Opinion ID: 3025318
Heading Depth: 3
Heading Rank: 2

Heading: The “Same Circumstances, Terms and

Text: Conditions” Test We agree with the District Court that Alcoa’s clean-up expenditures in 1993 do not qualify as the restoration of income to which Alcoa found it did not have a claim of right. How then can a taxpayer satisfy section 1341's requirement that it “was established after the close of [a] prior taxable year (or years) that the taxpayer did not have an unrestricted right” to an item of income or a portion of such item? 26 U.S.C. § 1341(a)(2). The District Court, adopting Reynolds, held that a taxpayer’s later arising obligation to remedy environmental ills is not a determination that the taxpayer did not have an unrestricted right to an item of income or to a portion of such item, as required by the statute, because the taxpayer had not demonstrated restoration of an item of income to an entity from whom the income was received or to whom the item of income should have been paid. Reynolds, 389 F. Supp. 2d at 702; see also included in the COGS for the years under review, on the other, is tenuous and speculative at best. The exact amount Alcoa expended on clean-up in 1993 cannot be simply apportioned among the 47 years at issue without regard to the difference in the kind of activity (immediate waste disposal vs. delayed cleanup), cost of labor, cost and availability of technology, etc. Moreover, it seems unlikely that the statute was intended to cover unspent money. What Congress had in mind was the situation where a taxpayer received income that it later had to relinquish. Alcoa’s artful argument that waste disposal expenses would have been part of COGS, and thus an item of income, exploits technicalities at the expense of common sense. 14 Kappel, 437 F.2d at 1226 (“[t]he requirement that a legal obligation exist to restore funds before a deduction is allowable under the claim of right doctrine is derived from the language of § 1341(a)(2) of the Code”). On appeal, Alcoa argues that, in order to take advantage of section 1341, it needs to show only that it discovered it could not keep the money it had not spent on more effective clean-up in 1940-1987 because after the enactment of CERCLA and other environmental laws it was forced to spend the money on remediation efforts. The government responds that this interpretation would extend the benefits of section 1341 far beyond its intended scope and that a taxpayer must show it has “restored” the amount at issue to another claimant with actual right to it. The government urges that a taxpayer is entitled to section 1341 treatment if the repayment arose from the “same circumstances, terms and conditions” as the original payment of the item to the taxpayer. See, e.g., Kraft v. United States, 991 F.2d 292, 295 (6th Cir. 1993); Dominion Res., 219 F.3d at 367; Cinergy Corp. v. United States, 55 Fed. Cl. 489, 507 (Fed. Cl. 2003); Blanton v. Comm’r, 46 T.C. 527, 550 (T.C. 1966). In other words, there must be a “substantive nexus between the right to the income at the time of receipt and the subsequent circumstances necessitating a refund.” Dominion Res., Inc. v. United States, 48 F. Supp. 2d 527, 540 (E.D. Va. 1999), aff’d, Dominion Res., 219 F.3d 359. Alcoa’s claim fails under this “same circumstances, terms, and conditions” test. Even if we were to credit Alcoa’s theory about its new obligation to engage in clean-up in 1993 – 15 namely, that it is equivalent to the discovery that it did not have a claim of right on the money it saved by not engaging in more extensive environmental efforts in 1940-1987 – it is clear that the new obligations did not arise from the same circumstances, terms, and conditions as the initial failure to spend additional funds on environmental clean-up. Rather, the obligations were created by new circumstances, terms, and conditions, namely, by an intervening change in environmental legislation. There is no substantive nexus that can be recognized for our purposes between the waste disposal expenses Alcoa did not incur in 1940 to 1987 and its clean-up expenses in 1993. Taxpayers’ claims have been rejected in analogous situations. For instance, in Cinergy, the Court of Federal Claims held that a utility company’s “refund” to current customers of payments for deferred taxes made by former customers arose from “subsequent and unrelated events.” 55 Fed. Cl. at 508. The “refund” did not arise from a recognition that the “amounts originally collected were excessive or otherwise unneeded”; rather, customers began protesting the utility’s rates and, faced with an investigation into the rates’ reasonableness, the utility proposed a reduction but paired it with a plan for “accelerated reversal of certain tax reserves” so as to reduce the effect of the impending rate reduction on its equity. Id. The court found that the obligation to reverse the tax reserves did not arise from the same circumstances, terms, and conditions as the original accumulation of the reserves, but from the later dispute with customers and wrote that “nothing in the case law suggests that the requisite nexus is satisfied simply because the receipt of income and its later return both derived from the same regulatory process.” Id. Here, the obligation to clean up certain 16 sites – though undoubtedly connected in some way to the earlier polluting activities – did not arise from some inherent fault in Alcoa’s waste management choices. The moneys not spent did not fall under the pall of a latent competing claim. Instead, the need to expend money for remediation arose from the more stringent regulations that were later enacted. We conclude then, as the government proposes, that because Alcoa’s expenditure of funds in 1993 was not the restoration of particular moneys to the rightful owner and did not arise from the same circumstances, terms, and conditions as Alcoa’s original acquisition of the income, Alcoa’s 1993 cleanup expenditures do not qualify for the beneficial tax treatment provided under section 1341. See id. This conclusion appears to be consistent with the language of the statute – although the language of section 1341 is ambiguous in that it does not explain “how a taxpayer or the IRS is supposed to establish that the taxpayer does not have an unrestricted right to income.” Chernin v. United States, 149 F.3d 805, 815 (8th Cir. 1998). To resolve this ambiguity in the language of the statute, we will turn to the congressional intent revealed in the history and purpose of the statutory scheme. See Adams Fruit Co. v. Barrett, 494 U.S. 638, 642 (1990). The historical background of the statute, recounted in some detail above, strongly suggests that Congress intended to allow taxpayers to reverse their tax liability for funds received and included in the relevant tax return although they were the object of a competing claim. As the Court of Federal Claims found, at the time the statute was enacted, claim of right cases “tend[ed] to coalesce around some dispute over the ownership of income 17 or a mistake of fact, deriving, for example, from a quarrel over the ownership of income producing property, the misapplication of a contract provision, or the payment of funds under a contingency based upon business expectations that were thought to, but actually did not, materialize.” Cinergy, 55 Fed. Cl. at 500 (citations omitted). The purpose of section 1341 was, quite simply, to ensure that, when the taxpayer found itself to be the losing party in the dispute and had to turn over specific funds to the rightful owner, the taxpayer should be able to recompute its income for the year of receipt so as to entirely reverse the tax liability due to the disputed item. Legislative history confirms this interpretation. It documents the section’s enactment in reaction to the perceived inequity of Lewis, supra, and makes repeated references to repayment, restoration, and restitution. See, e.g., H.R.Rep. No. 83-1337, at 86-87, reprinted in 1954 U.S.C.C.A.N. 4017, 4113 (“The committee's bill provides that if the amount restored exceeds $3,000, the taxpayer may recompute the tax for the prior year, excluding from income the amount repaid” ; “excluding the amount repaid from the earlier year's income is likely to have little, if any, tax advantage over taking a deduction in the year of restitution”) (emphasis added); S.Rep. No. 83-1622, at 188, reprinted in 1954 U.S.C.C.A.N. 4621, 4751 (same). Similarly, the accompanying regulations explain that [i]f, during the taxable year, the taxpayer is entitled under other provisions of chapter 1 of the Internal Revenue Code of 1954 to a deduction of more than $3,000 because of the restoration to another of an item which 18 was included in the taxpayer's gross income for a prior taxable year (or years) under a claim of right, the tax imposed by chapter 1 of the Internal Revenue Code of 1954 for the taxable year shall be the tax provided in paragraph (b) of this section. 26 C.F.R. § 1.1341-1(a)(1) (emphasis added).7 Clearly in order to qualify under the section, the taxpayer must show not simply that it is no longer entitled to keep money it has included in an earlier return, but also that it has “restored” it. Alcoa argues, however, that, even if section 1341 includes a restoration requirement, it does not mean that restoration must be to the taxpayer’s customers or to a connected third party. Rather, all the regulations require is restoration “to another,” and therefore any “other” to whom moneys are paid will do. We reject this argument. The requirement that there be a nexus is inherent in the concept of “restoration” itself. It is true, as Alcoa points out, that “restoration to another” is not 7 We also note, of course, that the title of section 1341, “Computation of tax where taxpayer restores substantial amount held under claim of right,” uses the verb “restore.” We do not rely on this, however; although generally “the title of a statute or section can aid in resolving an ambiguity in the legislative text,” INS v. Nat'l Ctr. for Immigrants’ Rights, 502 U.S. 183, 189 (1991), the Internal Revenue Code’s rules of construction provide that no “legal effect” should be given to descriptive matter in the Code. 26 U.S.C. § 7806(b). 19 further defined in the statute or the regulations; the latter merely state, somewhat tautologically, that “restoration to another means a restoration resulting because it was established after the close of [the] prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item (or portion thereof).” 26 C.F.R. § 1.1341-1(a)(2). For clarification then we will turn to the dictionary. See Perrin v. United States, 444 U.S. 37, 42 (1979) (it is a fundamental canon of statutory construction that “unless otherwise defined, words will be interpreted as taking their ordinary, contemporary, common meaning”). Webster’s Third International Dictionary defines “restore” as: “1: to give back (as something lost or taken away); make restitution of; return. . . . 2: to put or bring back; 3: to bring back to or put back into a former or original state.” Webster’s Third International Dictionary Unabridged 1936 (1971). The American Heritage Dictionary lists “4. To make restitution of; give back; [e.g.,] restore the stolen funds.” The American Heritage Dictionary of the English Language 1538 (3d ed. 1992). Clearly, to restore something to another means to give it to the person who either once had it or should have had it all along – in this case, the person with the actual claim of right to the item of income. Alcoa’s argument that the legislative history shows that Congress intended to extend section 1341 benefits to completely unconnected third parties is unavailing. Alcoa grounds its contention on the statement found in both the Senate and House reports that section 1341 would apply to cases of transferee liability such as Arrowsmith v. Comm’r, 344 U.S. 6 (1952). In Arrowsmith, a corporation was liquidated, but subsequent to the 20 liquidation a judgment was rendered against it. As a result, the shareholders who had received capital gain income from the liquidation of the corporation were required to disgorge part of that income to satisfy a claim by the corporation’s creditor. Somewhat puzzlingly, Alcoa presents this as evidence that Congress intended payments to anyone to count. But the references to Arrowsmith in the legislative history intimate precisely the opposite. In Arrowsmith, the funds received by the shareholders at the time of their corporation’s liquidation were partly the object of a competing claim; when that competing claim was perfected, the shareholders were obligated to turn over the funds. There is nothing remarkable about the recognition that section 1341 applies to such an instance – and nothing at all that could be construed as analogous to Alcoa’s situation here. Moreover, for substantially the same reasons given by the District Court in Reynolds (and adopted by the District Court here), we decline Alcoa’s invitation to follow the Court of Federal Claims’ decision in Pennzoil-Quaker State Co. v. United States, 62 Fed. Cl. 689 (Fed. Cl. 2004). See Reynolds, 389 F. Supp. 2d at 700-702. In Pennzoil, the taxpayer, Quaker State, had purchased crude oil from independent oil producers for a period of time. In 1994, a number of these independent producers brought an antitrust action against Quaker State, alleging that Quaker State had engaged in price-fixing of its own products, thereby reducing the price at which the producers could sell their oil to Quaker State. Eventually Quaker State settled the lawsuit for $4.4 million and claimed that the corresponding deduction on the year of the settlement was entitled to Section 1341 treatment. The Court of Federal Claims 21 agreed. Pennzoil is both unpersuasive and distinguishable. It is unpersuasive because the decision is based on a number of problematic assumptions, including that Quaker State’s COGS during the years of the price-fixing would have been higher without its alleged misconduct and that there was an ascertainable relationship between the settlement amount and the amount by which Quaker State’s COGS would have been higher. In addition, Pennzoil is distinguishable because even if the Pennzoil court’s understanding of the facts was correct, there was an identifiable entity – the wholesale oil merchants – who would have received the money had Quaker State not saved it by illegally keeping the wholesale prices down. In Alcoa’s case, there simply was never any entity that had a better right to the funds Alcoa deducted in 1993 than Alcoa itself.8 The other case Alcoa relies on, Barrett v. Comm’r, 96 T.C. 713 (1991), is no more persuasive. The taxpayers in that case had bought and sold stock options and realized a large short-term capital gain. The Securities & Exchange Commission charged Barrett with using inside information to buy the options and instituted proceedings to cancel his broker’s license. Certain other brokers filed suit against Barrett and 8 Evidently aware that this is a significant weakness in Alcoa’s theory, amicus Entergy Corporation argues that the restoration requirement is satisfied because the aim of CERCLA was “to restore to the public the income attributable to the producers’ environmental consumption.” Like Alcoa’s own proposed interpretation of the statute, the argument that the amount not spent by Alcoa in 1940-1987 was somehow restored to “the public” in 1993 is creative but not convincing. 22 others, seeking $10 million. The lawsuits were eventually settled, with Barrett paying about $54,000 to the plaintiffs. The Tax Court allowed Barrett to benefit from section 1341 treatment for the settlement amount. In doing so it treated the settlement as directly related to the profit, talking about “the $54,400 of the proceeds from the sale of the options.” Id. at 718. After the Tax Court’s decision, the I.R.S. declared its nonacquiescence with the decision. 1992-2 C.B. 1, 1992 WL 1483929 (I.R.S. A.C.Q. Dec. 31, 1992). The IRS noted that “[t]he Tax Court in the instant case failed to consider whether there was a nexus between the obligation to repay and the original option profits received by Barrett. Specifically, neither the plaintiffs’ complaint nor any other evidence was introduced by either party to establish the grounds for the civil suit, the allegations made in the complaint or the focus of the plaintiffs’ discovery.” I.R.S. AOD 1992-08, 1992 WL 794825 (I.R.S. A.O.D. March 13, 1992). Barrett, like Pennzoil, appears to be based on the rationale that the settlement gave back certain funds to persons or entities that had a better right to them, but in each case the analysis was too imprecise to be followed. In sum, only the most torturous reading of section 1341 could equate Alcoa’s expenditures to clean up its sites with restoring moneys to the rightful owner. Under Alcoa’s theory, a taxpayer may qualify under section 1341 almost any time that it is faced with an expense that can be related in any way to the fact that the taxpayer did not pay that expense in a prior year. This approach turns the annual accounting system into an 23 illusion.9