Court Opinion

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Opinions of the United
2003 Decisions                                                                                                             States Court of Appeals
                                                                                                                              for the Third Circuit

12-8-2003

Inductotherm Ind Inc v. USA
Precedential or Non-Precedential: Precedential

Docket No. 02-4292

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                      PRECEDENTIAL

                            Filed December 8, 2003

    UNITED STATES COURT OF APPEALS
         FOR THE THIRD CIRCUIT

                No. 02-4292

     INDUCTOTHERM INDUSTRIES, INC.
                              Appellant
                     v.
       UNITED STATES OF AMERICA

 Appeal from the United States District Court
          for the District of New Jersey
       (D.C. Civil Action No. 99-cv-02451)
District Judge: Honorable Joseph H. Rodriguez

            Argued July 31, 2003
   Before: SCIRICA, Chief Judge, RENDELL
         and AMBRO, Circuit Judges

      (Opinion filed: December 8, 2003)
               Ronald L. Glick, Esquire (Argued)
               Stevens & Lee
               1415 Route 70 East
               Suite 506
               Cherry Hill, NJ 08034
                Attorney for Appellant
                                  2

                        Eileen J. O’Connor
                         Assistant Attorney General
                        Gilbert S. Rothenberg, Esquire
                        Francesca Ugolini, Esquire (Argued)
                        Department of Justice
                        Tax Division
                        Post Office Box 502
                        Washington, D.C. 20044
                             Attorneys for Appellee

                  OPINION OF THE COURT

AMBRO, Circuit Judge:
   This appeal involves a dispute between a taxpayer and
the Internal Revenue Service about the proper time to
recognize income and losses. The taxpayer maintains that
it was not required to recognize the proceeds from the sale
of goods as income in the year it received those proceeds
because the funds were subject to a governmental blocking
order and, under the Claim of Right Doctrine, it did not
have unfettered discretion as to the funds. It also seeks to
deduct the manufacturing costs of other goods in a year
prior to that in which it sold those goods, reasoning that
the Iraqi Sanctions Regulation then in place — which
prohibited the taxpayer from selling those goods — either
was in effect a confiscation or deprived the goods of any
market value. The District Court held in favor of the
Government as to both claims. We affirm.

                        I.    Background
   In 1989, taxpayer Inductotherm Industries, Inc.
(“Inductotherm”),  through   its   subsidiary   Consarc,1
contracted with Iraq to manufacture three vacuum
furnaces. One furnace (“Furnace A”) is an Induction Skull
Melting Furnace. The other two (“Furnaces B and C”) are
Electron Beam Furnaces — a technology that later became

1. For convenience, we refer to Inductotherm and Consarc throughout
this opinion simply as Inductotherm.
                                  3

disfavored and apparently is no longer in widespread use
today. Iraq represented that the furnaces would be used to
manufacture prosthetics for veterans of the Iran-Iraq war.
It later came to light that Iraq instead intended to use the
furnaces in its nuclear weapons program. Inductotherm
was unaware of Iraq’s true intentions.
   As the three furnaces were about to be exported to Iraq,
it invaded Kuwait. In response, on August 2, 1990,
President George H.W. Bush entered an Executive Order —
the Iraqi Sanctions Regulation — blocking all property in
which Iraq had an interest. As applied to Inductotherm, the
Executive Order precluded the sale or transfer of the three
furnaces without the permission of the Office of Foreign
Assets Control (“OFAC”). Moreover, all funds in which
Inductotherm had an interest due to the Iraqi contract were
blocked pursuant to the Executive Order unless OFAC
issued a license unblocking them. See 31 C.F.R. § 575.201,
et seq. At the time, those funds in which Iraq potentially
had an interest included a $6.4 million letter of credit (“LC”)
and Iraq’s $1.1 million deposit for the three furnaces.
Moreover, because Inductotherm had received this $1.1
million deposit, OFAC took the position that Iraq had a
property interest in all three furnaces and thus they were
blocked property.
   To mitigate its losses, Inductotherm attempted to find
new buyers for the furnaces. It sold Furnace A to
Mitsubishi in its 1991 tax year for approximately $1.8
million.2 Rather than place the sale proceeds in a blocked
account, Inductotherm commingled them with other
corporate funds. It was unable to sell Furnaces B and C in
that year. Eventually, however, Inductotherm sold the
furnaces in 1997 to Reading Alloys for what Inductotherm
alleges was less than its production and carrying costs.
  When the Government learned of the Mitsubishi sale, it
directed Inductotherm to block the sale proceeds. On June
17, 1991, during Inductotherm’s 1992 tax year, the
Government confirmed those instructions by issuing a
“Directive License,” which specifically applied the Executive
Order to Inductotherm. Inductotherm disputed, inter alia,

2. Inductotherm’s tax year ends on April 30.
                             4

the applicability of the Executive Order to the sale
proceeds, and protracted litigation ensued in the United
States District Court for the District of Columbia and then
in the United States Court of Appeals for the District of
Columbia Circuit. Ultimately, the D.C. Circuit held that the
furnaces, and the proceeds therefrom, were blocked
property but could be released if Inductotherm placed the
$1.1 million deposit in a blocked account — a procedure
clearly contemplated in the Executive Order. Consarc Corp.
v. United States Treasury Dep’t Office of Foreign Assets
Control, 71 F.3d 909 (D.C. Cir. 1995).
   Meanwhile, when filing its tax returns, Inductotherm did
not record the 1991 Furnace A sale proceeds as taxable
income in 1991, reasoning that, as a result of the Executive
Order and the Directive License, it did not have unfettered
discretion to dispose of the proceeds. It urges that, under
the Claim of Right Doctrine (discussed in Section II below),
if a taxpayer does not have unfettered discretion with
respect to funds, those funds need not be recognized as
income. The IRS disputed Inductotherm’s reasoning and
assessed a tax deficiency. Inductotherm paid the back taxes
on Furnace A as the IRS required and filed suit in the
United States District Court for the District of New Jersey
to recover the alleged overpayment. The Court held against
Inductotherm on this issue, granting summary judgment in
favor of the Government.
   In its 1991 and 1992 tax years, Inductotherm took
deductions on account of the production costs of Furnaces
B and C, despite the fact that it did not sell them until
1997. Inductotherm argued that, while normally costs may
be deducted only in the year that an item is sold, see
United States v. Catto, 384 U.S. 102, 109 (1966), in its case
an exception should apply: as a result of the Executive
Order, the furnaces, in effect, were no longer
Inductotherm’s property and indeed were confiscated from
it. The IRS disallowed this deduction. Again, Inductotherm
paid the required tax deficiency and filed suit to recover.
The District Court granted summary judgment in favor of
the IRS on this claim as well.
                                   5

     Inductotherm appeals both rulings.3

                          II.   Discussion
A.    Furnace A
   Inductotherm argues that it was not required to treat the
sale proceeds for Furnace A as income in 1991 under the
Claim of Right Doctrine. That Doctrine, set out in North
American Oil Consolidated v. Burnet, 286 U.S. 417 (1932),
holds that funds received by a taxpayer will be considered
income if (1) “a taxpayer receives earnings under a claim of
right” and (2) “without restriction as to its disposition,”
“even though it may still be claimed that [the taxpayer] is
not entitled to retain the money, and even though [the
taxpayer] may still be adjudged liable to restore its
equivalent.” Id. at 424.
   Here, Inductotherm has conceded that it received the
Furnace A proceeds under a “claim of right,” i.e., it
acknowledged its entitlement to the proceeds. However, it
disputes that it held the Furnace A proceeds without
restriction as to disposition in 1991. Inductotherm reasons
that the Executive Order, issued during its 1991 tax year,
required it to place the funds in a blocked account (which,
however, it did not do) and thus restricted its discretion as
to those funds in 1991. Inductotherm relies principally on
a line of cases holding that public utilities were not
required to recognize as income customers’ deposits,
prepayments, or “overrecoveries,” which those utilities
clearly were obligated to return, despite the fact that the
utilities commingled the funds (as Inductotherm did). See,
e.g., Commissioner v. Indianapolis Power & Light Co., 493
U.S. 203 (1990) (customer deposits made to assure prompt
payment of future bills not income; even though funds
commingled with general funds, deposits represent merely
loans because customers are entitled to demand return of
funds under specified circumstances); Mutual Tel. Co. v.

3. The District Court had jurisdiction under 28 U.S.C. § 1331. We
exercise jurisdiction pursuant to 28 U.S.C. § 1291. Because the issues in
this appeal are questions of law, our review is plenary. Epstein Family
P’ship v. Kmart Corp., 13 F.3d 762, 765-66 (3d Cir. 1994).
                               6

United States, 204 F.2d 160, 161 (9th Cir. 1953) (monies
utility held in reserve at the direction of the Public Utilities
Commission were not income because “it cannot be said
that the receipts came into the possession of [the utility]
subject to its ‘unfettered command’ and that it was free to
enjoy the receipts at its option”); Florida Progress Corp. v.
Commissioner, 114 T.C. 587, 599 (T.C. 2000) (“Because the
time and method of refunding overrecoveries is controlled
by [agencies] rather than by Florida Power, [it] does not
have complete dominion over the overrecoveries and is not
required to recognize them as income when received.”);
Houston Indus. Inc. & Subs. v. United States, 32 Fed. Cl.
202, 210 (Fed. Cl. 1994) (“overrecoveries” for fuel costs are
not income because “[e]very dollar of overrecovery must
eventually be repaid.”).
  The Government argues that these utility cases are not
analogous because the first prong of the Claim of Right
Doctrine was not satisfied: the utilities did not claim that
they were entitled to the funds for their own benefit.
Rather, they conceded at all times that they held the funds
in a fiduciary capacity or, at least, with a clear obligation to
return the funds. Moreover, as to the second prong, the
utilities’ discretion with respect to the funds was at all
times limited by extensive regulatory oversight by state
administrative agencies. The Government directs our
attention instead to James v. United States, 366 U.S. 213
(1961), which held that money embezzled must be included
in income, even though it likely would have to be disgorged
in the future. Just as Inductotherm argues that its
commingling of the Furnace A proceeds is not dispositive
under the utility cases, the Government cites James for the
proposition that Inducotherm’s legal duty to block the
proceeds under the Executive Order is likewise not
dispositive. In James, it was clear that the embezzler had
no right to the funds at issue. Nonetheless, because the
embezzler treated the funds as his own during the relevant
tax year, he was required to recognize those funds as
income.
  We agree with the Government. As already noted,
Inductotherm’s concession (no doubt correct) that it
asserted title to the proceeds of Furnace A’s sale in 1991
answers the first prong of the Claim of Right Doctrine.
                                  7

   As to the Doctrine’s second prong (no disposition
restriction on the sale proceeds), Inductotherm, having
commingled the funds instead of blocking them, placed
itself in a position of complete dominion over those funds
(at least during the 1991 tax year). In this context, the
Executive Order was “a potential or dormant restriction . . .
which depends on the future application of rules of law to
present facts [and therefore was] not a ‘restriction on use’
within the meaning of North American Oil v. Burnet.” Healy
v. Commissioner, 345 U.S. 278, 284 (1953). The
Government was entitled to prosecute Inductotherm for
failure to comply with the Executive Order. However, as
with any regulation or criminal law, the Government had
the discretion not to pursue Inductotherm’s Executive
Order violation. Thus, Inductotherm’s control over the
Furnace A proceeds was analogous to that of the embezzler
in James.4 See also Continental Illinois Corp. v.
Commissioner, 998 F.2d 513 (7th Cir. 1993) (because
bank’s obligation to refund interest paid over a known
percentage is contingent on the fulfillment of conditions by
the debtor, and thus the obligation is uncertain, bank must
treat interest as income in year received).
  That Inductotherm was required after the conclusion of
the 1991 tax year to block the Furnace A proceeds is in no
way relevant to the analysis. There are numerous cases in
which a taxpayer treated funds as its own in one year, only
to find that it was required to disgorge them in a later year.
In all these cases, courts required the taxpayer to recognize
the funds as income in the year received, notwithstanding
the later disgorgement. See, e.g., Healy, 345 U.S. 278
(salary a taxpayer earned in one year from a closed
corporation in which he was an officer and stockholder,
which had to be returned to the company in a subsequent
year because it was excessive compensation, was income in
the year the salary was earned); Wentworth v.
Commissioner, 510 F.2d 883 (6th Cir. 1975) (taxpayer
whose stock was illegally redeemed was required to
recognize proceeds from redemption in year he received

4. While we do not suggest that Inductotherm’s behavior was criminally
culpable (as was that of the taxpayer in James), its position for tax
purposes is legally indistinguishable.
                                8

them, despite later duty to return proceeds); United States
v. Lesoine, 203 F.2d 123 (9th Cir. 1953) (taxpayer properly
included dividend as income in the year it was received,
even though it was later determined that dividend had to be
repaid to corporation because there was insufficient
surplus for payment); Saunders v. Commissioner, 101 F.2d
407 (10th Cir. 1939) (sums taxpayers received from the sale
of corporation’s capital stock were income, although
taxpayers returned money to corporation on advice of
counsel, who said that taxpayers were not entitled to
receive funds).
  In this context, the Claim of Right Doctrine does not
shield the Furnace A proceeds from being income in 1991.
B.   Furnaces B and C
   Inductotherm sold Furnaces B and C in 1997. However,
it sought to deduct production costs of those furnaces in its
1991 and 1992 tax years. In the District Court,
Inductotherm claimed that the Executive Order was in
effect a confiscation that deprived it of its property rights in
those two furnaces and thus, under § 165(a) of the Internal
Revenue Code,5 it was entitled to deduct the costs of the
furnaces when the Executive Order went into effect.
   26 C.F.R. § 1.165-1 sets out a two-prong test for
determining whether a taxpayer may recognize a loss under
§ 165(a) in a given year. There must be: (1) a closed and
completed transaction fixed by identifiable events and (2)
no reasonable prospect of recovery. Inductotherm contends
that the promulgation of the Executive Order was a closed
and completed transaction with respect to Furnaces B and
C, and in 1991 and 1992 there was no reasonable prospect
that it would recover the furnaces.
  This argument fails. First, other courts have held, as a
matter of law, that a blocking order is not a closed and
completed transaction because it is merely a temporary
restriction on the use of property. See, e.g., Tran qui Than
v. Regan, 658 F.2d 1296, 1301 (9th Cir. 1981) (“The

5. 26 U.S.C. § 165(a) provides that “[t]here shall be allowed as a
deduction any loss sustained during the taxable year and not
compensated for by insurance or otherwise.”
                                 9

blocking of the assets . . . does not affect the interest, right
or title to them which [the taxpayer] may possess. The
blocking action merely suspends indefinitely the right to
transfer those funds.”) (internal citation omitted); Nielsen v.
Sec’y of the Treas., 424 F.2d 833, 843-44 (D.C. Cir. 1970)
(“The blocking of accounts is generally recognized as
different from taking, though raising a problem of taking ‘if
continued indefinitely.’ ”). Moreover, we note that a taxpayer
may not recognize a loss unless it has exhausted its
remedies to reduce its loss. Investors Diversified Servs., Inc.
v. Commissioner, 325 F.2d 341, 350 (8th Cir. 1963). In this
case, Inductotherm could have sought a license from OFAC
to unblock Furnaces B and C. See 31 C.F.R. §§ 575.202(c),
575.203(c). Yet it did not do so.
   On appeal, Inductotherm sets out what it acknowledges
is a new theory for deducting the costs of Furnaces B and
C in 1991 and 1992. It argues that, because electron-beam
furnaces such as Furnaces B and C used a disfavored
technology, the Executive Order’s promulgation deprived it
of the only available market for the furnaces — Iraq, leaving
the furnaces with little or no resale value. In this context,
Inductotherm contends that it was entitled to recognize a
loss under 26 C.F.R. § 1.471-2, which directs companies to
value their inventory at the lower of cost or market value
and allows write-downs based on declines in inventory
value (e.g., for obsolescence).6
  Ironically, Inductotherm expressly disclaimed reliance on
this theory before the District Court. In response to an
interrogatory from the Government, Inductotherm stated,
“Plaintiff claims the deductions taken in fiscal years 1991
and 1992 because of the lack of control over the assets as
a result of the freeze on the assets as issued by President
Bush, not because there was an actual loss of value to the
actual assets.” The response went on explicitly to state,
“Plaintiffs do not assert that the deductions were taken
pursuant to Section 471.”
  In light of Inductotherm’s express disclaimer in the
District Court, we decline to entertain this new argument

6. Regulation § 1.471-2 complements § 471 of the IRC, which sets out
the general rule for valuing inventories.
                                   10

on appeal.7 Moreover, considering this argument would
require calculating the decline in market values of Furnaces
B and C that the Executive Order caused. Yet Inductotherm
has failed to enter into the record any data that would
enable us (or the District Court on remand) to perform this
inquiry.8 Having failed to meet its burden, we decline to give
Inductotherm a second turn at bat.9
                         * * * * * * * * * * *
  Under the Claim of Right Doctrine, Inductotherm was
required to recognize proceeds from the sale of Furnace A
in the year it received those proceeds, 1991. Moreover,
Inductotherm did not adequately prove its entitlement to
deduct costs associated with Furnaces B and C in 1991
and 1992. We therefore affirm the District Court’s grant of
summary judgment in favor of the Government.

A True Copy:
        Teste:

                       Clerk of the United States Court of Appeals
                                   for the Third Circuit

7. Inductotherm also makes essentially the same argument under IRC
§ 165, contending that because of the Executive Order Furnaces B and
C were unsaleable on the open market and therefore it was permissible
to recognize their decline in value in 1991 and 1992. Because
Inductotherm’s response to the Government’s interrogatory stated that it
did not claim “an actual loss of value to the actual assets,” which is the
factual underpinning of this new § 165 argument, we deem this
argument waived on appeal as well.
8. Inductotherm argues that it provided this information in its position
letter to the IRS, attached to the complaint. However, the position letter
contains no “evidence” as such, but rather Inductotherm’s arguments
that the end-of-year value of Furnaces B and C was $0 because the
Executive Order deprived them of any market value. These assertions,
without more, do not provide a basis for a court to calculate Furnaces
B and C’s decline in value.
9. While we will consider arguments raised for the first time on appeal
“where a gross miscarriage of justice would occur,” Kahn v. United
States, 753 F.2d 1208, 1222 n.8 (3d Cir. 1985), this is not such a case.