Opinion ID: 3044762
Heading Depth: 2
Heading Rank: 1

Heading: “Product Liability” Losses.

Text: The I.R.C. defines “product liability” for purposes of section 172(f)(1)(A)(I) as: (A) liability of the taxpayer for damages on account of physical injury or emotional harm to individuals or damage to or loss of the use of property, on account of any defect in any product which is manufactured, leased, or sold by the taxpayer, but only if (B) such injury, harm or damage arises after the taxpayer has completed or terminated operations 23 with respect to, and has relinquished possession of, such product. 26 U.S.C. § 172 (f)(4). Neither the Supreme Court, nor any circuit court of appeals has interpreted this provision. The bankruptcy court analyzed the language of the statute and concluded that Harvard’s settlement with Harco and other customers qualified as “liability . . . for damages on account of . . . loss of the use of property.” 324 B.R. at 241 (quoting I.R.C. § 172(f)(4). It reasoned that the word “property,” which is not defined in the statute, should be read to include the lock-nuts themselves. Therefore, the court concluded: Loss of the use of the defective property is precisely what occurred here. Harvard’s customers were distributors who were unable to use the Lock-Nuts manufactured by [Harvard] because of a defect known as hydrogen embrittlement. Here again, the court gives the term “use” its plain meaning which would include intended use as an item to resell. Id. 24 The district court rejected the interpretation of the bankruptcy court. It reasoned that: Loss contemplates possession followed by the failure to maintain possession. Harvard’s customers did not have possession of lock-nuts fit for resale at any point; they merely had possession of defective lock-nuts that were unfit for resale. Consequently, Harvard’s customers could not have lost the use of the property for its intended purpose where they did not possess usable lock- nuts in the first place. Additionally, Section 172(f)(4)(B) requires that “such injury, harm, or damage arises after the taxpayer has completed or terminated operations with respect to, and has relinquished possession of, such product.” In the instant case, the defect that gave rise to Harvard’s liability arose during the manufacturing of the lock-nuts, as Harvard’s own brief admits. [] Since the damage to the property clearly occurred before Harvard relinquished possession of the product, the damage to the lock-nuts is excepted from the statutory definition of product liability as stated in 26 U.S.C. § 172(f)(4). App. 38. 25 As we have just noted, product liability is “liability of the taxpayer for damages on account of physical injury or emotional harm to individuals or damage to or loss of the use of property, on account of any defect in any product which is manufactured, leased, or sold by the taxpayer . . . .” I.R.C. § 172(f)(4)(A) (emphasis added). It is uncontested that the lock-nuts were defective. It is also uncontested that none of Harvard’s customers suffered physical injury or emotional harm because of the defective lock-nuts.9 There is also no allegation that any of the lock-nuts caused any damage to other property of any customer or “down-stream” user. (For instance, had a defective lock-nut caused a plane to crash, Harvard might well have been 9 Harvard notes in its opening brief that a defective lock-nut may have been related to the crash of a Navy plane and the death of a pilot. However, that incident occurred after the 1996 tax year and is not relevant to this appeal. Moreover, it appears from the record that no suit was ever filed against Harvard in relation to that crash. 26 liable for the cost of replacing the plane as well as other damages.) The question then is whether the distributor’s inability to resell the defective product itself qualifies as “damage to or loss of the use of property.” Both the district court and the bankruptcy court examined the statute closely, referencing dictionary meanings for each significant term. Yet, those two courts arrived at opposite conclusions. This clearly suggests an ambiguity in the language of the statute. Much of the textual ambiguity arises from the fact that it is not clear whether Congress intended “property” in the phrase, “loss of the use of property,” to include the defective product itself as opposed to the property of downstream purchasers or users to which the defective product has caused loss or damage.. In arguing that “property” refers to something other than the actual lock-nuts, the government focuses on the fact that 27 Congress used “property” and “product” differently in the statute. Relying on this distinction, the government reminds us that: Where the statutory language refers to the defective product, it uses the term “product,” which term appears once in subparagraph (A) and once in subparagraph (B). I.R.C. § 172 (f)(4). Subparagraph (A) refers to “damages . . . on account of any defect in any product,” while subparagraph (B) refers to the requirement that the “damage arises after the taxpayer has completed or terminated operations with respect to, and has relinquished possession of, such product.” I.R.C. § 172(f)(4). Not only is the defective product referred to in both instances by the term “product,” but the second instance in effect refers back to the first instance by using the term “such product.” Id. On the other hand, the term “product” does not appear in the phrase “loss of the use of property,” i.e., the statutory language does not refer to a “loss of use of the product or other property.” Id. Rather, the statute refers to a “loss of use of property.” Id. In this context, the term “product,” and not the term “property,” refers to the lock-nuts. Thus, when viewed in the context of the definition as a whole, the 28 distributor’s inability to resell the lock-nuts did not constitute a loss of use of property. Reply Br. 35-36. Although this approach has some surface appeal, we believe it actually does more to demonstrate the difficulty of textual analysis than to establish the congressional intent underlying the language we must interpret. We therefore turn to legislative history for guidance. In re Unisys Sav. Plan Litigation, 74 F.3d 420, 444 (3d Cir. 1996) (“If the statutory language is unclear, we then look to [a statute’s] legislative history.”). The House Conference Report stated that “[t]he definition of product liability under the senate amendment is intended to include the kinds of damages that are recoverable under prevalent theories of product liability.” H.R. Rep. No. 95-1800, at 286 (1978). It went on to state that “[t]he definition of product liability in the amendment does not include liabilities arising under warranty, which essentially are contract 29 liabilities.” Id. at 287.10 Unfortunately, there was more than one prevalent theory about the kinds of damages recoverable under product liability law when the statute was enacted. Fortunately, the Supreme Court has discussed the divergent views of product liability that were viable around that time. In East River Steamship Corp. v. Transamerica Delaval, Inc., 476 U.S. 858, 867-70 (1986), a defectively designed ship 10 In 1986, the I.R.S. promulgated a regulation which paraphrases the conference report’s statement: “product liability does not include liabilities arising under warranty theories relating to repair or replacement of the property that are essentially contract liabilities.” Treas. Reg. §1.17213(b)(2)(ii). It goes on to explain, by way of example, that “The costs incurred by a taxpayer in repairing or replacing defective products under the terms of a warranty, express or implied, are not product liability losses.” Id. Neither party has devoted much time to arguing the Chevron implications of this regulation. Were we to conduct a Chevron analysis, the result would likely accord with that which we have reached. That is, in the face of ambiguous language, it is reasonable to construe the statute so as to exclude damage to, or loss of, the use only of a defective product itself from the scope of specified liability losses. 30 turbine component malfunctioned and damaged the turbine itself without harming any other part of the ship. The Supreme Court was called upon to determine whether, in the context of admiralty law, injury to a product itself was the kind of harm that should be addressed by contract law or product liability law. This was then a question of first impression in admiralty. The Court began its analysis by noting that “general maritime law is an amalgam of traditional common-law rules, modifications of those rules, and newly created rules,” which are “[d]rawn from state and federal sources.” Id. at 864-65. It is this analysis of prevailing common law rules that makes the Court’s opinion useful to our analysis here. The Court viewed the “paradigmatic products-liability action [as] one where a product ‘reasonably certain to place life and limb in peril,’ distributed without reinspection, causes bodily injury.” Id. at 866 (citing MacPherson v. Buick Motor 31 Co., 111 N.E. 1050 (N.Y. 1916)). It then discussed the expansion of products liability to include protection against property damage based on similar concerns of safety. Id. at 867. However, the expansion traditionally only involved cases where “the defective product damages other property.” Id. (emphasis added). The Court described the “majority approach” as one which held that there should be no action in tort for “purely monetary harm” in order to “preserv[e] a proper role for the law of warranty . . . .” Id. at 868 (citation omitted). The minority approach “held that a manufacturer’s duty to make nondefective products encompassed injury to the product itself, whether or not the defect created an unreasonable risk of harm.” Id. at 86869. After evaluating the merits of these different approaches, the Court concluded that where the only injury was to the product itself, “the resulting loss due to repair costs, decreased 32 value, and lost profits is essentially the failure of the purchaser to receive the benefit of its bargain - traditionally the core concern of contract law.” Id. at 869 (citing E. Farnsworth, Contracts § 12.8, pp. 839-40 (1982)). The Court concluded that “a manufacturer in a commercial relationship has no duty under either a negligence or strict products-liability theory to prevent a product from injuring itself.” Id. The Court also reasoned that the policy concerns for public safety were not as compelling in these circumstances as in those where bodily injury or harm to other property occurred. Thereafter, we had to decide what rule Pennsylvania would adopt when a defective product “damaged itself.” In Aloe Coal Co. v. Clark Equipment Co., 816 F.2d 110 (3d Cir. 1987), we predicted that “Pennsylvania courts, although not bound to do so, would nevertheless adopt the Supreme Court’s reasoning in East River.” Id. at 112. In so doing, we reversed 33 a conclusion we had reached in a previous case, because we were persuaded by the “cogent reasoning” of East River. Id. at 119. Neither of these cases controls our present inquiry under the Tax Code. However, we continue to find the reasoning of East River persuasive, and the distinction it draws between warranty and contract damages on the one hand, and product liability and tort damages on the other, is similar to that drawn by the Congress that drafted and enacted 26 U.S.C. § 172(f). Moreover, this approach is reinforced here because Harco sued Harvard on various theories of contract and warranty liability based on the defective lock-nuts. Harco did not assert a product liability cause of action. Thus, the damages here are “liabilities arising under warranty,” which Congress did not intend to include in the statute. 34 As noted earlier, the taxpayer has the burden of proving its eligibility for a deduction, and statutes authorizing deductions are a matter of legislative grace and are to be construed narrowly unless the text of the statute authorizing the deduction reflects a different congressional intent. See B.A. Properties Inc., v. Government of the Virgin Islands, 299 F.3d 207 (3d Cir. 2002). Viewed in that context, we are not persuaded by the Trust’s argument that the IRS’s interpretation of the statute will leave manufacturers with no incentive to make safe products. In fact, the argument is specious. Even if corporations are not allowed to carry-back this deduction 10 years - they may still take a deduction for such expenses in the applicable tax year. Furthermore, regardless of how such liabilities are treated for tax purposes, the threat of products liability and other claims hangs over a company that makes unsafe products. Here, for example, the potential products liability and tort recovery from 35 death and injury that could have resulted from a plane crash caused by the defective lock-nuts would dwarf the claimed tax benefit of allowing a ten year carry-back. We therefore conclude that the district court did not err in reversing the bankruptcy court’s conclusion that the loss fell within the scope of § 172(f). The district court was correct in accepting the government’s position and disallowing the Trust’s claim that the payments for defective lock-nuts qualified for the ten year carry-back.