Indianapolis Power & Light Trips Circuits

In a split decision, the Third Circuit Court of Appeals required a grocer to include in gross income a payment characterized as a loan from a supplier. The loan could be forgiven if the grocer, Karns Prime and Fancy Foods Ltd. of Harrisburg, Pa., purchased a certain volume of goods. But because Karns had no unconditional obligation to repay the proceeds when it executed the purchase agreement, the loan was more in the nature of an advance rebate, the majority opinion said.

The court thus reached an opposite conclusion from the Ninth Circuit earlier in Westpac Pacific Foods v. Commissioner , a ruling the IRS agreed to follow this summer (see “Tax Matters,” JofA , Dec. 06, page 80, and Sept. 07, page 86). That case involved payments explicitly designated as advance rebates to grocers from a supplier. Both courts based their decisions on a 17-year-old Supreme Court ruling that customer security deposits held by an electric utility were not income.

To raise capital, Karns asked its principal supplier, Super Rite Foods Inc., for a loan. In 1999, in exchange for $1.5 million from Super Rite, Karns executed a promissory note and supply agreement. Karns could either repay the loan in six annual installments of $250,000 each or purchase at least $16 million worth of product each year to have that year’s installment forgiven. For the first three years of the agreement, Karns exceeded the minimum purchase amounts, and those years’ payments were forgiven. The company included $250,000 as income on its returns for tax years 2001 and 2002.

In 2003, however, the IRS issued a deficiency notice of $486,355 for tax year 2000, claiming that since Karns had no unconditional obligation to repay the $1.5 million, the entire amount was income when received. Karns petitioned the Tax Court, lost and appealed.

The Third Circuit contrasted Karns’ loan from customers’ security deposits on electric service that were the subject of the Supreme Court’s 1990 ruling in Commissioner v. Indianapolis Power & Light Co. , 65 AFTR 2d 90-394 (110 S.Ct. 589). In that case, the court held that the deposits were not income, since customers could demand repayment when they discontinued their electrical service. But unlike the utility, Karns alone could control whether it could keep the money, simply by meeting the required terms, the Third Circuit said.

The majority opinion, after saying the loan could be considered an advance rebate, disagreed with the Ninth Circuit in Westpac , in which that court said an advance rebate could be considered a loan. Specifically, the Third Circuit faulted the Ninth Circuit’s application of Indianapolis Power , saying it ignored the Supreme Court’s discussion of when a deposit would be income: in situations where “so long as the recipient fulfills the terms of the bargain, the money is its to keep.”

One judge of the Third Circuit’s panel of three, in a dissenting opinion, emphasized provisions in Karns’ supply agreement that she said gave Super Rite “immense latitude” to cancel the agreement, allowing Karns no advance guarantee the loan would be forgiven and hence little control over keeping its proceeds.

The situation was left unclear, however, given Rev. Proc. 2007-53, issued by the IRS in response to the Westpac ruling but before the decision in Karns . In it, the IRS said it would follow Westpac and established a method for accrual taxpayers to recognize advance trade discount payments as a reduction in cost of inventory.

Karns Prime & Fancy Food Ltd. v. Commissioner , 100 AFTR 2d 2007-5267

Prepared by Charles J. Reichert , CPA, professor of accounting, University of Wisconsin–Superior.