Appeal from a final judgment for plaintiff, entered in the United States District Court for the Southern District of New York, Morris E. Lasker, Judge, in suit for refund of corporate income taxes. Reversed.
Before Feinberg, Chief Judge, and Mansfield and Kearse, Circuit Judges.
This appeal requires us to determine whether the Commissioner of Internal Revenue ("Commissioner") properly exercised his discretion when he rejected as "not clearly reflect(ing) income" within the meaning of § 446(b) of the Internal Revenue Code of 1954 ("I.R.C."), 26 U.S.C. § 446(b) (1976), the accrual method of accounting used in 1958 and 1959 by plaintiff RCA Corporation ("RCA") to account for revenues received from the prepayment of fees associated with certain service contracts entered into with purchasers of its products. The United States District Court for the Southern District of New York, 499 F. Supp. 507, Morris E. Lasker, Judge, held, after a bench trial, that the Commissioner had abused his discretion in rejecting RCA's accrual method of accounting, and awarded judgment to RCA in the amount of $5,956,039.25, plus assessed deficiency interest and statutory interest, on its claim for a refund of corporate income taxes for the years 1958 and 1959. Believing that the Commissioner properly exercised his discretion, we reverse.
The case was tried largely on a stipulated record, and the facts are substantially undisputed. Since 1946 RCA has carried on a business, either directly or through its wholly-owned subsidiary RCA Service Company ("RCAS"), of servicing television sets and other consumer products it sold. In the typical service arrangement, the purchaser of an RCA product would contract, at the time of purchase, to receive service and repair of the product for a stated period in exchange for prepayment of a single lump sum.*fn1 Under these agreements, service was available to the purchaser on demand at any time during the contract term, which might range from three to twenty-four months. Until 1958, this service business was conducted by RCAS. On December 31, 1957, however, RCAS was liquidated by means of its merger into RCA; thereafter RCA continued the business of RCAS through RCA's Service Company division.
RCAS, and later RCA, employed an accrual method of accounting for service contract revenues on their books. For each group of service contracts of a given duration entered into in a given month, the seller credited to current income a sum that represented the actual cost of selling and processing the contracts, plus a profit. The balance of the revenues derived from each group of contracts, # i. e.,* the portion to be earned through future performance under them, was credited to a deferred income account. Each month thereafter, the seller journaled from the deferred income account to current income that proportion of the revenues from each group of contracts that the seller estimated had been earned in the month through actual performance. For the most part, the seller's estimates of its rate of performance for a particular class of contracts were based on its past experience in the business, and took into account such factors as seasonal repair patterns, variations in average daily workloads, and the number of working days in each month.*fn2 Although these forecasts were not perfect and may have rested to some extent on untested assumptions, they matched service contract revenues and related expenses with reasonable accuracy.
Although RCAS accounted for service contract revenues on an accrual basis in keeping its own books, it employed a cash method of accounting for service contract income on its tax returns.*fn3 For tax purposes, RCAS added to its gross taxable income for each year the amount by which the aggregate year-end balance in its deferred service contract income accounts exceeded the previous year's closing balance; if the accounts had decreased, RCAS subtracted the amount of the decrease from its gross taxable income.
After the liquidation of RCAS, RCA continued to employ RCAS's accrual method, based on reasonably accurate forecasts of monthly variations in the demand for service, in its book accounting for the prepaid service contract income of its Service Company division. For tax purposes, however, RCA discontinued RCAS's former practice of adjusting taxable income by the amount of the annual change in the deferred service contract income accounts. Instead, RCA reported the service contract income of the Service Company division on the same accrual basis used in its books, including in taxable gross income only those service contract revenues that it estimated it had earned during the taxable year by actual performance. Thus, although the aggregate balance of the deferred income accounts increased from $8,223,755.27 to $9,497,896.51 between December 31, 1957 and December 31, 1958, RCA did not add to its gross taxable income for 1958 the $1,274,141.24 increase. Similarly, RCA did not include in its gross income for 1959 the $1,956,024.68 increase, to $11,453,921.19, that occurred in that year. In addition, in an adjustment designed to reconcile differences in book and taxable income, RCA reduced its 1958 taxable income by $7,624,775.27, thus eliminating from taxable income most of the $8,223,755.27 balance in the RCAS deferred income accounts (on which RCAS had already paid taxes) that had been credited to RCA's book income accounts after the merger. RCA reduced its taxable income for 1959 by $598,980 through a similar adjustment. These accounting changes and adjustments had the effect of reducing RCA's 1958 income taxes by $4,627,436.59 and its 1959 income taxes by $1,328,602.66. In neither 1958 nor 1959 did RCA seek the Commissioner's permission, pursuant to I.R.C. § 446(e), to adopt its accrual method of tax accounting for service contract income.*fn4
After an audit of RCA's tax returns for 1958 and 1959, the Internal Revenue Service ("IRS") required RCA to report its service contract revenues upon receipt, rather than deferring recognition of any portion of them. For 1958, this change from accrual to cash accounting increased RCA's taxable income by $8,898,916.51 and increased its tax liability by $4,627,436.59. For 1959, the adjustment increased taxable income by $2,555,004.68 and tax liability by $1,328,602.66. RCA paid these increased income taxes and filed timely administrative claims for refund of the disputed sums. RCA commenced this litigation on June 18, 1969, and, after what seems to have been a lengthy interregnum of fruitless settlement talks, the case was tried in 1979.
At trial, RCA contended, first, that its accrual method of tax accounting for prepaid service contract revenues "clearly reflect(ed) income" within the meaning of I.R.C. § 446(b), and that the Commissioner had therefore abused his discretion in rejecting that method.*fn5 Alternatively, RCA argued that its adoption of the accrual method after its merger with RCAS was permissible under regulations promulgated pursuant to I.R.C. § 381(c)(4), concerning an acquiring corporation's assumption of an acquired corporation's accounting practices.*fn6 Finally, RCA asserted that its accrual method was acceptable because certain revenue rulings, Rev.Proc. 71-21, 1971-2 C.B. 549, and Rev.Rul. 71-299, 1971-2 C.B. 218, promulgated by the Commissioner in 1971 and permitting limited use of accounting procedures such as RCA's, are retroactive in effect.*fn7
For its part, the government argued that under a trio of Supreme Court Cases, Automobile Club of Michigan v. Commissioner, 353 U.S. 180, 77 S. Ct. 707, 1 L. Ed. 2d 746 (1957), ("Michigan"); American Automobile Association v. United States, 367 U.S. 687, 81 S. Ct. 1727, 6 L. Ed. 2d 1109 (1961) ("AAA"), and Schlude v. Commissioner, 372 U.S. 128, 83 S. Ct. 601, 9 L. Ed. 2d 633 (1963) ("Schlude"), methods of accrual accounting based on projections of customers' demands for services do not "clearly reflect income," and that in view of these decisions the Commissioner did not abuse his discretion in rejecting RCA's method. The government also pressed a broader argument that accrual accounting is never permissible without express legislative authorization and the Commissioner's consent. In addition, the government contended that RCA was not entitled to a refund because its adoption of the accrual method was a change of accounting methods for which it was required to, but did not, obtain the Commissioner's consent under I.R.C. § 446(e). Finally, the government argued that the regulations promulgated under I.R.C. § 381(c)(4)*fn8 were inapplicable to the RCA-RCAS merger, and that Rev.Proc. 71-21 and Rev.Rul. 71-299 are not retroactive.
After reviewing the stipulated facts and hearing the testimony of the one live witness, an accounting expert, the district court ruled for RCA. The court read Michigan, AAA, and Schlude, supra, to proscribe, as "not clearly reflect(ing) income," only those methods of deferring recognition of income that are not based on demonstrably accurate projections of future expenses required to earn the income. In addition, the court expressed its belief in the continued vitality of our decision in Bressner Radio, Inc. v. Commissioner, 267 F.2d 520 (2d Cir. 1959), nonacq., Rev.Rul. 60-85, 1960-1 C.B. 181 (1960), decided after Michigan but before AAA and Schlude, in which we held that deferral methods of accounting based upon reasonably accurate estimates of future costs were permissible under I.R.C. § 446. Finding that RCA's accrual method matched service contract revenues and related expenses "with reasonable precision" and therefore "clearly reflect(ed) income," the court held that the Commissioner had abused his discretion under I.R.C. § 446(b) in rejecting RCA's method and imposing on RCA a cash method of accounting.
Alternatively, the district court held that RCA's adoption of its accrual method of accounting was insulated from challenge by Treas.Reg. § 1-381(c)(4)-1(e) (1964), promulgated pursuant to I.R.C. § 381(c)(4). In addition, the court rejected the government's argument that the Commissioner may disallow any deferred-income method of accounting that is not specifically authorized by statute, and it held that RCA was not barred from seeking a refund by its failure to secure the Commissioner's consent for its adoption of its accrual method. The court found it unnecessary, in view of its disposition of the other issues, to discuss the parties' contentions concerning the retroactivity of Rev.Proc. 71-21 and Rev.Rul. 71-299.
Accordingly, the district court entered judgment for RCA in the amount of $4,627,436.59 for 1958 and $1,328,602.66 for 1959, plus deficiency interest previously assessed against and paid by RCA on those ...