Opinion ID: 381301
Heading Depth: 1
Heading Rank: 4

Heading: discount issue

Text: 82 During each of the taxable years at issue here, the taxpayer offered a discount to its customers. For the first taxable year, 1960, and part of 1961, the discount was 10cents per barrel for gray cement and 20cents per barrel for white cement. In 1961, the discount was increased to 20cents per barrel for gray cement and 40cents per barrel for white cement. It remained at this level for the succeeding taxable years. Until January 1, 1964, the terms of the discount required payment of the discounted price within 15 days from the invoice date, or payment of the full price within 30 days of the invoice date. The terms were changed effective January 1, 1964, and for 1964 and succeeding taxable years, the terms of the discount required payment of the discounted price by the 10th of the month for shipments invoiced during the previous month, or payment of the full price by the last day of that month. 83 The district court found, and its finding is amply supported in the record, that taxpayer strictly enforced its discount policy. 84 For the years at issue, between 90% and 95% of taxpayer's customers took advantage of the discount, and 5% to 10% did not. By dollar volume, approximately 95% of the potential discounts were allowed by taxpayer, and approximately 5% either were not taken advantage of by the customer or were affirmatively disallowed by taxpayer. Of that 5%, between 15% and 20% were affirmatively disallowed, the balance of the customers having paid the full price without attempting to obtain the discount rate. Thus, taxpayer affirmatively disallowed the discount in approximately 1% of the sales. 85 It is undisputed that most other competing cement manufacturers offered a discount with terms similar to those offered by taxpayer. 86 It is also undisputed that both the 1961 increase in the amount of the discount and the 1964 change in the terms of the discount were made by taxpayer at the same time the industry made similar changes and that taxpayer's changes were in response to competitive forces. 87 The government introduced evidence to support its argument that the terms of the discount were not essentially equivalent to interest, namely, that the discount did not represent a fair rate of interest for taxpayer to pay for the use of money, i. e., for the use of the prepaid discounted price. The government's witness, Mr. Townsend, testified that taxpayer's various discounts were equivalent to interest at an annualized rate ranging from 73% to 128%. 38 The witness determined the amount of the discount (e. g., 20cents per barrel), and the discount percent 39 (e. g., on a sales price of $3.75 per barrel, the 20cents per barrel discount represents a 5.3% discount.) The witness considered that taxpayer was paying an interest equivalence in the amount of the discount for use of the money-i. e., for the use of the prepaid discounted price-for the prepayment period-i. e., the length of time between the date by which the discounted price must be paid in order to obtain the discount and final due date of the account 40 (e. g., 20 days when the discount terms provided for payment of the discounted price by the 10th day of the month following shipment or payment of the full price by the end of that month). Based on these determinations, Mr. Townsend calculated the annualized rate of interest represented thereby. 41 Mr. Townsend's calculations were based on the median mill price of bulk cement for taxpayer's various cement products. These prices did not include the 40cents to 60cents extra which would be reflected in taxpayer's sales of bagged cement, which were approximately 10% to 20% of taxpayer's sales. Nor did these mill prices include the freight charge which would have been included in a customer's invoiced delivered price. Taxpayer's official estimated that freight charges would range from 50cents to 75cents per barrel. 88 There was evidence that the most prevalent cash discount in the business community in general was the  2/10 net 30 discount. This discount entitled the customer to a 2% reduction if the discounted price is paid within 10 days, or the full price must be paid within 30 days. This classic discount represents an annualized interest rate of 37%. 89 Taxpayer asserts two purposes for its discount: to encourage prompt payment and to insure ultimate collection. Taxpayer argues that its discount is a cash discount which is entitled to a favorable treatment, which we explain as background for our discussion of the discount issue. Taxpayer argues that its full, undiscounted sales price should be included in the gross sales figure of the proportionate profits formula 42 and that the discount should be treated as an expense incurred by taxpayer for the benefit of the entire operation, thus to be allocated in part to the mining phase and in part to the nonmining phase. The effect would be to increase the gross sales figure in the formula, thereby increasing gross income from mining and increasing taxpayer's percentage depletion deduction. 90 The government, on the other hand, argues that the effect of the treatment taxpayer seeks is to give taxpayer a percentage depletion deduction, based not only on the discounted sales price which it actually receives, but also on the discount amount itself, which taxpayer does not receive. The government argues that the appropriate treatment is to reduce the sales price by the discount, and thus include in the gross sales figure of the proportionate profits formula only the discounted price actually received. 91 The district court stated the issue as whether the discounts are cash discounts or trade discounts, and characterized the question as one of fact. Quoting from Standard Lime, the court distinguished cash discounts, which it described as discounts granted to encourage prompt payment, from trade discounts, which it described as discounts available without regard to the time of payment. The court held that the discounts at issue were cash discounts and entitled to the favorable treatment taxpayer seeks. The court divided its inquiry into two steps. First, the court found, as a matter of fact, that the actual policy and results of taxpayer's business were that the discounts were granted to induce prompt payment. Subsidiary supportive findings included: 92 (1) Taxpayer offered the discount to induce early cash payment; 93 (2) The discount was effective in collecting 90% to 95% of the accounts receivable; 94 (3) Taxpayer strictly enforced the cash discount; and 95 (4) Strict enforcement of the cash discount was achieved through close supervision of personnel who were allowed to give discounts. 96 In the second step of its inquiry, the district court held that the interest equivalency test, if applicable at all, was improperly applied by the government. The court rejected the government's interest equivalency test on the ground that the prepayment period used by the government's witness was not supported in the evidence because collections often were not made until some time after the final due date. 97 The district court committed legal error in its holding that the government improperly applied the interest equivalency test. We hold that the government properly applied the test and that the district court's refusal to consider the interest equivalency factor was legal error. Assuming arguendo that the ultimate determination of the purpose of the discount and the classification as a cash discount or a trade discount is a question of fact, 43 we conclude that the discount at issue is a trade discount. Because the contrary conclusion, i. e., a determination that the discount is a cash discount, would be clearly erroneous on the facts of this case, we need not remand to the district court to make findings of fact applying the standards we set out. 98 We turn first to the interest equivalency test. 44 We hold that the proper prepayment period is, as the government urges, the time between the final due date of the account and the date by which the discounted price must be paid in order to be eligible for the discount. The Ninth Circuit so held in California Portland. Rev.Rul. 60-257 45 so held. On the other hand, the court below cited no authority for its suggestion that the prepayment period should include the period during which any accounts were delinquent. We respectfully reject this suggestion of the district court, both on the basis of the authorities cited and because common sense points us to this conclusion. For example, if the final due date of an account is the last day of August, and the last date on which the discounted price can be paid is August 10, then it seems to us rather clear that both parties would ordinarily contemplate that the time period for which the prepaying customer would lose the use of his money, and conversely the extra time that the seller would have the use of the money, is the approximately 20 days between August 10 and the last day of August. 99 We further hold that there is no need for the district court on remand to reconsider the question of whether the discount here is substantially equivalent to a charge in the nature of interest for the use of the prepaid discounted price. The errors in the government's evidence, as pointed out by the taxpayer, 46 are not significant, and the evidence in the record clearly shows that the discount represents an interest equivalence far in excess of the prevailing interest rate, which the record shows would range from 4% to 7%. Accordingly, we hold that the discount at issue is not substantially equivalent to a charge in the nature of interest. 100 The interest equivalency test is only one of the factors to weigh in determining whether a discount is a cash discount or a trade discount. We next examine the relevant authorities to flesh out the other factors, and articulate the standards to be applied in distinguishing cash from trade discounts. 101 Taxpayer relies primarily on Standard Lime. 47 Taxpayer asserts that Standard Lime involved the same discount that we must evaluate, that the government conceded it was a cash discount, and that the case is controlling. The discount in Standard Lime does appear identical to the one at issue here for the taxable year 1960 and part of 1961. However, because the government conceded that the discount was a cash discount, the discussion of the Court of Claims is dictum. We need not consider the precedential value, if any, of the government's concession because Rev.Rul. 60-257, clarifying the Internal Revenue Service position on cash discounts, was prospective only, to apply only to taxable years after January 1, 1960. The government's concession in Standard Lime related to the taxable year 1954, and the Internal Revenue Service had served notice that it would apply the stricter standard of Rev.Rul. 60-257 beginning in 1960. 48 102 Standard Lime also distinguishes cash discounts from trade discounts, saying that the former are granted to encourage prompt payment and are optional with the customer, while the latter are granted at the option of the seller and do not depend upon when payment is made. As note above, this definition is dictum. Our analysis leads us to the conclusion that this is only one 49 of several factors to be weighed in the determination of whether a discount is a cash discount entitled to the favorable tax treatment which taxpayer seeks. 103 Standard Lime also stated that trade discounts are deemed reductions in the sales price thus not includable in taxpayer's gross income. 329 F.2d at 947, n.18. This statement comports with our understanding of the law. 50 104 In California Portland the Ninth Circuit dealt with the discount issue in the cement industry. The court held that a discount very similar 51 to the one at issue was a trade discount, and not a cash discount, entitled to the favorable treatment taxpayer urges. The court below had made a finding of fact, very similar to that in the instant case, that the purpose of discount was to induce prompt payment and that the discount was a cash discount. The Ninth Circuit found that the discount-calculated in the same manner as the interest equivalency has been determined in the instant case-did not represent a fair interest rate. The court concluded on the basis of that fact, plus the fact that the discount was rarely disallowed, plus the fact that the same discount was prevalent in the industry, that the discount was a trade discount and not a cash discount. 105 Taxpayer argues that California Portland can be distinguished because the discount there was rarely disallowed. Only .03% of the discounts there were disallowed, compared to approximately 5%, by dollar volume, in the instant case. We do not find this difference sufficient to distinguish California Portland ; we consider the discounts disallowed in the instant case to be small in comparison to the total discounts available. 106 Taxpayer next argues that California Portland is distinguishable on the basis of the substantial evidence in our case that General Portland strictly enforced its discount policy. We note that the Ninth Circuit did not indicate whether or not the discount policy was strictly enforced; it noted only that in one of the taxable years there involved discounts of only $347 were disallowed while $1,000,000 in discounts were allowed. Nevertheless, we do consider the demonstrated strict enforcement of taxpayer's discount policy to be an important factor favoring the taxpayer's position, and providing some evidence that the discount was not a disguised price reduction for competitive purposes. We will weigh this factor in taxpayer's favor in our application of the legal standards to the facts of this case. 107 In Rev.Rul. 60-257 the Internal Revenue Service ruled that: 108 (I)n determining 'gross income from the property' for percentage depletion purposes the gross selling price should be reduced by the amount of any prepayment discount allowed by the taxpayer and utilized by the purchaser unless the discount is a cash discount and one that under all the circumstances is substantially equivalent to a charge in the nature of interest for the use of the net amount paid in advance of the date when it was otherwise due and payable. 109 1960-2 C.B. at 198. The ruling clarified the earlier Rev.Rul. 55-13 52 and clarified the acquiescence in Montreal Mining Company v. Commissioner, 2 T.C. 688 (1943), acq. 1944 C.B. 20. The ruling approved the result in Montreal Mining because the discount there constituted in substance a payment by the taxpayer for the use of the net purchase price for time period of the prepayment, and represented a fair interest rate. 53 The Ruling pointed out that to allow the favored treatment to a discount which did not reflect a fair rate of interest would be to allow taxpayer percentage depletion on amounts to which taxpayer was never entitled and could never collect. 110 We note that the ruling requires that the discount be both a cash discount and one which is substantially equivalent to interest. As our analysis in the next two paragraphs indicates, we do consider interest equivalency to be an important factor, but we do not adopt the ruling's position that interest equivalency is a prerequisite. 111 We turn now to analyze the cash discount at issue and the favorable treatment taxpayer seeks, in light of the purpose behind the percentage depletion deduction. We can see that it is reasonable to treat as an expense a payment for the use of money for the prepayment period. This is substantially equivalent to a simple bank loan by taxpayer, secured by his account receivable and repayable when the account receivable is due. Such interest would be an expense allocated between the mining and nonmining phases. In the bank loan situation, of course, the full account receivable is received and would be included in the gross sales figure. To the extent that the substance of a discount situation is like the bank loan, the treatment taxpayer seeks is proper. Rev.Rul. 60-257 so holds. Thus, we conclude that if a cash discount were essentially equivalent to interest, taxpayer's treatment would comport with the purpose of percentage depletion. 112 However, we are not convinced that a discount, to qualify for the favorable treatment, must be approximately equal to the prevailing interest rate. We concede to the government that a taxpayer, using good business judgment, would not pay more than the prevailing interest rate just to encourage customers to pay 20 days early. The taxpayer here, however, asserts an additional purpose, i. e., to insure ultimate collection. We conceive that a cement manufacturer might be willing to offer a discount which reflects a rate of interest somewhat higher 54 than the prevailing interest rate in order to encourage customers to pay their bills. The manufacturer may well deem the monetary sacrifice for prompt and early payment reasonable in the construction trade where contractors often experience cash flow difficulties. Sometimes the early bird is the only one who gets a worm. A discount for the sole purpose of ultimate collection, like expenses for credit reports and other collection expenses and like interest expenses, would properly receive the favorable treatment taxpayer seeks. Such a discount would in substance be the same as if taxpayer did receive the full, undiscounted sales price, but then incurred a financial expense to ensure collection. 113 Applying the above principles to the facts of the instant case, we consider that three facts are potentially favorable to taxpayer: (1) the fact that the discount was tied to prompt payment; (2) the fact that the discount policy was effective in accomplishing the prompt collection of approximately 95% of taxpayer's collections; and (3) the fact that the policy was strictly enforced. 114 The first fact, the tie to prompt payment, is of course a prerequisite, but it does not foreclose the possibility that the discount might also serve a significant, competitive price-reducing function. California Portland so holds. 115 Similarly, the second fact is not persuasive. Although it is obvious that the larger the discount, the more effectively it will encourage prompt payment, it is also obvious that the larger the discount, the greater the likelihood it also serves a competitive price-reducing function. 116 The third fact provides the basis of taxpayer's strongest argument. It is true, as taxpayer urges, that strict enforcement of the discount policy could operate in a manner adverse to taxpayer's competitive interests. If taxpayer strictly enforces its discount policy, as the evidence demonstrates, and taxpayer's competitors do not, taxpayer's competitive position is hurt. Although we do consider this to be an important factor in favor of taxpayer's position, we will weigh this factor, keeping in mind that any adverse competitive impact would be confined to the approximately five percent of taxpayer's sales with regard to which the discount was not allowed. Even within this 5%, the record shows that the discount was affirmatively disallowed in only 15% to 20% of those sales, while the customer simply mailed in the full price in the balance of the sales. Thus, taxpayer affirmatively disallowed the discount in only approximately 1% of its sales. 117 The factors favoring the government's position are: (1) the large size of the discount; (2) the small number of sales in which the discount was not actually allowed to customers; (3) the prevalence in the industry of the same discount; and (4) the record evidence demonstrating that taxpayer's changes in its discount terms resulted from competitive forces. 118 First, 55 the discount at issue far exceeds the prevailing interest rate. Thus, it seems unlikely that taxpayer would pay a discount of this size merely to accelerate its collections, when taxpayer could have obtained, at a fraction of the cost, a bank loan pending payment of the accounts at the final due date. With regard to taxpayer's other stated purpose for its discount policy-to secure ultimate collection-there is no evidence in the record to explain why taxpayer had to offer a discount so large to accomplish this purpose. The record does reveal that the most prevalent cash discount in business is the  2/10 net 30 discount. Taxpayer's discount far exceeds the classic discount. Taxpayer has not demonstrated that its discount is in substance a financial expense incurred either to encourage prompt payment or to insure ultimate collection. Such a large discount carries implications that the discount is serving not only a collection purpose, but also a competitive price-reducing purpose. 119 Second, the fact that only approximately 5% of taxpayer's sales, by dollar volume, did not in fact take advantage of the discount means that, for all practical purposes the effective price of taxpayer's products was the discounted price. 120 Third, the prevalence in the industry of the same discount constitutes an implication that the discount has a competitive purpose and effect. 121 Fourth, the evidence in the record demonstrates that both the 1961 increase in the amount of the discount, and the 1964 change of terms lengthening the time to pay the discounted price and the time to pay the full price were in response to competitive forces. While the third factor provides only an implication, this fourth factor is concrete evidence that both the size and the terms of the discount at issue were influenced by competitive forces. 122 The determination of whether a discount is a cash discount or a trade discount must be made upon consideration of all the facts and circumstances and in light of the purpose of the percentage depletion deduction. In this case, the factors listed and discussed above are the relevant factors. The district court considered only the three factors listed above as favoring the taxpayer; we hold that the district court committed legal error in failing to consider the four factors listed above as favorable to the government. Although we reverse the district court for failure to apply the proper legal standards, we find no need for the court below to review the facts in light of these standards, because we hold that it would have been clearly erroneous on the facts in this record to find that the discount at issue did not have a significant competitive price reducing purpose and effect. Weighing the facts, 56 we conclude that the discount at issue-while it did serve effectively to encourage prompt payment and perhaps also ultimate collection-also had a significant competitive price reducing purpose and effect. This conclusion is fatal to taxpayer's case. To allow taxpayer the favorable tax treatment it seeks for the discount at issue would be to allow a deduction for amounts that do not fit within the two categories of legitimate deductions asserted by taxpayer, i. e., interest expenses and collection expenses. To allow the favorable treatment to this discount, which reflects in significant part a competitive price reduction, would be to grant taxpayer a windfall, a percentage depletion deduction based not only on the reduced sales price actually received by taxpayer, but also on the discount amount itself which taxpayer does not receive and which taxpayer has failed to demonstrate is the equivalent of a deductible interest or collection expense. We hold that taxpayer has failed to carry its burden of proving that its discount comes within the purpose of the percentage depletion deduction, which like any other tax deduction is a matter of legislative grace and must be narrowly construed. 123 Accordingly, we hold that, for purposes of the percentage depletion deduction, the discounts 57 at issue are trade discounts, and should not be included in the gross sales figure of the proportionate profits formula. 58 V. INTEREST ISSUE 124 For the years 1960 through 1964, taxpayer incurred interest expenses totaling $3,236,927.84. The interest expenses were primarily attributable to interest on $15 million in debentures issued by taxpayer in 1957. In the same years, taxpayer had interest income totaling $1,519,447.71. The interest income was primarily attributable to short term investments in Treasury bills and commercial paper. 125 The interest issue before us is whether the taxpayer may reduce his interest expense deduction by the amount of interest income earned on the borrowed funds. This issue does not involve the proportionate profits method; nor is it involved in the determination of gross income from mining. Rather, the issue involves a separate limitation on the percentage depletion deduction. Section 613(a) provides that the percentage depletion deduction shall not exceed 50% of the taxpayer's taxable income from the property (computed without allowance for depletion). The regulations provide, 59 and the parties agree, that taxable income from the property is computed by subtracting from gross income from mining certain expenses, including that portion of the interest expense properly allocable to the mining phase. There is no dispute between the parties as to the proper method of allocation. The dispute is whether the proper interest expense figure is the full $3,236,927.84 or the net interest expense of $1,717,480.13, obtained by netting the interest income of $1,519,447.71 against the total interest expense. It is apparent that if the interest expense figure is reduced, as taxpayer urges, the taxable income from the property will be increased, thus increasing the 50% limit and taxpayer's percentage depletion deduction. 126 The district court held that taxpayer is entitled to reduce its interest expense by the interest income earned on the borrowed funds. 127 Apparently only one case has addressed this narrow issue. 60 The government relies heavily upon Island Creek Coal Company v. Commissioner, 30 T.C. 370 (1958) (hereinafter referred to as Island Creek). There the taxpayer realized income on the sale of certain scrap items, including steel, wire, etc. These scrap items represented waste from supplies which had originally been charged to the production costs of the mine. The taxpayer sought to set this income from its scrap salvage operations off against its current supplies and maintenance account, thus reducing that account and increasing its taxable income from the property. The Tax Court rejected taxpayer's attempt. Relying upon cases which had refused taxpayer attempts to include in gross income from mining income from sources extraneous to the mining operation, and saying that the income from the scrap salvage operations was not income attributable to the mining operations and that the taxpayer could not do by indirection that which he was prevented from doing directly, the Tax Court rebuffed taxpayer's attempt to offset its scrap income against its expense of supplies. 128 The government and the taxpayer in this case agree, and this court agrees, that gross income from mining does not include income items extraneous to the mining operations. The Tax Court in Island Creek leapt from this truism to the conclusion that an income item could not be offset against an expense account. The Tax Court set forth no reasons or analysis other than it is axiomatic that a taxpayer may not do by indirection that which it may not do directly. 30 T.C. at 384. Although we agree that taxpayer cannot include its interest income in gross income from mining, we do not agree that the taxpayer here is seeking to accomplish that result by indirection. Whether taxpayer's interest income is part of gross income from mining is not, we submit, the same question as whether taxpayer's interest income is related to its actual cost for interest on borrowed funds. We cannot so easily conclude that an item, just because it is an income item under technical accounting principles, can never be an offset against an expense item. We think the purpose behind the 50% limit argues in favor of the taxpayer in the instant case. We believe that purpose is served by subtracting the actual cost of interest, rather than an inflated amount. Taxpayer's actual cost of interest is its net interest expense. The taxpayer would not have derived the interest income had it not first incurred its interest expense. An example will reinforce our reasoning. Assume that a mining company bought, or brought to its laboratory on approval, ten aprons for the use of its laboratory personnel. Assume further that nine were kept, and one was returned. Even if the return of the tenth apron would give rise to a refund which under the company's accounting practices would be an income item, it seems clear to us that the actual cost incurred for aprons is for nine, not ten. 129 On the basis of the above analysis, we decline to follow the implication in Island Creek that a technical income item can never offset an expense item. 61 We hold that taxpayer's actual interest cost is the net amount, and that taxpayer can offset its interest income against its interest expense in calculating taxable income from the property for purposes of the 50% limit. 130 Accordingly, we affirm in part, reverse in part, and remand. 62 131 AFFIRMED IN PART, REVERSED IN PART, AND REMANDED IN PART.