Case Name: VALERO ENERGY CORPORATION And Subsidiaries, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee
Court: United States Court of Appeals for the Fifth Circuit
Jurisdiction: United States
Decision Date: 1996-03-14
Citations: 78 F.3d 909
Docket Number: No. 95-60102
Parties: VALERO ENERGY CORPORATION And Subsidiaries, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
Judges: Before KING, DAVIS and SMITH, Circuit Judges.
Reporter: Federal Reporter 3d Series
Volume: 78
Pages: 909–920

Head Matter:
VALERO ENERGY CORPORATION And Subsidiaries, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
No. 95-60102.
United States Court of Appeals, Fifth Circuit.
March 14, 1996.
Lawrence W. Sherlock, George A. Hrdlicka, Chamberlain, Hrdlicka, White, Williams and Martin, Houston, TX, for petitioner-appellant.
Kevin M. Brown, Washington, DC, Stuart L. Brown, Chief Counsel, Internal Revenue Service, Washington, DC, Loretta Argrett, Asst. Atty. General, United States Department of Justice, Washington, DC, Teresa Ellen McLaughlin, Charles Brieken, United States Department of Justice, Tax Division Appellate Section, Washington, DC, Gary R. Allen, United States Department of Justice, Tax Division, Appellate Section, Washington, DC, for respondent-appellee.
Before KING, DAVIS and SMITH, Circuit Judges.

Opinion:
KING, Circuit Judge:
The original majority opinion and dissent in this case, Valero Energy Cory. v. Commissioner, 75 F.3d 1006, 1007 (5th Cir.1996), are withdrawn and the following majority opinion and dissent are substituted in their place:
Taxpayer corporation filed a petition in the tax court contesting the Internal Revenue Service's determination that taxpayer had overstated its 1984 net operating loss by taking a double deduction for payments made pursuant to a settlement agreement. The tax court affirmed the determination, concluding that the deduction was correctly disallowed. Taxpayer appeals. We affirm.
I. FACTUAL AND PROCEDURAL BACKGROUND
The relevant facts in this case are not disputed; many of them are stipulated. Valero Energy Corporation ("Valero") is a Delaware corporation that had its principal offices in San Antonio, Texas, when the petition in this case was filed. The predecessor of Valero was a subsidiary of Coastal States Gas Corporation ("Coastal"). Valero and Coastal have always used the accrual method of accounting for federal income tax purposes.
In the early 1970s, Coastal and its subsidiaries were sued by natural gas customers for breach of natural gas delivery contracts. The Texas Railroad Commission ruled that the customers were due refunds in excess of $1.6 billion as a result of those breaches. In the settlement negotiations that followed this ruling, the customers demanded, inter alia, that the refund obligations be satisfied with cash. Coastal and its subsidiaries, however, did not have the capacity to make such cash payments. The customers' next preference was debt securities, but this method of payment was also infeasible. Therefore, the customers agreed to accept equity securities and other negotiable instruments in lieu of cash or debt securities.
To implement the settlement, the parties executed a settlement plan ("the Plan"). One of the provisions of the Plan was that Valero would be spun off from Coastal as an independent corporation. In addition, a trust ("the Settlement Trust") was established for the benefit of the settling customers. Pursuant to the Plan, Valero transferred into the Settlement Trust various amounts of different equity securities and a promissory note, all done in settlement, payment, and satisfaction of the settling customers' claims. The spinoff and transfer of property to the Settlement Trust occurred on or about December 31,1979.
Among the assets transferred into the Settlement Trust were 1.15 million shares of newly-issued Valero $8.50 Cumulative Series A Preferred Stock ('"Valero Series A Stock"). When Coastal and Valero first proposed including this stock in the settlement package, the customers refused to accept it without an assurance from Coastal and Valero as to the amount of proceeds that would be realized from the stock. Coastal and Valero initially rejected such a provision, but later relented when restrictions were placed on the sale and redemption of the stock. Accordingly, the Settlement Trustee was authorized to sell the Valero Series A Stock (subject to certain restrictions), to receive dividends (if any), and to distribute the sale proceeds and dividends to the settling customers. The customers were only entitled to the proceeds from the disposition of the stock, and not the stock itself; if any of the stock remained as of December 1, 1986, Valero's Certificate of Incorporation required it to begin redeeming the stock at a rate of 57,500 shares per year. Under the Plan, Valero gave its assurance that the Settlement Trust would realize at least a total of $115 million from the sale or redemption of and dividends on the stock by April 29,1988: When the Settlement Trustee disposed of the last of the Valero Series A Stock, it would determine the aggregate amount of proceeds collected from sales and dividends; if this amount was less than $115 million, Valero would make up the difference.
The Plan also provided that, for purposes of the settlement and federal income tax obligations, the value of the Valero Series A Stock was its liquidation value of $115 million. This arrangement was described in a prospectus, dated February 14, 1979, that was issued to the settling customers in connection "with the customers' approval of the Plan. The prospectus advised the customers, inter alia, that: (1) the Plan provided that all parties would treat the Valero Series A Stock as having a value of $115 million; (2) in computing its taxable income, Coastal or Valero would claim in the year of settlement a deduction equal to the agreed value of the Valero Series A Stock; and (3) each settling customer subject to federal income tax may recognize ordinary income reflecting receipt of its proportionate interest in the Settlement Trust at the time that the securities, including the Valero Series A Stock, were transferred to the Settlement Trust. Coastal, Valero, and Coastal's other subsidiaries filed a consolidated federal income tax return for 1979. Pursuant to a tax deconsolidation agreement between Coastal and Valero, effected as part of the Plan, (1) Valero deducted $115 million in respect of its transfer of its own preferred stock to the Settlement Trust; (2) the deduction was reported on the Coastal group's consolidated tax return; and (3) Valero was paid $50 million by Coastal in respect of the Coastal group's tax benefit from Valero's deduction.
Between 1980 and 1984, the following transactions occurred with respect to the Valero Series A Stock in the Settlement Trust:
(1) Valero paid approximately $34.5 million in dividends on the stock.
(2) An unrelated party, Variable Annuity Life Insurance Company, purchased 230,-000 shares of the stock for approximately $12.4 million.
(3) In two separate transactions, Valero redeemed a total of 920,000 shares of the stock for approximately $48.3 million.
When Valero redeemed the last of the stock held by the Settlement Trust in August 1984, the Trust had only received approximately $95.2 million from the transactions listed above. This was partly the result of a decline in the value of Valero securities between August 1983 and August 1984. Accordingly, in August 1984, pursuant to the assurance it had made in the Plan, Valero paid approximately $19.8 million into the Settlement Trust — the difference between the $115 million assured in the Plan and the $95.2 million actually realized by the Settlement Trust from the disposition of and dividends on the stock. Valero deducted this $19.8 million payment on its 1984 federal income tax return.
On August 29, 1990, the Internal Revenue Service ("IRS") issued a notice of deficiency to Valero asserting, inter alia, that Valero had overstated its 1984 net operating loss by $19.8 million — i.e., the amount it deducted for paying the shortfall in the amount realized by the Settlement Trust from the disposition of the Valero Series A Stock. Valero filed a petition in tax court contesting this determination. Specifically, Valero claimed that the two deductions were separate because they were related to two separate obligations under the Plan: (1) the obligation to transfer to the Settlement Trust the 1.15 million shares of Valero Series A Stock, which had an agreed value of $115 million; and (2) the obligation to pay for any difference between $115 million and the amount realized from the disposition of and dividends on the stock. In response, the Commissioner of Internal Revenue ("the Commissioner") argued that Coastal had accrued and deducted the entire amount of its obligation to the settling customers in 1979, including any future payments that might be required by the assurance that the customers would realize at least $115 million from the stock. Accordingly, the Commissioner argued that Valero's 1984 deduction of the $19.8 million payment was an improper double deduction of an amount previously deducted in 1979. The Commissioner further contended that the duty of consistency in tax reporting precluded Valero from taking the 1984 deduction.
The tax court concluded that the Commissioner was correct in disallowing the $19.8 million deduction in 1984. The court explained that Valero's assurance that the settling customers would receive $115 million from the disposition of the stock was "an integral part of a unified plan and agreement that settled all claims," and therefore, each payment under the Plan could not be considered a separate liability. Consequently, the court held that Coastal's $115 million deduction in 1979 included any subsequent payments that Valero might have become obligated to make under the assurance, so that Valero's 1984 deduction of the $19.8 million payment was an improper double deduction. Having so held, the court did not reach the duty of consistency issue. Valero timely appealed.
II. DISCUSSION
We review the decision of a tax court under the same standards that apply to district court decisions. Thus, issues of law are reviewed de novo, and findings of fact are reviewed for clear error. Park v. Commissioner of Internal Revenue, 25 F.3d 1289, 1291 (5th Cir.), cert. denied, — U.S. -, 115 S.Ct. 673, 130 L.Ed.2d 606 (1994); McKnight v. Commissioner of Internal Revenue, 7 F.3d 447, 450 (5th Cir.1993). Because the facts of this case are undisputed and the parties' contentions concern purely legal issues, our entire review will be de novo.
Valero contends on appeal that the $19.8 million payment it made in 1984 was not included in the $115 million deduction taken by Coastal in 1979. First, Valero argues that the 1979 deduction does not represent an obligation by Valero to pay $115 million to the settling customers, but rather, it represents the value of the Valero Series A Stock that was transferred to the Settlement Trust. Because the deduction was for the value of the stock transferred, Valero argues that it could not have included any future payments that Valero had to make under the assurance that the customers would receive $115 million from the stock.
Second, Valero contends that there were two deductions because there were two separate obligations under the Plan related to the Valero Series A Stock: There was a fixed obligation to transfer the stock, which had an agreed value of $115 million, to the Settlement Trust. There was also a second, contingent obligation to pay for any difference between $115 million and the amount that the Settlement Trust realized from the disposition of and dividends on the stock. Valero took a deduction for what it paid under each of these obligations. As evidence of the distinctiveness of these obligations, Valero points to the sequence in which the settlement terms were negotiated, noting that the assurance covenant was added some time alter the parties had agreed that the Valero Series A Stock would be transferred to the Settlement Trust.
Finally, Valero contends that there never was an obligation for Valero to pay the settling customers $115 million, and consequently, the 1979 deduction could not have been for the accrual of this obligation. Valero maintains that its obligation to pay the difference between $115 million and the amount ultimately realized by the Settlement Trust from disposition of the stock is not the same as an obligation to pay the settling customers $115 million. As evidence that no such obligation existed, Valero points out that some of the $115 million received by the customers did not come from Valero, but rather from an unrelated company who purchased some of the Valero Series A Stock. In this same vein, Valero notes that another portion of the $115 million came from its payment of dividends on the stock, dividends that all parties agree Valero was not obligated to pay. Valero also notes that the 1979 deduction could not have contemplated an obligation to make future payments under the assurance provision because there was no way to know in 1979 whether Valero would ever have to pay anything under this provision. Because its obligation under the assurance provision was contingent on future events, Valero argues that this obligation did not accrue in 1979, and therefore, was not part of the $115 million deduction taken by Coastal.
The Commissioner counters that, in 1979, Valero undertook a contractual obligation that the settling customers would receive $115 million from the disposition of and dividends on the Valero Series A Stock, and that Coastal deducted this liability on its 1979 federal income tax return. In this regard, the Commissioner points out that the parties have stipulated that the stock's fair market value when transferred to the Settlement Trust was in fact only about $89.1 million, and therefore, the $115 million deduction taken by Coastal must have included more than the value of the stock. Because the entire $115 million obligation accrued and was deducted in 1979, the Commissioner contends that any future payments in satisfaction of this obligation were included in the 1979 deduction.
The Commissioner also argues that there were not two separate obligations under the Plan related to the Valero Series A Stock. The Commissioner points out that the transfer of the stock and the assurance provision were part of an integrated agreement designed to ensure that the settling customers received $115 million from one of the assets transferred to the Settlement Trust. In this regard, the Commissioner notes that the customers would not have accepted the transfer of the stock without the assurance provision and that the transfer and assurance are both described in the same paragraph of the Plan. Therefore, the Commissioner argues that the order in which these items were discussed in the settlement negotiations is irrelevant.
Finally, the Commissioner maintains that the Plan created a contractual right in the settling customers to receive $115 million, regardless of whether the funds came from sales of the stock, dividends paid on the stock, or direct payments by Valero. In other words, the overall liability to pay $115 million was fixed in 1979, although the source of the funding was contingent on future events. Because this obligation was established in 1979, the Commissioner contends that Coastal properly deducted it in that year, and that the deduction included any future payments that might be made in support of the obligation. In this regard, the Commissioner quotes Helvering v. Russian Finance & Constr. Corp., 77 F.2d 324, 327 (2d Cir.1935), for the proposition that "[t]he existence of an absolute liability is necessary [for the liability to be deducted]; absolute certainty that it will be discharged by payment is not."
Our decision in this case depends upon whose interpretation of the settlement is correct. Valero's interpretation is that it had two separate obligations regarding the stock — one to transfer the stock to the Settlement Trust and one to pay any difference between $115 million and the income generated by the stock. Valero then contends that these two separate obligations gave rise to two separate tax consequences — a $115 million deduction for the transfer of the stock and a $19.8 million deduction for satisfaction of the assurance provision. The Commissioner counters that Valero had one obligation — to ensure that the settling customers received $115 million from the payment of the Valero Series A Stock into the Settlement Trust and the operation of the assurance provision — with one tax consequence— the $115 million deduction for this accrued obligation. The Commissioner characterizes the later payment of $19.8 million as in support of this previously deducted obligation and thus not deductible itself.
We believe that the Commissioner's interpretation of the settlement is the correct one. Viewing all the facts and circumstances of the settlement, it is abundantly clear that Valero had a contractual obligation to the settling customers in the amount of $115 million. It is equally clear that the transfer of the Valero Series A Stock and the assurance were inseparable provisions that operated in concert to extinguish this obligation, and therefore should not be characterized as distinct liabilities.
First, in a real sense, Valero's obligation to the customers did not arise out of the Plan, but out of the Railroad Commission's ruling that the customers were entitled to refunds. The Plan did not generate a new obligation as such, but established the amount of the obligation and the means by which Valero and Coastal were to satisfy that obligation. The amount of the portion of that obligation relevant in this case was ascertainable in 1979 from Valero's assurance that the customers would receive at least $115 million in cash as part of the settlement. The transfer of the Valero Series A Stock to the Settlement Trust and the assurance provided the mechanism whereby the customers received that $115 million. Therefore, the relevant portion of Valero's obligation to the customers was fixed at $115 million in 1979.
Further, it is inappropriate to characterize the transfer of the Valero Series A Stock and the assurance as two separate obligations because the course of the settlement negotiations and the terms of the Plan indicate that these provisions are properly viewed as inseparable. First, we note that the customers initially demanded cash for satisfaction of the refund obligations. Had Coastal and Valero been able to meet this demand, the customers would have received at least $115 million in cash as part of the settlement and the Valero Series A Stock would never have entered the negotiations. Because Coastal and Valero were unable to generate the necessary cash, the customers agreed to accept the proceeds of the stock instead. The customers would not have accepted this arrangement, however, without Valero's assurance that the customers would realize at least $115 million from the disposition of the stock. The customers' demand for the assurance is understandable; the expected proceeds from this newly-issued stock from a newly-formed company were necessarily uncertain and speculative. Without the assurance, the stock would not have been issued because there would not have been a settlement. Indeed, the inclusion of the stock transfer and the assurance in the same section in the Plan reflects the conjunctive nature of these provisions. As the tax court stated, "Valero's assurance that the settling customers would realize at least $115 million in proceeds from the series A preferred stock was an integral part of a unified plan and agreement that settled all claims against Lo-Vaca, Valero, and Coastal." Therefore, to parse the stock transfer and assurance provisions of the Plan into separate obligations is to belie the economic realities of the parties' settlement. Cf Washington Post Co. v. United States, 186 Ct.Cl. 528, 405 F.2d 1279, 1283 (196?) (while "analytically possible," misleading to view each relationship under taxpayer's incentive plan as a separate liability where import of plan as a whole dictates that relationships be viewed together).
This explanation of the settlement becomes clearer when it is observed that the customers ultimately received what they had originally demanded — cash. Valero could not satisfy this demand in 1979 because it did not have the cash on hand. Therefore, it was necessary for Valero to create an income-generating asset to produce the cash that the customers wanted. Of course, it would have been inappropriate for Valero, as an adverse party, to manage this asset to produce income for the customers. Consequently, the asset was transferred to a third party — the Settlement Trustee — to manage the asset for the benefit of the customers. This transfer was only temporary; that is, the customers did not have permanent ownership of the stock, as Valero was required to redeem the stock after a certain date. Rather, the customers held the stock for a discrete period while it generated cash to satisfy the $115 million obligation to the customers. While the customers temporarily held the stock, the assurance provision shifted the risk of loss due to fluctuation in the stock's value to Valero, so that the customers were insured a minimum return regardless of the stock's performance. Therefore, the Valero Series A Stock and the assurance provision are more appropriately viewed as the means by which Valero satisfied its $115 million obligation to the customers, as opposed to obligations unto themselves.
Because Valero had only one liability to the settling customers with respect to the Valero Series A Stock, only one deduction was proper. An accrual basis taxpayer may deduct a business expense in the first year in which the taxpayer "incurs," or becomes liable for, that expense, regardless of when the taxpayer actually pays the expense. Treas.Reg. § 1.461-l(a)(2); United States v. Anderson, 269 U.S. 422, 424, 46 S.Ct. 131, 70 L.Ed. 347 (1926). Whether a taxpayer has incurred an expense is governed by the "all events" test. Under this test, all the events must have occurred that establish the liability, and the amount must be capable of being ascertained with reasonable accuracy. Id. As stated above, Valero incurred a liability to the settling customers when the Railroad Commission ruled that the customers were entitled to refunds. The amount of a portion of that liability was ascertainable by reference to the assurance provision in the Plan, which fixed that amount at $115 million. Because the Plan was implemented in 1979, Coastal properly took a deduction in the amount of $115 million in that year.
We recognize that in 1979 it was uncertain whether Valero would ever have to make any payments pursuant to the assurance provision; such payments were dependent on the performance of the Valero Series A Stock. This uncertainty, however, does not undermine the propriety of the $115 million deduction in 1979. When a liability is fixed, "other uncertainties do not necessarily destroy that initial certainty." United States v. Hughes Properties, Inc., 476 U.S. 593, 600, 106 S.Ct. 2092, 2096, 90 L.Ed.2d 569 (1986). Stated differently, "[t]he existence of an absolute liability is necessary; absolute certainty that it will be discharged by payment is not." Russian Finance & Constr. Corp., 77 F.2d at 327; see also Washington Post, 405 F.2d at 1284 (noting that certainty of liability is significant for tax purposes, as opposed to certainty of time over which payment is made or certainty as to identity of payees). Therefore, the deduction of the $115 million liability in 1979 was proper, even if the amount or time of payments in support of that liability under the assurance provision was uncertain.
Finally, because Coastal deducted the entire $115 million liability when it was incurred in 1979, it was improper for Valero to take further deductions when the liability was actually extinguished by payment. As such, Valero's 1984 deduction of the $19.8 million payment made pursuant to the assurance provision was an improper double deduction. Accordingly, the IRS and the tax court correctly determined that this deduction should be disallowed.
III. CONCLUSION
For the foregoing reasons, we AFFIRM the judgment of the tax court.
. The Plan did not obligate Valero to declare any dividends on the Valero Series A Stock because such action would depend on Valero's earnings and financial condition.
. Both parties refer to this assurance as a "guarantee." As the tax court correctly points out, however, this covenant was not a guarantee in the true sense of the word, whereby the guarantor agrees to pay an obligation in the event of a default by the principal obligor. In addition, the Plan itself uses the word "assure."
. If the proceeds from the stock exceeded $115 million, the excess was to be included in the distribution to the settling customers. Valero did not make similar assurances with respect to the other assets in the Settlement Trust.
. During this litigation, the parties stipulated that the fair market value of the Valero Series A Stock in 1979 was, in fact, $89.1 million.
. Other issues were involved in the notice of deficiency, but these were resolved before trial.
. Having so held, we need not reach the duty of consistency issue.
. We decide this case under the version of the Internal Revenue Code of 1954, and the Treasury Regulations thereunder, that were in effect in 1979. The result we reach today may have been different if Valero's obligation under the Plan had been incurred after July 18, 1984, the effective date of I.R.C. § 461(h). Since that date, I.R.C. § 461(h)(2) and Treas.Reg. § 1.461-4(g)(2) have required that an accrual method taxpayer's obligation to make a payment or a series of payments to another person, arising under, inter alia, a breach of contract, is not deductible until economic performance occurs, defined as when payment is actually made to the person to whom the obligation is owed. This change was occa sioned by a time-value-of-money "loophole" resulting from an accrual method taxpayer's taking a full deduction for the year in which an obligation to make periodic payments that extend well into the future is incurred. See Boris I. Bittker and Lawrence Lokken, Federal Taxation of Income, Estates and Gifts ¶ 105.6.4 (2d ed. 1992 & Supp.1995) (discussing Burnham Corp. v. Commissioner of Internal Revenue, 878 F.2d 86 (2d Cir.1989), a case illustrating the problem).