using a Code Sec. 1341(a) computation in the first sentence does not apply “if the deduction arises out of refunds or repayments made by a regulated public utility,” if required by a government agency, a court, or “made in settlement of litigation or under threat or imminence of litigation.” The Court observed that, although it may not be impossible for a public utility’s refund or repayment to be based on “sales returns, allowances, and similar items,” it defies logic to believe that Congress in enacting the final sentence of Code Sec. 1341(b)(2) was concerned with only such a refund or repayment.

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