Sixth Circuit Addresses Three Discrete Issues in Chrysler Appeal
Tax Controversy Alert
Editor's Note: In Chrysler Corp. v. Commissioner, 436 F.3d 644 (6th Cir. 2006), aff'g 116 T.C. 465 (2001), the Sixth Circuit addressed issues involving anticipated warranty expense deductions, the timeliness of foreign tax credit elections, and ESOP redemption cost deductions. This alert addresses each of those three issues in turn.
Anticipated Warranty Expense Not Deductible
The Sixth Circuit held that Chrysler could not deduct its anticipated warranty expense no matter how statistically certain the expense -- because its liability was not fixed until a customer submitted a valid warranty claim. When Chrysler sold a vehicle, it would deduct its anticipated warranty expense for that vehicle. Chrysler argued that its liability for the warranty expense was fixed because state and federal law require Chrysler to perform warranty repairs. Chrysler relied on United States v. Hughes Properties, Inc., 476 U.S. 593 (1986), in which the Supreme Court held that the taxpayer, who operated a casino, could deduct the amount of a progressive jackpot that had not been won by the end of the tax year. The Court held that the taxpayer's liability was fixed because Nevada state law required the casino eventually to pay the amount of the jackpot to a future winner.
The IRS argued that Chrysler's liability was not fixed until a customer submitted a warranty claim. The IRS relied on United States v. General Dynamics Corp., 481 U.S. 239 (1987), which held that the taxpayer, who had a self-insured medical plan, could not deduct the estimated cost of medical care that had been rendered to its employees but who had yet to file a claim because the taxpayer's liability was not fixed until such a claim was filed.
The Sixth Circuit stated that the distinction in the two cases can be found by looking to the last act necessary to establish the liability in each case. In Hughes, the last act necessary to establish the liability was the last play of the machine at yearend because, even if the jackpot was not won with that play, Nevada state law had the effect of "irrevocably setting aside" the amount of the jackpot set by that play, which the casino eventually was required to pay. On the other hand, in General Dynamics, the last act that established the liability was an employee filing a claim, which had not yet happened (and might never happen).
In Chrysler, the Sixth Circuit held that the last act necessary to establish the liability was, like General Dynamics, the filing of a valid warranty claim. The court was unconvinced by the taxpayer's argument, holding that the statutes governing warranties require Chrysler to make warranty repairs only if a buyer submits a valid warranty claim (which might never happen).
Election to Take Foreign Tax Credits Not Timely
The Sixth Circuit held that in cases where there has been a carryover of foreign taxes, the ten-year limitations period for making or changing an election to take foreign tax credits for a taxable year commences with the due date of the return for the year from which the excess foreign taxes are carried, rather than the year to which they are carried. The Court of Claims reached the opposite conclusion in Ampex Corp. v. United States, 223 Ct. Cl. 428 (April 16, 1980).
Chrysler initially took deductions for foreign taxes on its 1980- 1982 tax returns. On July 24, 1995, Chrysler amended its 1980-1982 returns to elect foreign tax credits in lieu of those deductions. Chrysler also amended its 1985 tax return to claim a refund from a carryover of the foreign taxes paid in those years. At that time, Chrysler's 1985 tax year was open for purposes of a claim of credit or refund, but its 1980-1982 tax years were closed. The Commissioner subsequently issued a notice of deficiency, disallowing the foreign tax credit carryforward to 1985 because of the election.
Section 901(a) provides that the choice to take a foreign tax credit "for any taxable year may be made or changed at any time before the expiration of the period prescribed for making a claim for credit or refund…for such taxable year." Section 6511(d)(3)(A) provides that the period of limitations for filing a claim for credit or refund attributable to foreign taxes is "10 years from the date prescribed by law for filing the return for the year with respect to which the claim is made."
Chrysler argued that section 901(a), when read in light of section 6511(d)(3)(A), allows a taxpayer to make or change a foreign tax credit election within ten years of the year in which the foreign tax credit is to be applied and therefore Chrysler's 1995 election was timely. The Commissioner interpreted sections 901(a) and 6511(d)(3)(A) to allow an election to be made or changed within ten years from the year in which the foreign taxes are paid.
The Sixth Circuit affirmed the Tax Court's holding that Chrysler's elections to take foreign tax credits for 1980, 1981, and 1982 were untimely. The Sixth Circuit noted that the initial reference in section 901(a) to "any taxable year" means the year for which the election of the foreign tax credit is made and concluded that "such taxable year" must refer to the same year, i.e., the year the foreign taxes were paid. In the Sixth Circuit's view, section 6511(d)(3)(A) provides the taxpayer with a ten-year limitations period for altering its election of a foreign tax credit, and section 901(a) fixes the year of election as the trigger for that limitations period.
In Ampex Corp. v. United States, 223 Ct. Cl. 428 (April 16, 1980), the Court of Claims addressed the same question and reached the opposite conclusion, holding that the ten-year limitations period commenced with the due date of the return for the year to which the foreign tax credits were carried. The Court of Claims focused on the language of section 6511(d)(3)(A) and concluded that the word "claim" refers to the claim for credit or refund and that the limitations period therefore commences with the due date of the return for the year for which the refund is sought. The Court of Claims did not address the application of section 901(a) or the interplay between sections 901(a) and 6511(d)(3)(A).
ESOP Redemption Costs Not Deductible Compensation Expenses
The Sixth Circuit upheld the Tax Court's holding that Chrysler could not treat redemption costs incurred in conjunction with the termination of its employee stock ownership plan ("ESOP") as deductible compensation expenses.
Chrysler established the ESOP in 1980 as a condition of a federal loan. The federal government required Chrysler to implement more than $587 million in wage and benefits concessions and to contribute at least $162.5 million in ESOP contributions.
Chrysler terminated the ESOP in 1985 pursuant to its collective bargaining agreement with the UAW, allowing ESOP participants to keep their shares of stock or have Chrysler redeem the stock at fair market value.
Chrysler redeemed more than $425 million of stock and deducted its costs as compensation expenses. In Chrysler's view, the contribution and redemption of shares in the ESOP was a compensation substitute for the wage and benefit concessions.
Code section 162(k), which was not yet effective when Chrysler deducted its redemption costs, currently prohibits a corporation from deducting amounts associated with the redemption of its stock. Prior to section 162(k), courts usually treated redemption costs as capital expenditures under the "origin of the claim" doctrine. This doctrine looks to the origin and character of the claim with respect to which an expense was incurred rather than the taxpayer's purpose in paying that expense. Chrysler and the Service disagreed about what constituted the claim with respect to which Chrysler incurred the redemption costs.
Chrysler argued that the claim was the union's demand that Chrysler terminate the ESOP and repurchase company stock in consideration of the prior wage and benefit concessions. Thus, the origin of the claim was the compensatory nature of Chrysler's stock contributions to the ESOP as required by the federal loan guarantee. Chrysler concluded that the redemption costs were compensatory and therefore deductible.
The Service argued that the Chrysler improperly included the prior wage and benefit concessions as part of the claim. The Service agreed that the stock contributions were compensatory, but argued that the redemption was a distinct, non-compensatory transaction that was not compelled by the federal loan or by the ESOP terms. The Service also argued that the ESOP participants received what they would have received had they sold the stock in the open market. The participants received no compensatory benefit because they sold their stock back to Chrysler. Therefore, the redemption costs were not compensatory in nature.
The Sixth Circuit agreed with the Service. Chrysler had deducted the cost of its contributions to the ESOP as it made the contributions. The Sixth Circuit reasoned that at the time of the redemption, Chrysler simply paid participants the fair market value for their shares and provided no additional compensation to the participants. The Sixth Circuit upheld the Tax Court's denial of Chrysler's deductions.
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