The Tax Court holds that under the qualified settlement fund rules in Sec. 468B, a cigarette importer could not deduct tobacco settlement obligations until they were paid.
The Tax Court held that an accrual-basis cigarette importer was not entitled to deductions for accrued but unpaid obligations to the Tobacco Master Settlement Agreement (MSA) between U.S. states and tobacco companies.
Facts: Vibo Corp., an S corporation wholly owned by the petitioner, Vidal Suriel, was the exclusive importer into the United States of cigarettes manufactured by a Colombian company, to which it was unrelated. Although the Colombian producer was a “nonparticipating manufacturer” under the MSA’s terms, it was still liable to make payments into an escrow account to satisfy any future judgments a U.S. state might obtain against it. Vibo made the payments on the producer’s behalf.
In 2004, an amendment allowed Vibo to voluntarily enter into the MSA on its own behalf and thereby seek to increase its market share. Vibo agreed to pay past and ongoing MSA obligations and interest on the past obligations. On its tax return for that year, Vibo deducted more than $295 million of its past and current MSA payment obligations as part of its cost of goods sold and $4.6 million as interest, although it paid none of those amounts into the MSA escrow account in 2004. On its 2006 return, Vibo similarly deducted more than $108 million in current MSA obligations and $2 million in related “other deductions,” of which it paid approximately $97 million during the tax year.
Based on its examination of Vibo’s returns, the IRS determined deficiencies against Suriel of nearly $34 million for 2004 and $5.8 million for 2006. Suriel petitioned the Tax Court.
Issues: Suriel argued that because the MSA documents referred to Vibo as an importer and distributor, MSA payment obligations it assumed on behalf of the Colombian company were a cost of purchasing cigarettes from the company. Therefore, the MSA payments should be allowed as cost of goods sold. The IRS contended that by entering the MSA itself, Vibo was bound by a special rule under Sec. 468B for determining economic performance under the all-events test for taxpayers making payments to a qualified settlement fund (QSF). The MSA includes a stipulation that it is a QSF within the meaning of the statute.
Generally, under Sec. 461, an accrual-basis taxpayer incurs a currently deductible liability when (1) all events have occurred that establish the liability; (2) the amount of the liability can be estimated with reasonable accuracy; and (3) economic performance with respect to the liability has occurred. However, under Sec. 468B(a) and Regs. Sec. 1.468B-3(c)(1), economic performance with respect to a QSF liability does not occur until the amount is transferred to the QSF in satisfaction of the liability.
Holding: The Tax Court disagreed with Suriel, concluding that Vibo was a manufacturer for purposes of the MSA, and, by voluntarily entering into the agreement, Vibo obligated itself and not the Colombian company as a participant in the MSA. The court also found that Vibo’s argument was further belied by the fact that the Colombian company had no MSA liability that Vibo could have assumed. Therefore, it held that Vibo was subject to the Sec. 468B rules for its accrued but unpaid MSA obligations in 2004 and 2006 and could not deduct them because economic performance did not occur until the obligations were paid. Because the special rules of Sec. 468B did not differentiate between interest and principal payments to a QSF, the court held that Vibo was not entitled to the deduction for accrued interest in 2004.
Suriel, 141 T.C. No. 16 (12/4/13)
By Mark A. McCoon, CPA, Ph.D., assistant
professor, University of Wisconsin–Superior.