The opinion of the court was delivered by: LASKER
RCA Corporation ("RCA") sues for a refund of nearly $ 6,000,000 of federal income taxes it paid for 1958 and 1959, plus deficiency interest paid and interest accrued on these amounts. After lengthy but unsuccessful efforts to negotiate a settlement, as well as time-consuming meetings to reach agreement on the facts, the parties executed a comprehensive stipulation of facts. At trial, RCA presented the testimony of an accounting expert who was the sole witness. This memorandum embodies the court's conclusions of law, based on the stipulated facts and testimony.
At issue is the extent to which a taxpayer may properly rely on the accrual method of accounting in computing its income for tax purposes. The case involves service contracts made in 1958 and 1959 between RCA and purchasers of new television sets. Under those contracts, the purchaser generally paid RCA a lump sum at the time of purchase, and, in return, RCA agreed to service the television anytime trouble developed over a specified period of from three to twenty-four months. Prior to 1958, such contracts were offered by RCA Service Company, Inc. ("RCAS"), a wholly owned subsidiary of RCA, which was merged into RCA on December 31, 1957, and subsequently operated as a separate corporate division.
Both RCAS and RCA kept their books on an accrual basis. The amounts received from the sale of service contracts were initially divided between that portion to be treated as revenue immediately, which covered the costs of selling and processing the contract, plus a profit, and that portion to be treated as unearned revenue, which was credited to a reserve account. Each month throughout the life of the contract a portion of this reserve was credited to revenue, based on statistically derived schedules designed to take into account as revenue each month that portion of prepaid service contract receipts attributable to the services performed that month under such contracts. This scheme was intended to ensure that such receipts were treated as revenue from month to month only in proportion to related expenses incurred, and thus that RCA's income-the difference between its revenues and expenses-was accurately reflected in its books.
In computing its 1958 and 1959 income for tax purposes, RCA employed the same method of accounting that it used in keeping its own books. Thus, in reporting its income for those years for tax purposes, RCA only included in income those portions of the amounts received each year from the sale of service contracts that were treated as immediate revenue attributed to the administrative costs of selling the contracts, or attributed, according to RCA's calculations, to services performed during that year. The remainder of the amounts received each year from the sale of service contracts was not included in income for that year, but carried over as a reserve and included in income for subsequent years.
In auditing RCA's returns for 1958 and 1959, the Commissioner concluded that RCA's method of spreading the recognition as revenue of prepaid service contract receipts over the life of the contracts did not "clearly reflect income," as required under I.R.C. § 446(a). Invoking his authority under I.R.C. § 446(b), the Commissioner treated RCA's prepaid receipts as revenue in the year received, and recomputed RCA's taxes on that basis. RCA paid the assessments, then commenced this suit to recover them.
The mechanics of RCA's method for accruing prepaid service contract revenue are set forth fully in the stipulation of facts. Briefly stated, RCA treated all contracts of a particular length entered into during a particular month as a single category. Drawing on its past experience, RCA developed statistical estimates of the percentage of all the service calls expected to be made under contracts of a particular category that would be made during each month of those contracts' term. These estimates were aggregate figures: RCA did not purport to predict when individual televisions covered by contract within a given category would require service, but only the incidence of service calls under such contracts. RCA continuously refined these estimates in light of its continuing experience.
These estimates of relative monthly service call volume provided the basis for RCA's monthly allocation to revenue of a portion of its receipts from the sale of contracts in each category, and ultimately for the recognition of those receipts as revenue in tax years other than that in which they were received. For instance, RCA's projections indicated that 4.33% of all service calls that would be required under all one-year service contracts entered into in September, 1959, would be made in September of that year, 9.08% in October, 7.87% in November, and 8.71% in December. The remaining service calls would all occur during the first nine months of 1960. Consequently, for tax purposes RCA treated as revenue in 1959 (in addition to the amounts treated as immediate revenue attributable to the costs of selling and processing contracts) only 29.96% of the amounts it received in September, 1959 from the sale of one year service contracts. The remainder would have been treated as revenue in 1960, had the Commissioner not intervened and insisted that RCA treat all amounts received in 1959 as revenue in 1959.
RCA contends that its accrual method of accounting did "clearly reflect income," and consequently that the Commissioner lacked authority under the Code to require RCA to adopt a different method. Alternatively, RCA argues that it is entitled to a refund of about 75% of the assessments it paid because a Revenue Procedure, Rev.Proc. 71-21, 1971-2 C.B. 549, and related Revenue Ruling, Rev.Rul. 71-299, 1971-2 C.B. 218, promulgated by the Commissioner in 1971, which permit a limited use of accounting procedures like that employed by RCA in 1958 and 1959, are retroactive in effect.
The Government responds, first, that it was within the Commissioner's discretion to find that RCA's accounting method did not "clearly reflect income," and therefore to require RCA to use a different method; second, that the Revenue Procedure and Revenue Ruling on which RCA relies do not have retroactive effect; and third, that in any event RCA is not entitled to a refund for taxes paid in 1958 and 1959 because RCA was required to, but did not, obtain the consent of the Commissioner before employing its accrual method in computing its income for tax purposes, since RCAS had never done so. See I.R.C. § 381(c)(4).
Prior to 1916, the Revenue Acts recognized only the "cash receipts and disbursements" method of accounting. However, in the Revenue Act of 1916 Congress provided that a corporate taxpayer that kept its books on some basis other than actual receipts and disbursements could report its income on the same basis, "unless such other basis does not clearly reflect its income." Revenue Act of 1916, c. 463, § 13(d), 39 Stat. 756. The purpose of the new provision
"was to enable taxpayers to keep their books and make their returns according to scientific accounting principles, by charging against income earned during the taxable period, the expenses incurred in and properly attributable to the process of earning income during that period."
United States v. Anderson, 269 U.S. 422, 440, 46 S. Ct. 131, 134, 70 L. Ed. 347 (1926). This provision of the 1916 Act is reflected today in section 446 of the Internal Revenue Code of 1954, which provides:
"(a) General Rule.-Taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books.
(b) Exceptions.-If no method of accounting has been regularly used by the taxpayer, or if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary, does clearly reflect income.
(c) Permissible methods.-Subject to the provisions of subsections (a) and (b), a taxpayer may compute taxable income under any of the following methods of accounting-
(1) the cash receipts and disbursements method;
(2) an accrual method; ...."
The first and principal question to be resolved here is whether the accrual method of accounting, as implemented by RCA, "clearly reflects income" within the meaning of section 446(a).
The Government relies principally on a trilogy of decisions of the United States Supreme Court: Automobile Club of Michigan v. Commissioner, 353 U.S. 180, 77 S. Ct. 707, 1 L. Ed. 2d 746 (1957), American Automobile Association v. United States, 367 U.S. 687, 81 S. Ct. 1727, 6 L. Ed. 2d 1109 (1961), and Schlude v. Commissioner, 372 U.S. 128, 83 S. Ct. 601, 9 L. Ed. 2d 633 (1963). In each of these cases the Court upheld the Commissioner's determination that the accrual method of accounting used by the taxpayer did not clearly reflect income; the Government argues here that together they establish that the Commissioner may reject the use, for tax purposes, of any accounting method which defers until subsequent tax years the inclusion in gross income of payments received for services to be rendered at unspecified dates in the future.
In the first case in the trilogy, Automobile Club of Michigan v. Commissioner, 353 U.S. 180, 77 S. Ct. 707, 1 L. Ed. 2d 746 (1957) ("Michigan"), the automobile club provided a variety of services to its members, at their request, such as road maps and highway repairs. Membership dues were collected annually, in advance. On its books, the club recorded one-twelfth of each dues payment as revenue each month of the membership year. For tax purposes, it reported its gross income as recorded on its books. Thus, it did not include the full amount of each dues payment in its gross income for the tax year in which it was received. Instead dues payments were split, one portion included in gross income for the tax year of receipt, the remainder in gross income for the following tax year, in proportion to the number of months of the membership year which fell within each tax year. The Court, holding that this method of accounting did not clearly reflect income, expressed its rationale in a single sentence:
"The pro rata allocation of the membership dues in monthly amounts is purely artificial and bears no relation to the services which petitioner may in fact be called upon to render for the member."
Id. at 189. In a footnote, the Court distinguished Beacon Publishing Co. v. Commissioner, 218 F.2d 697 (10th Cir. 1955), in which it was held that the Commissioner exceeded his authority in requiring the taxpayer to treat sums received for prepaid newspaper subscriptions as revenue during the year they were received, rather than over the life of the subscriptions, and Schuessler v. Commissioner, 230 F.2d 722 (5th Cir. 1956), in which the court rejected the Commissioner's attempt to require the taxpayer to treat as revenue during the year received that portion of receipts from the sale of gas furnaces which was properly attributable to the taxpayer's contractual obligation to turn the furnaces on and off each year for five years:
"In Beacon, performance of the subscription, in most instances, was, in part, necessarily deferred until the publication dates after the tax year. In Schuessler, performance of the service agreement required the taxpayer to furnish services at specified times in years subsequent to the tax year. In this case, substantially all services are performed only upon a member's demand and the taxpayer's performance was not related to fixed dates after the tax year."
353 U.S. at 189 n.20, 77 S. Ct. at 712 n.20. In many respects, the parties' contrary positions here are reflected in these two quotations. RCA, relying on the statement quoted from the text of the decision, contends that the teachings of this decision and the subsequent decisions in the trilogy is simply that an accounting method that is "purely artificial" is not acceptable, but that a method which can be shown to accurately record related revenues and expenses in the proper accounting period is not. The Government, relying on the quotation from the footnote, argues that the Commissioner may reject any method for deferring recognition of receipts as revenue, no matter how accurately it matches revenues and expenses, if "the contract revenues in question are tied to future services to be performed without relation to fixed dates in the future." We conclude that RCA's position is the correct one. In our view, the subsequent decisions of the Supreme Court establish that the fact that the services paid for are not to be performed on fixed dates is not in and of itself determinative, but is significant only insofar as it throws light on the question whether the challenged accounting method is "artificial" because it fails adequately to ensure that receipts are included in gross income in any tax year only in proportion to related expenses incurred during that year.
Two years after the Supreme Court's decision in Michigan, the Second Circuit, in Bressner Radio, Inc. v. Commissioner, 267 F.2d 520 (2d Cir. 1959), nonacq., Rev.Rul. 60-85, 1960-1 C.B. 181 (1960), adopted the interpretation of Michigan which RCA urges here. The facts in Bressner were virtually identical to those of the case at hand: Like RCA, Bressner sold televisions and entered into written contracts to service them. Bressner's service contracts, unlike RCA's, covered initial installation as well as service, and were available for a twelve month term only. Bressner received between $ 80 and $ 100 for each contract, the initial cost of installation was approximately $ 19, and Bressner's experience showed that an average of 8 to 12 service calls would be made during the term of each contract. Accordingly, Bressner treated 25% of the contract price as revenue at time it was received, to cover the costs of installation, and "deferred the balance over the twelve month period of the contract." Id. at 521. The Second Circuit found that this method of accounting did clearly reflect income, that the method which the Commissioner sought to substitute for it (which is similar to the method the Commissioner employed here in recomputing RCA's income for 1958 and 1959) and grossly distorted income, and held that the Commissioner overstepped his authority in rejecting Bressner's method in favor of his own.
Distinguishing the Supreme Court's decision in Michigan, the Second Circuit stated:
"It is apparent from the decision of the majority that at least for purposes of the decision of the case it assumed that a realistic deferral would have been permissible, and found only that no realistic deferral was made.... The majority appears to have proceeded from an assumption that accrual accounting would be acceptable tax practice."
Id. at 526-27. The court found that unlike the taxpayer in Michigan, Bressner had proven that its deferral method was "realistic":
"There is nothing apparently artificial about the petitioner's method of deferral here. Drawing on its experience with thousands of contracts it has demonstrated that it was subjected to a reasonably uniform demand for services, so that it could and did anticipate that the expenses incident to the performance which alone would entitle it to regard the sum received as earned would be distributed across the life of the contract. It therefore deferred revenues until they ...