Court Opinion

ID: 4330866
Source: CourtListenerOpinion
Date Created: 2018-11-13 23:51:53.825836+00
Date Added: 2024-06-11T14:47:23.482430
License: Public Domain

107 T.C. No. 17

                   UNITED STATES TAX COURT

THE CHARLES SCHWAB CORPORATION AND INCLUDABLE SUBSIDIARIES,
      Petitioner v. COMMISSIONER OF INTERNAL REVENUE,
                         Respondent

  Docket No.   1271-92.                     Filed November 14, 1996.

       P, an accrual basis taxpayer, provides discount
  securities brokerage services for which it earns a
  commission fee. As a discount broker, P does not
  engage in activities, such as research and portfolio
  management, that are normally conducted by a full-
  service broker. P executes a customer’s order to buy
  or sell securities on the trade date, but the
  securities are not actually transferred and payment is
  not due until the settlement date, which was generally
  5 days after the trade date. Between those dates, P
  performs certain functions to record, confirm, and book
  the customer’s trade.

       P commenced business in the State of California on
  Apr. 1, 1987. P deducted its California franchise
  taxes based on income for its first year ended Dec. 31,
  1987, on its Federal income tax return for the taxable
  year ended Mar. 31, 1988. P then changed to a calendar
  year for Federal income tax purposes and is attempting
  to deduct its California franchise taxes based on
                               - 2 -

     income for its second year on its Federal income tax
     return for the taxable year ended Dec. 31, 1988.

          Held: Under the "all events" test, P must accrue
     commission income for the purchase or sale of
     securities on the trade date as opposed to the
     settlement date.

          Held, further: Under California law, P's
     liability for franchise taxes based on its income
     during its second year ended Dec. 31, 1988, was fixed
     on that date. Sec. 461(d), I.R.C., which would act to
     disallow the accrual of State taxes "to the extent that
     the time for accruing taxes is earlier than it would be
     but for any action of any taxing jurisdiction taken
     after December 31, 1960" does not apply because under
     California law as it existed prior to Dec. 31, 1960,
     all events fixing P's liability for franchise tax based
     on income earned during its second year would have
     accrued on Dec. 31 of its second year.

     Philip C. Cook, Terence J. Greene, Timothy J. Peaden,

Karen S. Sukin, Ben E. Muraskin, Michelle M. Henkel,

Glenn A. Smith, Michael R. Faber, Teresa A. Maloney, for

petitioner.

     Usha Ravi, Steven A. Wilson, and Emily Kingston, for

respondent.

     RUWE, Judge:   Respondent determined deficiencies in

petitioner’s Federal income taxes for the taxable years ending

March 31, 1988, and December 31, 1988, in the amounts of

$16,136,176 and $12,146,497, respectively.

     After concessions, the issues remaining for decision are:

(1) Whether petitioner must accrue brokerage commission income on

the date a trade is executed or on the settlement date; and (2)
                                - 3 -

whether petitioner is entitled to a deduction for its California

franchise tax liability in the amount of $932,979 on its Federal

income tax return for the 9-month period ending December 31,

1988.

       Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

                          FINDINGS OF FACT

       Some of the facts have been stipulated and are so found.

The stipulation of facts and supplemental stipulation of facts

are incorporated herein by this reference.    At the time its

petition was filed, petitioner’s principal place of business was

located in San Francisco, California.

       Petitioner is a consolidated group consisting of The Charles

Schwab Corp.; its first-tier subsidiary, Schwab Holdings, Inc.;

and its second-tier operating subsidiary, Charles Schwab & Co.,

Inc.    Petitioner provides discount securities brokerage and

related financial services, primarily to individuals, throughout

the United States.    During the years in issue, petitioner was a

member of all major U.S. securities exchanges and had software

links with all registered U.S. securities exchanges, major

dealers, the National Securities Clearing Corp., and the

Depository Trust Co.    During the relevant years, petitioner filed
                               - 4 -

consolidated Federal income tax returns and computed its taxable

income under the accrual method of accounting.

     Charles Schwab & Co., Inc., the operating subsidiary, was

incorporated in 1971 as the First Commander Corp. under the laws

of the State of California.   First Commander Corp. changed its

name to Charles Schwab & Co., Inc. (Schwab & Co.), in 1973 after

Charles R. Schwab became its owner and chief executive officer.

     Schwab & Co. initially conducted a retail securities

brokerage business from a single office in California and

published an investment advisory newsletter.   In 1974, Schwab &

Co. took advantage of a trial period during which the Securities

& Exchange Commission (SEC) permitted discounts on securities

commissions.   On May 1, 1975, the SEC abolished fixed commission

rates, and Schwab & Co. engaged exclusively in discount

securities brokerage transactions by focusing its marketing

efforts on investors who wished to conduct their own research,

make their own investment decisions, and avoid paying brokerage

commissions for research, advice, and portfolio management.

     In November 1982, Schwab & Co.’s parent company, Schwab

Holdings, Inc. (which, at that time, was called The Charles

Schwab Corp.), agreed to merge into BankAmerica Brokerage Co.

(BBC), a wholly owned subsidiary of BankAmerica Corp.

(BankAmerica).   As a result of the merger, Schwab & Co. became a

wholly owned subsidiary of BBC.    In January 1983, BBC changed its

name to The Charles Schwab Corp.
                               - 5 -

     On March 31, 1987, Charles R. Schwab, through CL Acquisition

Corp. (currently known as The Charles Schwab Corp.), purchased

from BankAmerica the stock of The Charles Schwab Corp. (formerly

BBC and currently known as Schwab Holdings, Inc.), and its wholly

owned subsidiary, Schwab & Co., in a management-led leveraged

buyout.

Commission Income Issue

     One of petitioner's primary sources of revenue is commission

income, which is earned by effecting sales and purchases of

stocks and other securities for its customers in a rapid,

efficient, and cost effective manner.

     The primary service performed by petitioner in effecting

sales and purchases of stocks and securities on behalf of

customers is the execution of trade orders.   Petitioner does not

engage in many of the other activities in which full-commission,

full-service brokerage firms engage, such as underwriting,

market-making, arbitrage, research, and portfolio management.

Petitioner also does not solicit transactions in any particular

security and does not offer investment advice to its customers

about the nature, potential value, or suitability of any

particular security.   Nor does petitioner exercise any

discretionary authority over customer accounts or, with certain

limited exceptions, engage in principal transactions in any

security.
                               - 6 -

     Petitioner's strategy is to serve self-directed customers,

focusing on those who do not need or want to pay, through

commissions, for research, investment advice, or portfolio

management.   As a result, a customer could save up to 76 percent

compared to rates charged by full-commission brokers.    By

concentrating on unsolicited transactions on an agency basis,

petitioner substantially avoids the risk of losses and

liabilities faced by full-commission firms that engage in

investment banking, underwriting, market-making, arbitrage, and

other advisory and principal activities.   Moreover, petitioner's

customers are not assigned to a particular representative but,

instead, may trade with any available representative.    As a

result, the departure of a registered representative from

petitioner does not typically result in a loss of customers.

     The "trade date" is the day a trade occurs.   On this day, a

customer’s order is executed by locating a seller or purchaser

for securities on terms acceptable to the customer.   The date on

which petitioner settles the accounts of a customer whose order

to buy or sell securities has been executed is termed the

"settlement date".   Settlement is the process of transferring

payment from buyer to seller and certificates from seller to

buyer.   When customers buy securities, petitioner must receive

the full confirmed amount due no later than the settlement date.

When customers sell securities, petitioner must receive the stock

certificates, properly endorsed, by the settlement date.
                               - 7 -

     In 1988, there was no Federal rule that mandated a specific

settlement cycle for securities transactions.1   Instead, the

settlement cycle in the United States varied among markets and

was largely a function of market custom, exchange rules, and

industry practice.   The rules of the New York Stock Exchange,

however, required transactions to be settled no later than the

fifth business day after the trade date.

     After a customer’s order is received, petitioner transmits

the order to the exchange floor for execution via the exchange’s

system or through floor brokers.   A report of execution, which

lists the transactions in terms of shares purchased or sold, but

not by customer name or account number, is returned to the firm

as a trade record.   After the trade is executed and while the

customer is still on the telephone, petitioner can verbally

confirm the execution for "market" orders2 placed via telephone

while the markets are open.   The price paid or received by the

customer for the purchase or sale of securities is determined

according to the market price in effect on the trade date.

     Petitioner must perform a series of functions after the

order is placed and the trade executed.    These functions, which

     1
      See infra note 4.
     2
      A "market" order is an order from a customer to buy or sell
securities as soon as practicable at the then-current market
price. This is in contrast to a "limit" order, which is an order
to buy or sell securities when the market reaches a price level
specified by the customer.
                               - 8 -

are performed up until settlement, consist of (i) recording, (ii)

figuration, (iii) confirmation, (iv) comparison, and (v) booking.

     In the recording function, each transaction is coded, and

each trade is assigned a number that identifies the issuer and

the issue.   The place of execution (i.e., a stock exchange) is

also coded along with any other details needed to process the

trade properly.

     In the figuration function, petitioner computes the contract

money, commission to be earned, taxes, fees, and all other

related money amounts associated with the trade during nightly

batch processing on the day the trade is executed.    The net is

the amount that the customer must pay in the case of a purchase

or is entitled to receive in the case of a sale.    The results of

the figuration function are available, in written format, on the

morning following the trade date.   In addition, petitioner can

apprise a customer of the commission cost of any trade at the

time of the execution of the trade by accessing a computer screen

designed to compute commissions on customer trades.

     The confirmation function involves mailing a written

notification to the customer, usually on the first business day

after the trade is executed.   The confirmation serves as an

invoice and written notification of the trade.    The confirmation

contains the following information:    (1) A description of the

trade, including the name of the security, quantity, execution

price, settlement money, commission, and other fees; (2) trade
                                - 9 -

date; (3) settlement date; (4) place of execution; (5) capacity

in which the firm acted; (6) customer’s name and address; (7)

customer’s account number; (8) type of customer account; and (9)

the amount due.    Petitioner also encloses a remittance stub and a

return envelope with the confirmation.

     The comparison function, which is required by the National

Association of Securities Dealers, Inc., and which generally

begins on the first day following the trade date, is the process

by which customers’ trades are balanced or reconciled against the

opposing brokerage firm’s transactions.    This is done through the

clearing facilities of the exchanges where petitioner holds

memberships.    In addition to the broker-to-broker comparison,

petitioner also compares the report of execution to its trade

record, which represents the customer’s order.

     Petitioner and the clearing facility attempt to resolve

"uncompared trades" (i.e., those trades whose terms do not match

or compare in some respect between petitioner and the opposing

firm) by the next business day following the execution of a

customer order.    However, the resolution of open items continues

until all trades are balanced, which may not occur until the

settlement date, to ensure that petitioner is not undergoing any

undue risk.    If petitioner has an uncompared trade that was

unreconciled, it will be required to enter the marketplace and

buy or sell to cover the trade.
                              - 10 -

     In the booking function, the customer’s transaction is

entered on petitioner’s records, including the recording of fees

and commissions due to petitioner.

     Unlike many other discount brokers, who depend on third-

party vendors, petitioner performs all execution, clearing, and

account maintenance functions for its customers.   This enables

petitioner to gain greater control over the quality of customer

service and to retain free credit balances and securities for use

in margin lending.

     On the settlement date, petitioner physically effects the

delivery of the securities and receipt of the sale price, in the

case of a sale, or receipt of the securities and delivery of the

purchase price, in the case of a purchase.   When a customer of

petitioner sells securities that are not held by petitioner in

street name,3 the certificates must be properly endorsed and

received by petitioner by settlement date.   If a customer of

petitioner already has sufficient funds in his or her account,

petitioner automatically uses these funds on the settlement date

to pay for securities purchased, even though the confirmation

indicated an amount due.   If petitioner does not receive payment

for securities purchased by the customer by the settlement date,

     3
      Securities are said to be carried in "street name" when
they are held in the name of the broker instead of the customer's
name. Holding securities in street name allows for ease of
transfer by the broker and convenience to the customer, because
it avoids the necessity of obtaining the customer's endorsement
to transfer the security.
                              - 11 -

petitioner reserves the right to cover the position, and the

customer is responsible for any loss resulting from the execution

of the trade order.

     A security is not debited or credited to the customer’s

account until the actual settlement date.    The settlement date is

also important for purposes of determining who is entitled to

receive dividends paid on stock and interest that has accrued on

bonds.   Dividends are paid to the holders of record (i.e., those

persons in whose name the stock is registered).   If a transaction

occurs, but does not settle prior to the dividend record date or

if the security is not re-registered in the new name by the

record date, the buyer is not entitled to the dividend.     Bonds

trade at market price plus accrued interest.   Interest continues

to accrue to the bond’s seller up to, but not including, the

settlement date.

     As a general rule, petitioner does not permit cash and next-

day orders.   In the event of customer hardship, such as a medical

emergency or an escrow closing, however, proceeds from a sale can

be paid to a customer prior to settlement.   In such instances,

the customer is charged a special prepayment fee of the greater

of $10 or 0.2 percent of principal in addition to the standard

commission for the trade.

     There was generally a 5-day delay between the trade and

settlement dates.   The 5-day delay between the trade and

settlement dates allows sufficient time to reflect the trade in
                                - 12 -

petitioner’s books and records and to deliver the securities.

The securities clearance and settlement system is exposed to

several sources of risk including market risk, participant or

credit risk, and external risk, such as a domestic or

international event.   A reduction of the time between trade

execution and settlement can make the settlement cycle safer, but

such reduction is not without obstacles, which would require

changing established settlement practices and educating retail

and institutional investors.4

     Mistakes can occur in placing the customer order, such as

trading the wrong security or quantity of securities, selling the

security when instructed to buy and vice versa, or performing

figuration incorrectly.   Petitioner determines if the error is a

representative error or a customer error by reviewing a tape

recording of the telephone order, if available.

     4
      The SEC adopted a new rule under the Securities Exchange
Act of 1934, ch. 404, 48 Stat. 881, which establishes a 3-
business-day settlement period for broker-dealer trades,
effective June 1, 1995. 17 C.F.R. sec. 240.15c6-1 (1996). The
new rule is designed to: (i) Reduce settlement risk, the risk to
clearing corporations, their members, and public investors
inherent in settling securities transactions by reducing the
number of unsettled trades in the clearance and settlement system
at any given time; (ii) reduce the liquidity risk among the
derivative and cash markets and reduce financing costs by
allowing investors that participate in both markets to obtain the
proceeds of securities transactions sooner; and (iii) facilitate
risk reduction by achieving closer conformity between the
corporate securities markets and Government securities and
derivative securities markets that currently settle in fewer than
5 days. 58 Fed. Reg. 52891 (Oct. 13, 1993).
                                - 13 -

     No customer of petitioner can cancel an order that is

executed in accordance with the customer’s instructions.     If

petitioner made an error, the customer is made whole by canceling

the transaction and rebilling it.    When transactions are canceled

and rebilled, new trade confirmations are generated and sent to

the customer, showing both the canceled trade information and the

corrected trade information.    When petitioner cancels and rebills

a customer for a trade that it incorrectly executed, the customer

is liable only for the amount determined according to

circumstances existing on the original trade date.

     Individual trades may be canceled if an entire transaction

is canceled.   For example, a customer’s trade would be canceled

if an initial public offering were canceled after trading was

initiated.   In these instances, the trades never settle and

petitioner collects no commission.

     For the taxable year ended December 31, 1988, petitioner

accrued commission income on the purchase or sale of securities

on the settlement date for tax and book purposes.    Petitioner’s

trades that were executed in 1988, but settled in 1989, resulted

in $3,357,576 net commission income.

Franchise Tax Issue

     Petitioner qualified to do business in California on

February 9, 1987.     Petitioner commenced business in California on

April 1, 1987.
                              - 14 -

     Petitioner elected a calendar taxable year for California

income and franchise tax purposes.     Petitioner’s first Federal

taxable year ended on March 31, 1988, but petitioner changed its

Federal taxable year to a calendar year for its second and

subsequent years.

     Petitioner reported California franchise tax in the amount

of $879,500 on its first California Franchise or Income Tax

Return (Form 100) for the income year ending December 31, 1987,

and paid such amount with its return.     Petitioner deducted this

amount on its Federal return filed for the taxable year ended

March 31, 1988.

     For the income year ending December 31, 1988, petitioner

reported California franchise tax in the amount of $932,979 on

its second California Franchise or Income Tax Return (Form 100)

and paid such amount with its return.     On its Federal return

filed for the taxable year ended December 31, 1988, petitioner

did not deduct the franchise tax that it paid for California

income year 1988.   Petitioner now claims that this was an error

and that it should be entitled to deduct the 1988 franchise tax

for its taxable year ended December 31, 1988.

                              OPINION

Commission Income Issue

     The first issue we must decide is whether petitioner, an

accrual basis taxpayer, must accrue brokerage commission income
                                - 15 -

on the trade date or on the settlement date.    Neither party

cites, nor did we find, any cases directly on point.5    The

question of when an accrual basis securities broker must accrue

commissions earned on securities transactions appears to be one

of first impression.

     Petitioner kept its books and records and filed its income

tax returns using the accrual method of accounting.     Under the

accrual method, income is to be included for the taxable year

when (1) all the events have occurred that fix the right to

receive such income, and (2) the amount can be determined with

reasonable accuracy.   Secs. 1.446-1(c)(1)(ii), 1.451-1(a), Income

Tax Regs.   The parties do not dispute that the second prong of

the test--that the amount of the commissions can be determined

with reasonable accuracy--is met as of the trade date.     Our

discussion is thus limited to whether petitioner had a fixed

right to receive the commission income as of that date.

     Under the all events test, it is the fixed right to receive

the income that is controlling and not whether there has been

actual receipt thereof.   Spring City Foundry Co. v. Commissioner,

292 U.S. 182, 184-185 (1934).    The taxpayer’s right to receive

income is fixed upon the earliest of (1) the taxpayer’s receipt

     5
      We note that in Rev. Rul. 74-372, 1974-2 C.B. 147, the IRS
ruled that a stock brokerage business using the accrual method of
accounting must accrue commission income on the trade date,
rather than on the settlement date. Respondent's position herein
is consistent with this ruling.
                               - 16 -

of payment, (2) the contractual due date, or (3) the taxpayer’s

performance.   See Schlude v. Commissioner, 372 U.S. 128, 133, 137

(1963); Cox v. Commissioner, 43 T.C. 448, 456-457 (1965).    An

accrual basis taxpayer must report income in the year the right

to such income accrues, despite the necessity for mathematical

computations or ministerial acts.   Continental Tie & Lumber Co.

v. United States, 286 U.S. 290, 295-297 (1932); Dally v.

Commissioner, 227 F.2d 724 (9th Cir. 1955), affg. 20 T.C. 894

(1953); Resale Mobile Homes, Inc. v. Commissioner, 91 T.C. 1085,

1095 (1988), affd. 965 F.2d 818 (10th Cir. 1992).    Moreover, the

fact that a taxpayer cannot presently compel payment of the money

is not controlling.   Commissioner v. Hansen, 360 U.S. 446, 464

(1959).

     Petitioner argues that its commission is earned when

delivery of the securities and payment of the purchase price

occur, which is not until the settlement date.    According to

petitioner, the acts that it performs between the trade date and

the settlement date are not merely ministerial.    Rather, they are

integral parts of the service for which it is paid a commission,

and they represent a substantial percentage of the total discount

brokerage services provided.   Respondent, on the other hand,

argues that execution of an order on behalf of a customer is the

essential service that petitioner performs and is the time at

which petitioner’s right to receive, and the customer’s

obligation to pay, the commission arises.   According to
                              - 17 -

respondent, all the actions that remain to be performed by

petitioner after the trade date are of a ministerial nature to

effectuate the mechanics of the transfer and are merely in

confirmation of the trade executed.    We agree with respondent.

     Petitioner is a member of all major U.S. securities

exchanges.   The essential service that petitioner provides to its

customers is the execution of trades through its access to the

securities exchanges.   It is through this access that the

customer acquires the ability to make a trade.    Indeed,

petitioner’s statement of Terms and Conditions, which states the

agreement between petitioner and the customer, provides that

petitioner "executes orders for securities only and does not give

investment advice."   There is no mention of posttrade services,

such as recording, confirmation, or booking.

     Moreover, the price of the securities that a customer

purchases or sells and the amount of commission due to petitioner

are determined as of the trade date.    If petitioner does not

receive payment on a purchase or sale order executed for the

customer, it liquidates the customer’s account to collect the

amount, including the commission, determined on the trade date.

Upon execution of a customer order, a written confirmation is

generated automatically and is sent to the customer on the next

business day following the trade date.    The written confirmation

serves as an invoice and as written notification to the customer

of the trade.   The confirmation statement itemizes the total cost
                              - 18 -

of the trade, including the amount of the commission, and lists

the total "amount due".   Petitioner encloses a remittance stub

and a return envelope with the confirmation.   The customer does

not have the right to cancel an order that petitioner executes in

accordance with the instructions of the customer.

     In applying the all events test, this and other courts have

distinguished between conditions precedent, which must occur

before the right to income arises, and conditions subsequent, the

occurrence of which will terminate an existing right to income,

but the presence of which does not preclude accrual of income.

Central Cuba Sugar Co. v. Commissioner, 198 F.2d 214, 217-218 (2d

Cir. 1952), affg. in part and revg. in part 16 T.C. 882 (1951);

Wien Consol. Airlines, Inc. v. Commissioner, 60 T.C. 13, 15

(1973), affd. 528 F.2d 735 (9th Cir. 1976); Buckeye Intl., Inc.

v. Commissioner, T.C. Memo. 1984-668; see also Resale Mobile

Homes, Inc. v. Commissioner, 965 F.2d 818, 824 (10th Cir. 1992),

affg. 91 T.C. 1085 (1988).6

     We think the above factors indicate that petitioner’s

execution of a trade for a customer is a condition precedent that

     6
      Although Central Cuba Sugar Co. v. Commissioner, 198 F.2d
214, 217-218 (2d Cir. 1952), affg. in part and revg. in part 16
T.C. 882 (1951), Wien Consol. Airlines, Inc. v. Commissioner, 60
T.C. 13, 15 (1973), affd. 528 F.2d 735 (9th Cir. 1976), and
Buckeye Intl., Inc. v. Commissioner, T.C. Memo. 1984-668,
involved the accrual of deductions rather than the proper
reporting of income, this Court has recognized that similar
considerations apply with respect to both issues. See Simplified
Tax Records, Inc. v. Commissioner, 41 T.C. 75, 79 (1963); Buckeye
Intl., Inc. v. Commissioner, supra.
                              - 19 -

fixes petitioner’s right to receive the commission income.     The

functions that remain to be performed by petitioner after the

trade date are of a ministerial nature to effectuate the

mechanics of the transfer and confirm the trade executed.

Although failure to perform these functions may ultimately divest

petitioner of its right to the commission income, we think that

these functions are conditions subsequent and, therefore, do not

preclude accrual of commission income on the trade date.

     Nor does the possibility that an executed trade may not

settle due to cancellation of an entire public offering make

petitioner’s right to the commission income too indefinite or

contingent for accrual.   See Brown v. Helvering, 291 U.S. 193,

199-200 (1934) (holding that overriding commissions received by a

general agent for policies written must be accrued even though

there was a contingent liability to return a portion of the

commission in the event the policy was canceled); Georgia School-

Book Depository, Inc. v. Commissioner, 1 T.C. 463, 468-470 (1943)

(holding that a book broker that represented publishers in sales

of school books to the State of Georgia must accrue commission

income, despite the fact that the State was obligated to pay for

the books only out of a particular fund, and, during the years in

issue, the fund was insufficient to pay for the books in full).

The possibility that a trade might not finally be settled is, if

anything, a condition subsequent to the execution of the trade,

which was the event that fixed petitioner's right to the
                              - 20 -

commission.   See Central Cuba Sugar Co. v. Commissioner, supra at

217-218 (holding that sales commission expenses were deductible

in the year the taxpayer entered the contract for sale even

though they were not payable until delivery, and even though the

commission expenses were subject to adjustment in accordance with

final weighing before shipment and forfeiture if the contract

were not carried out).

     Petitioner argues that unlike full-commission securities

brokers who engage in a full range of activities, such as

research and portfolio management, the functions performed by

petitioner between the trade and settlement dates represent a

substantial percentage of the services provided by petitioner to

its brokerage customers.   According to petitioner, the commission

income received by petitioner does not represent payment for

investment advice or other pretrade services, but rather is a fee

for the specific services of executing the transaction and

handling the mechanics of the transfer of title and delivery on

the settlement date.   Therefore, petitioner argues, even if the

posttrade activities conducted by a full-commission broker are

considered ministerial, they cannot be considered ministerial

when performed by a discount broker such as petitioner.

     While we appreciate the differences in the services provided

by full-commission and discount brokers, we cannot agree that

ministerial acts that constitute conditions subsequent to a

customer’s obligation to pay commissions are converted to
                               - 21 -

conditions precedent merely because they may comprise a

significant percentage of the overall activities conducted by the

broker.

     Petitioner argues that this case is governed by Hallmark

Cards, Inc. v. Commissioner, 90 T.C. 26 (1988).    In Hallmark, a

manufacturer and seller of greeting cards shipped its Valentine

merchandise to customers in the year prior to that in which the

holiday occurred.    The terms of the sale specified that title and

risk of loss did not pass to the customer until January 1 of the

year following the shipment.    This Court held that the taxpayer’s

right to income from the sale became fixed only upon passage of

title and risk of loss to the purchasers, notwithstanding that

delivery of the goods had occurred earlier.    Id. at 32-33.

Petitioner argues that because title to the securities does not

pass, and petitioner is not relieved of its risk of loss until

the settlement date, its right to the commission income is not

fixed until the settlement date.

     Hallmark v. Commissioner, supra, is distinguishable from the

instant case.    In Hallmark, the taxpayer was a manufacturer and

seller of goods.    Thus, passage of title and risk of loss

constituted the essence of the transaction; without such passage,

no sale occurred.    Conversely, the present case involves a

service provider that executes securities trades as an agent of

its customers.   We think that the focus in this case must be on

the contractual relationship between petitioner and its customer,
                              - 22 -

not on the relationship between the customer and the purchaser or

seller of the securities.7   The agreement between petitioner and

its customers was that any trade executed by petitioner in

accordance with the customer's instructions could not be

canceled.   In contrast, the customer in Hallmark had the right to

return the merchandise without penalty until title passed.     Id.

at 33.   The essence of the transaction between petitioner and its

customer is the execution of a trade on behalf of the customer.

     Accordingly, we uphold respondent’s determination that

petitioner must accrue commission income for the purchase or sale

of securities on the trade date as opposed to the settlement

date.

California Franchise Tax Issue

     The next issue we must decide is whether petitioner is

entitled to a deduction for its California franchise tax

liability in the amount of $932,979 on its Federal income tax

return for the taxable year ended December 31, 1988.

Respondent does not dispute that petitioner properly deducted

$879,500 on its Federal return for the taxable year ended March

     7
      We note, however, that the legislative history of the Tax
Reform Act of 1986 indicates that for Federal income tax
purposes, both cash and accrual method taxpayers must recognize
gain or loss on the sale of securities traded on an established
market on the date the trade is executed. S. Rept. 99-313
(1986), 1986-3 C.B. (Vol. 3) 131. Such treatment, while not
controlling as to brokerage commissions, is consistent with our
holding herein.
                               - 23 -

31, 1988, for the franchise tax it paid for the California income

year 1987.    Regardless of whether the franchise tax properly

accrued on December 31, 1987, as petitioner contends, or on

January 1, 1988, as respondent contends, both parties agree that

the deduction was proper in petitioner’s first Federal taxable

year.    Instead, the parties’ dispute centers on the deductibility

of the California franchise tax for petitioner’s second Federal

taxable year.

     To understand the crux of the dispute, it is necessary to

understand some of the history with respect to the California

franchise tax.    California imposes an annual franchise tax on

most corporations doing business within the State of California

for the privilege of exercising their corporate franchises.      Cal.

Rev. & Tax. Code sec. 23151(a) (West 1992).    In general, the tax

computed for the "taxable year"8 is based upon the net income of

the preceding year, which is designated the "income year".       Id.

secs. 23041(a), 23042(a), 23151(a) (West 1992).

     Prior to the 1972 amendments to the California franchise tax

statutes, the California franchise tax generally accrued on the

first day of the taxable year.    In Central Inv. Corp. v.

Commissioner, 9 T.C. 128, 132-133 (1947), affd. per curiam 167

F.2d 1000 (9th Cir. 1948), we held that even though the

     8
      The "taxable year" is the year for which the California
franchise tax is payable. Cal. Rev. & Tax. Code sec. 23041(a)
(West 1992)
                              - 24 -

California franchise tax was measured by the preceding year’s

income, accrual basis taxpayers could accrue the tax only during

the taxable year.   Under pre-1972 law, withdrawal or dissolution

relieved the taxpayer from taxation for the period of the taxable

year during which the corporate franchise was not exercised.    The

tax was essentially a tax on the privilege of doing business in

the taxable year.   Id. at 133.   All events fixing a corporation's

liability for the California franchise tax did not occur until

the taxable year in which it exercised its privilege.     Epoch Food

Serv., Inc. v. Commissioner, 72 T.C. 1051, 1053 (1979).

     In 1972, California amended its franchise tax law so that

withdrawal or dissolution would no longer relieve a taxpayer from

tax based on the preceding year's income.    In Epoch Food Serv.,

Inc. v. Commissioner, supra at 1054, we found that the effect of

this amendment was to change the accrual date for the tax from

January 1 of the taxable year to December 31 of the income year.

Thus, after the 1972 amendment, the event fixing the liability

for the California franchise tax is the earning of net income in

the income year, rather than the exercising of the corporate

franchise in the taxable year.    Id.

     Section 164(a) permits a deduction for State taxes during

the taxable year in which paid or accrued.   However, section

461(d) overrides the normal rules for accruing taxes in certain

situations.   Section 461(d)(1) provides:
                              - 25 -

     In the case of a taxpayer whose taxable income is
     computed under an accrual method of accounting, to the
     extent that the time for accruing taxes is earlier than
     it would be but for any action of any taxing
     jurisdiction taken after December 31, 1960, then, under
     regulations prescribed by the Secretary, such taxes
     shall be treated as accruing at the time they would
     have accrued but for such action by such taxing
     jurisdiction.

Under the regulations, any action of a taxing jurisdiction that

would accelerate the time for accruing a tax is to be disregarded

in determining the time for accruing such tax for purposes of the

deduction allowed under section 164(a).   Sec. 1.461-1(d)(1),

Income Tax Regs.   This applies to a taxpayer upon which the tax

is imposed at the time of the taxing jurisdiction's action, as

well as a taxpayer upon which the tax is imposed at any time

subsequent to such action.   Id.

     Respondent argues that section 461(d)(1) governs and that

petitioner may not accrue any deduction for California franchise

taxes based on 1988 income until 1989.    Petitioner, on the other

hand, argues that respondent’s position fails to take into

account the special California statutory rules that applied to a

commencing corporation’s first and second income and taxable

years under pre-1972 California franchise tax law.   Petitioner

contends those rules would have applied to petitioner's first and

second taxable years so that under the pre-1972 State law,

petitioner's liability would have become fixed on December 31,

1988, for the $932,979 franchise tax based on its 1988 income.
                               - 26 -

Thus, petitioner argues that the 1972 amendments did not

accelerate the accrual of its California franchise tax and that

section 461(d)(1) and the cases interpreting that section with

respect to California law are inapplicable.   See Epoch Food

Serv., Inc. v. Commissioner, supra; Central Inv. Corp. v.

Commissioner, supra; see also Hitachi Sales Corp. of Am. v.

Commissioner, T.C. Memo. 1992-504.

     The general rule for a taxpayer that commenced business in

California before 1972 was that the franchise tax for the

taxpayer’s first taxable year was based upon the income received

during that year and that the income for the first taxable year

also served as the measure of the franchise tax for the

taxpayer’s second taxable year.   Cal. Rev. & Tax. Code sec.

23222(a) (West 1992).   Thereafter, the tax due for each taxable

year was based on the income earned in the next preceding income

year.   Id. sec. 23151(a).   However, a special rule applied where

the commencing corporation’s first taxable year was less than 12

months:

     In every case in which the first taxable year of a
     taxpayer constitutes a period of less than 12 months,
     or in which a taxpayer does business for a period of
     less than 12 months during its first taxable year, said
     taxpayer shall pay as a prepayment of the tax for its
     second taxable year a tax based on the income for the
     first taxable year computed under the law and at the
     rate applicable to the second taxable year, the same to
     be due and payable at the same times and in the same
     manner as if that amount were the entire amount of its
     tax for that year; and upon the filing of its tax
     return within 2 months and 15 days after the close of
                             - 27 -

     the second taxable year it shall pay a tax for said
     year, at the rate applicable to that year, based upon
     its net income received during that year, allowing a
     credit for the prepayment; but in no event, except as
     provided in Section 23332, shall the tax for the second
     taxable year be less than the amount of the prepayment
     for that year, and said return for its second taxable
     year shall also be the basis for the tax of said
     taxpayer for its third taxable year, if the second
     taxable year constitutes a period of 12 months. [Id.
     sec. 23222(a).]

     Cal. Rev. & Tax Code sec. 23222(a) was in effect prior to

December 31, 1960.9   Thus, prior to December 31, 1960, where a

taxpayer’s first taxable year was a period less than 12 months,

the income from the short year was not used as the basis for

computing the franchise tax for the second taxable year; rather,

the income earned in the taxpayer’s second taxable year was used

as a measure of its franchise taxes for the second taxable year.

     Petitioner argues that under the law as it existed prior to

December 31, 1960 (prior to the 1972 amendment), its first year

ending December 31, 1987, constituted both its first income year

and its first taxable year, and that its franchise tax liability

based on 1987 income would have become fixed on the last day of

1987, even if petitioner had dissolved on January 1, 1988.

Similarly, petitioner argues that since its first taxable year

was a period less than 12 months, its second taxable year (the

     9
      Pursuant to the 1972 amendment, sec. 23222(a) of the Cal.
Code applies only to taxpayers who commenced doing business in
California prior to Jan. 1, 1972. Cal. Rev. & Tax Code sec.
23222(b) (West 1992).
                              - 28 -

taxable year in issue) and income year would also have been the

same, and, thus, the franchise tax based on its second year's

income would have accrued on December 31, 1988.   We agree.

     None of our prior opinions dealt with a situation where the

income year and the taxable year would have been the same for

purposes of the franchise tax as it applied prior to December 31,

1960.   However, that is the result of applying section 23222(a)

of the California code, as it existed prior to the 1972

amendment, to the facts of this case.   Pursuant to that section,

the franchise tax for petitioner's first taxable year ended

December 31, 1987, would have been computed on income earned

during that period and would have been payable to the State for

the privilege of exercising the corporate franchise for the same

period.   This franchise tax based on income received during the

first year would have been due regardless of whether petitioner

exercised its privilege after the close of its first year.

     Because petitioner's first taxable year for franchise tax

purposes was for a period of less than 12 months, prior to the

1972 amendment, Cal. Rev. & Tax Code sec. 23222(a) would have

required petitioner to pay a franchise tax based on its income

for the second year for the privilege of exercising the corporate

franchise during the second year.   The franchise tax liability

based on income earned during the second year would not have

depended upon the occurrence of an event subsequent to the end of
                               - 29 -

the second year.10   All events necessary to fix petitioner's

liability for franchise tax in the amount of $932,979 based on

income earned during its second year would have occurred at the

end of the second year under the law as it existed prior to

December 31, 1960.   It follows that petitioner's liability to the

State of California for franchise tax based on income earned

during its second year, which ended December 31, 1988, would have

accrued at the end of its second taxable year, regardless of the

1972 amendment to the franchise tax.    We hold that section 461(d)

does not prevent petitioner from accruing its liability for

franchise tax in the amount of $932,979.

     Respondent argues that even if petitioner's liability for

the franchise tax in the amount of $932,979, is otherwise

accruable in 1988, petitioner should not be allowed the deduction

because it would constitute a change in petitioner's accounting

method to which respondent has not consented.   We disagree.

     Petitioner used the accrual method of accounting.   It

apparently did not accrue the $932,979 on its Federal income tax

return because it relied on Rev. Rul. 79-410, 1979-2 C.B. 213.

That ruling relied on section 461(d) and the premise that prior

     10
      Under Cal. Rev. & Tax Code sec. 23222(a), as it applied
prior to 1972, the second taxable year would also have been the
income year for purposes of computing the franchise tax for
petitioner's third taxable year. Prior to the 1972 amendment,
the franchise tax for the third taxable year would not be
accruable until Jan. 1, 1989, and the franchise tax for each
succeeding year would have been accruable in similar fashion.
                                - 30 -

to 1972, California corporations could not generally have accrued

franchise tax based on an "income year" until the first day of

the following "taxable year".    While the revenue ruling is based

in part on our holdings in Central Inv. Corp. v. Commissioner, 9

T.C. 128 (1947), and Epoch Food Serv., Inc. v. Commissioner, 72

T.C. 1051 (1979), those cases did not address the effect of

section 23222(a) of the California code on the accruability of

California franchise tax in a corporation's second taxable year

where the first taxable year was less than 12 months.11    The

impact of section 23222(a) on the case before us is a "fact"

determining whether the all events test has been met.

Petitioner's initial misconstruction of the facts in reliance on

respondent's revenue ruling should not be viewed as a method of

accounting other than the accrual method.   Applying petitioner's

method of accounting to the correct facts is not a change in

accounting method requiring respondent's approval.     We hold that

petitioner is entitled to accrue and deduct franchise tax in the

amount of $932,979 for purposes of computing its Federal income

tax for the taxable year ended December 31, 1988.

                                          Decision will be entered

                                     under Rule 155.

     11
      We note that the facts described in Rev. Rul. 79-410,
1979-2 C.B. 213, 213-214, address the impact of California law
prior to the 1972 amendment where a corporation's first year was
"other than a short year". (Emphasis added.)