UNITED STATES OF AMERICA, PETITIONER v. HUGHES PROPERTIES, INC. APPENDIX No. 85-554 In the Supreme Court of the United States October Term, 1985 The Solicitor General, on behalf of the United States, petitions for a writ of certiorari to review the judgment of the United States Court of Appeals for the Federal Circuit in this case. Petition for a Writ of Certiorari to the United States Court of Appeals for the Federal Circuit TABLE OF CONTENTS Question Presented Opinion below Jurisdiction Statutes involved Statement Reasons for granting the petition Conclusion Appendix A Appendix B Appendix C Appendix D Appendix E OPINIONS BELOW The opinion of the court of appeals (App., infra, 1a-3a) is reported at 760 F.2d 1292. The opinion of the Claims Court (App., infra, 5a-20a) is reported at 5 Cl. Ct. 641. JURISDICTION The judgment of the court of appeals (App., infra, 4a) was entered on May 2, 1985. On July 11, 1985, the Chief Justice extended the time within which to petition for a writ of certiorari to and including September 29, 1985 (a Sunday). The jurisdiction of this Court is invoked under 28 U.S.C. 1254(1). STATUTES INVOLVED The relevant portions of Sections 162, 446 and 461 of the Internal Revenue Code of 1954 (26 U.S.C.), and of Section 1.461 of the Treasury Regulations on Income Tax (26 C.F.R.), are set out in a statutory appendix (App., infra, 22a-24a). QUESTION PRESENTED Whether a gambling casino using the accrual method of tax accounting may deduct amounts shown on the "jackpot indicators" of its progressive slot machines at the close of its taxable year, even though it has no obligation to pay those amounts unless and until the jackpots are won by its patrons in some future year. STATEMENT 1. The relevant facts were stipulated (App., infra, 5a). Respondent Hughes Properties, Inc., is a Nevada corporation that owns Harolds Club, a gambling casino in Reno, Nevada (id. at 6a). During the tax years at issue, respondent operated "progressive slot machines" in its casino (ibid.). Like other slot machines, a "progressive" slot machine pays fixed amounts when certain combinations of apples, oranges, or other symbols appear. Unlike other slot machines, however, a "progressive" machine also has an additional, "progressive" jackpot. This jackpot is initially set at a minimum amount determined by the casino (id. at 6a; C.A. App. 45-46). It automatically increases, according to a ratio determined by the casino, as money is gambled on the machine. The amount of the jackpot outstanding at any given time is registered on a meter, or "payoff indicator," on the face of the machine (App., infra, 6a-7a & n.2). This sum continues to increase as patrons gamble on the machine until the jackpot is won or until a maximum amount, again determined by the casino, is reached (id. at 6a). A progressive jackpot can be won only when a customer gambles the required amount of money and the machine displays the winning combination of symbols (ibid.). The odds of winning a progressive jackpot are a function of the number of reels on the machine, the number of positions on each reel where the reel may stop, and the number of winning symbols placed on each reel (App., infra, 6a; C.A. App. 46). The odds are determined by respondent; provided that there actually exists a possibility that the winning combination of symbols can appear, respondent's discretion in setting odds is unrestricted. By adjusting the odds, respondent can determine, within limitations prescribed by the law of averages, the frequency with which any particular progressive slot machine will pay off. In a 1976 study of 24 representative machines, respondent ascertained that one machine had been in operation for 13 months without a payoff, that another machine had been in operation for 35 months without a payoff, and that the payoff frequency of the other 22 machines ranged from a high of 14.3 months to a low of 1.9 months (App., infra, 7a n.1). 2. In September 1972 the Nevada Gaming Commission promulgated a rule that, for the first time, regulated the use of progressive slot machines by licensed casinos. Nev. Gaming Reg. Section 5.110 (reprinted in App., infra, 7a-9a nn. 2 & 3). The rule requires gaming establishments to maintain daily records of the progressive jackpot amounts registered on each machine (Nev. Gaming Reg. Section 5.110(5)). It directs that "(n)o payoff indicator shall be turned back to a lesser amount" unless the progressive jackpot is won by a customer, or unless "the change in the indicator reading is necessitated through a machine malfunction" (id. Section 5.110(2)). In the latter event, a report explaining the reduction in the payoff indicator must be filed (id. Section 5.110(5)). This rule is strictly enforced by the Gaming Commission, which is authorized to impose sanctions (including license revocation) on casinos that wrongfully refuse to pay a progressive jackpot to a winning customer or that otherwise breach the Commission's rules (App., infra, 9a). The Gaming Commission rule described above applies to all Nevada casinos so long as they remain in the gaming business (C.A. App. 59). If a casino were to go out of business, to surrender its gaming license, or to enter bankruptcy proceedings, it would no longer be subject to the rule and would be free to reduce or eliminate the amounts shown on its progressive jackpot indicators (id. at 58-59). The rule does not address the treatment of progressive slot machines in the event of the sale or other disposition of a gaming business. During the tax years in question, the Gaming Commission's unwritten policy in such circumstances was apparently to require the buyer to continue the progressive slot machines in play, without reduction of the payoff indicators (id. at 58). Whether the sales price would be adjusted to reflect that requirement, however, was a matter of negotiation between the buyer and the seller (ibid.). 3. Respondent uses the accrual method of accounting for federal tax purposes. In compliance with the Gaming Commission rule described above, respondent recorded the meter readings shown on its progressive slot machines every day and made no impermissible reductions of the machines' payoff indicators (App., infra 9a). At midnight on the last day of its fiscal tax year, respondent entered the unpaid jackpot amounts shown on those indicators as an "accrued liability" on its books (ibid.). From that total, respondent subtracted the previous year's accrued jackpot liability to produce a "net accrued liability" for the tax year in question (id. at 10a). On its federal income tax returns for 1973-1977, respondent deducted the latter amounts under Section 162 of the Code /1/ as "ordinary and necessary (business) expenses paid or incurred during the taxable year." On audit, the Commissioner disallowed the claimed deductions. Under the accrual method of tax accounting, he noted, an expense may not be deducted until "all of the events have * * * occurred which fix the liability" (Treas. Reg. Section 1.461-1(a)(2)). The Commissioner determined that the events which would fix respondent's liability to pay a progressive jackpot would be some lucky patron's pull of the handle, and the consequent appearance of the winning symbols on the slot machine, in some future tax year. Until those events occurred, the Commissioner concluded, respondent's obligation to pay the jackpots was contingent and thus gave rise to no deductible expense (App., infra, 10a). The Commissioner accordingly determined a deficiency in respondent's income tax in the amount of $433,000 for the tax years at issue (id. at 1a, 21a). 4. Respondent paid the asserted deficiency and, following the denial of its administrative claim for refund, filed this refund suit in the Claims Court. That court ruled for respondent. It concluded that, under the Nevada Gaming Commission rule described above, respondent's liability to pay the amounts shown on the progressive jackpot indicators became "unconditionally fixed" (App., infra, 14a) on "midnight of the last day of the fiscal year" (id. at 19a). In the Claims Court's view, the last event necessary to fix respondent's liability for the progressive jackpots was "the last play (successful or not) of the machine before the close of the fiscal year, that is, the last change in the jackpot amount before the amount is recorded for accounting purposes" (id. at 13a). "The winning handle pull," the court said, would "only determine() the fortunate gambler in whose favor the liability (would be) enforced" (id. at 14a) (original quotation marks omitted)). The court seemed to acknowledge that if respondent "were to close its doors and go out of business, * * * it would not owe the jackpots to anybody" (id. at 15a (original quotation marks omitted)). But "(e)ven if the progressive slot machines were to never pay off," the court reasoned, "the set jackpot amounts indicated on the face of the machine(s) would still continue to be an incurred liability fixed by state law" (id. at 14a (emphasis in original)). The court "respectfully declined to follow" (id. at 15a) the Ninth Circuit's contrary decision in Nightingale v. United States, 684 F.2d 611 (1982). The Federal Circuit affirmed (App., infra, 1a-3a). It acknowledged (id. at 2a) that the Claims Court had "declined to follow the contrary conclusion of the Ninth Circuit" in Nightingale v. United States, supra. However, without further discussing that decision or the reasoning that the Ninth Circuit there advanced, the court of appeals "affirm(ed) on the basis of the * * * Claims Court opinion," concluding that the trial judge had "carefully examined all of the arguments raised on the present appeal" (App., infra, 3a). REASONS FOR GRANTING THE PETITION The court of appeals has decided an important question of federal tax law in a way that conflicts directly with a recent decision of the Ninth Circuit. The reasoning of the opinion below is squarely at odds with fundamental principles enunciated by this Court to govern accrual of deductions under the "all events" test of tax accounting. The decision below produces an irrational result, for it permits respondent to take current tax deductions for amounts to which no one can assert any present claim and which respondent may never have to pay at all. The revenue impact of the decision below, rendered by a court of nationwide jurisdiction, would be substantial even if confined to the casino industry. But it is by no means clear that its effect would be so limited. The "all events" test is one of the most frequently-recurring concepts in tax law, and the Federal Circuit's erroneous construction of that test could be pressed into service by taxpayers seeking to take current deductions for almost any sort of contingent future liability. Review by this Court is therefore appropriate. 1. The decision below, as the Federal Circuit acknowledged (App., infra, 2a), squarely conflicts with the Ninth Circuit's decision, on virtually identical facts, in Nightingale v. United States, 684 F.2d 611 (1982). Like respondent, the taxpayer there was a Nevada gambling casino that used the accrual method of tax accounting (684 F.2d at 612). Like respondent, it sought to deduct unpaid amounts shown on the jackpot indicators of its progressive slot machines as "accrued liabilities" at the close of its tax year (ibid.). Like respondent, it was subject to the Nevada Gaming Commission rule prohibiting casinos from turning back the payoff indicators on their slot machines (id. at 612-613). And like respondent, it contended that the year-end amounts shown on those indicators in consequence were "fixed liabilities" justifying deduction under the "all events" test of tax accounting, despite the fact that the jackpots had not yet been won by any player (id. at 613). The Ninth Circuit unanimously rejected the casino's argument. Notwithstanding the Gaming Commission rule, the court held, "(i)t (was) not true * * * that 'all events ha(d) occurred which determine(d) the fact of the liability'" at the close of the casino's tax year (684 F.2d at 614, quoting Treas. Reg. Section 1.461-1(a)(2)). Rather, as the Ninth Circuit saw it (684 F.2d at 614): The one, indispensable such event is the winning of the progressive jackpot by some fortunate gambler. Until that event occurs, no actual liability has been incurred. Gambling being what it is, and gambling odds being what they are, it is entirely possible that no actual liability will ever occur. And if we assume that it is bound to occur some day, there is no way of knowing when that will be. The record shows that it may be four years hence. If the casino "were to close its doors and go out of business," the court observed, "it would not owe the jackpots to anybody," a fact that "tend(ed) to show that there (was) no present liability" (684 F.2d at 615). Because the casino's liability on each slot machine was "contingent upon a winning pull," an event that "is most naturally regarded as a condition precedent" to the creation of a fixed obligation, the Ninth Circuit refused to permit deduction of progressive slot machine jackpots before they are actually won by a customer (id. at 614-615). 2. In declining to follow the Ninth Circuit's reasoning, the Federal Circuit ignored basic principles of tax accounting enunciated long ago by this Court and subsequently embodied in the Treasury Regulations. The Code generally permits taxpayers to compute taxable income under either the "cash receipts and disbursements method" or the "accrual method" of tax accounting (I.R.C. Section 446(c)(1) and (2)). Cash-method taxpayers may deduct expenses only in the year paid (Treas. Reg. Sections 1.446-1(c)(1)(i), 1.461-1(a)(1)). Accrual-method taxpayers, by contrast, are entitled to deduct expenses in the year "incurred," even though actual payment is deferred until a subsequent year. E.g., I.R.C. Section 162(a); see Treas. Reg. Sections 1.446-1(c)(1)(ii), 1.461-1(a)(2). It is well settled that "'to incur' means to become liable or subject to.'" Ox Fibre Brush Co. v. Blair, 32 F.2d 42, 47 (4th Cir. 1929), aff'd sub nom. Lucas v. Ox Fibre Brush Co., 281 U.S. 115 (1930). "(A) thing for which there exists no obligation to pay, either express or implied, cannot in law be claimed to constitute an 'expense incurred.'" United States v. St. Paul Mercury Indemnity Co., 238 F.2d 594, 598 (8th Cir. 1956). For more than fifty years, the standard for determining when an item of expense is to be regarded as "incurred," and hence as being properly deductible for federal tax purposes, has been the "all events" test. First articulated by this Court in United States v. Anderson, 269 U.S. 422, 424 (1926), the test was subsequently incorporated in the Treasury Regulations. It has two elements, both of which must be satisfied before accrual of an expense is proper. First, "all the events (must) have occurred which establish the fact of the liability giving rise to (the) deduction" (Treas. Reg. Section 1.446-1(c)(1)(ii)). Second, the amount of the deduction must be "determin(able) with reasonable accuracy" (ibid.). While the second part of the test permits a degree of computational flexibility, the Regulations emphasize that the first part of the test is absolute: "no accrual shall be made in any case (unless) all of the events have * * * occurred which fix the liability" (Treas. Reg. Section 1.461-1(a)(2)). In determining whether a liability has become "fixed," and thus constitutes an "expense incurred during the taxable year" for federal tax purposes, this Court early made clear that "a liability does not accrue as long as it remains contingent." Brown v. Helvering, 291 U.S. 193, 200 (1934). "The prudent businessman," Justice Brandeis wrote for the Court, "often sets up reserves to cover contingent liabilities. But they are not allowable as deductions." Lucas v. American Code Co., 280 U.S. 445, 452 (1930) (footnote omitted). To be deductible for tax purposes, the liability must be "unconditional." Lucas v. North Texas Lumber Co., 281 U.S. 11, 13 (1930). It must be "fixed and absolute." Brown v. Helvering, 291 U.S. at 201. "(T)he tax law requires," in short, "that a deduction be deferred until all the events have occurred that will make it fixed and certain." Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 543 (1979) (original quotation marks omitted). Respondent's liability for the progressive slot machine jackpots was plainly not "fixed and certain," was plainly not "unconditional" or "absolute," at midnight on the last day of its taxable year. At that moment, there existed no person at all who could assert any possible claim to those sums. If respondent the following morning were to have closed its doors, sold its business, or entered bankruptcy, or if its patrons were to have ceased playing the slot machines, respondent would have had no liability, and would never have had any liability, to pay the jackpots to anyone -- a fact that clearly demonstrates the conditional status of its obligation the night before. Respondent's obligation was in the nature of the offer of a prize, a prize that might be won if and when some future patron paid his money and plucked the winning combination of stars, bars, and fruit. So long as respondent chose to stay in the gambling business, of course, this offer was required to be irrevocable. But respondent's liability on the offer was nevertheless contingent. One does not have an "unconditional liability" unless there exists some person to whom he is liable, and respondent was not liable to anyone until somebody won the jackpot. Contrary to the Federal Circuit's belief, the Nevada Gaming Commission rule concerning progressive slot machines does not alter the conditional nature of respondent's obligation. That rule simply sets a floor beneath the amount of respondent's liability, while leaving the liability itself contingent. The rule provides that the dollar amount of the jackpot respondent offers can never ratchet down, but must always stay the same or ratchet up; it dictates that respondent's liability, if and when it is incurred, will be in an amount proportional to the number of times the machine has previously been played. But the rule does not require respondent to pay a jackpot unless and until it is won by a cusomter. The rule thus leaves respondent's year-end liability in exactly the same contingent state that it was in before the Gaming Commission began regulating progressive slot machines in September 1972. If respondent did have a fixed rather than a contingent liability at the close of its tax year, of course, the Gaming Commission rule could well permit the casino to satisfy the second prong of the "all events" test. Given the existence of that rule, arguably, "the amount (of respondent's year-end liability could) be determined with reasonable accuracy" (Treas. Reg. Section 1.461-1(a)(2)). Respondent, however, did not have a fixed liability at that time, and the Gaming Commission rule makes no difference in determining whether this first, and essential, component of the "all events" test has been satisfied. 3. In permitting respondent to take a current deduction for a contingent future loss, the decision below also conflicts in fundamental principle with this Court's decisions emphasizing the critical differences between tax and financial accounting. As the Claims Court noted (App., infra, 11a), taxable income is generally computed "under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books" (I.R.C. Section 446(a)). Section 446(b), however, sets forth an exception to this rule, providing that, if the accounting method used by the taxpayer "does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the (Commissioner), does clearly reflect income." The Regulations categorically state that "no method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income." Treas. Reg. Section 1.446-1(a)(2). Section 446 and its implementing Regulations obviously "vest the Commissioner with wide discretion in determining whether a particular method of * * * accounting should be disallowed." Thor Power Tool Co., 439 U.S. at 532. This Court early noted that the general rule permitting use of the taxpayer's usual accounting practice "is expressly limited to cases where the Commissioner believes that the accounts clearly reflect the net income." Lucas v. American Code Co., 280 U.S. at 449. And the Court recently reaffirmed that the Commissioner in the accounting area has "'(m)uch latitude for discretion'" and that "his interpretation of the statute's clear-reflection standard 'should not be interfered with unless clearly unlawful.'" Thor Power Tool Co., 439 U.S. at 532 (quoting Lucas v. American Code Co., 280 U.S. at 449). Congress's decision to grant the Commissioner "broad powers" (Commissioner v. Hansen, 360 U.S. 446, 467 (1959)) to depart from the taxpayer's accounting practice in computing taxable income owes to "the vastly different objectives that financial and tax accounting have." Thor Power Tool Co., 439 U.S. at 542. "The primary goal of financial accounting is to provide useful information to management, shareholders, (and) creditors" and "to protect these parties from being misled" (ibid.). Financial accounting accordingly "has as its foundation the principle of conservatism, with its corollary that possible errors in measurement (should) be in the direction of understatement rather than overstatement of net income" (ibid.; original quotation marks omitted). "(T)he major responsibility of the Internal Revenue Service," by contrast, "is to protect the public fisc," so that "understatement of income is not destined to be its guiding light" (ibid.). Thus, whereas financial accounting "typically require(s) that a liability be accrued as soon as it can reasonably be estimated," the tax law mandates "that a deduction be deferred until all the events have occurred that will make it fixed and certain" (id. at 543 (original quotation marks and footnote omitted)). "Indeed, th(is) Court's cases demonstrate that divergence between tax and financial accounting is especially common when a taxpayer seeks a current deduction for estimated future expenses or losses" (id. at 541 (citing cases)). The court of appeals departed from these well-established principles in sustaining respondent's deduction. It may well be, as respondent's witnesses testified below, that the year-end accrual of its contingent slot machine liabilities "conform(ed) with generally accepted accounting principles" (C.A. App. 42). There was a probability, gambling being what it is, that respondent would eventually incur liability for its progressive slot machine jackpots. Although the timing of that liability's incurrence was largely within respondent's control, subject as it was to respondent's discretion in setting odds, there was also a mathematical possibility that the liability might be incurred the very next day. Thus, "the principle of conservatism" (Thor Power Tool Co., 439 U.S. at 542) may well have required respondent to set up a reserve for those items at once and show them as a liability on its books. "(B)ut the accountant's conservatism cannot bind the Commissioner in his efforts to collect taxes" (id. at 543). Although "estimates, probabilities, and reasonable certainties * * * may be useful, even essential, in giving shareholders and creditors an accurate picture of a firm's overall financial health," the tax law, "with its mandate to preserve the revenue, can give no quarter to uncertainty" (ibid.). "Only a few reserves voluntarily established as a matter of conservative accounting are authorized by the Revenue Acts." Brown v. Helvering, 291 U.S. at 201-202 (Brandeis, J.) (quoted in Thor Power Tool Co., 439 U.S. at 543-544). A reserve for contingent slot machine liabilities is not among those so authorized. In sustaining respondent's deduction, finally, the court of appeals ignored this Court's warning about the "potential for tax avoidance" (Thor Power Tool Co., 439 U.S. at 538) inherent in accounting techniques of the sort involved here. As the Ninth Circuit observed in Nightingale, casinos on respondent's theory could put new machines on the floor near the end of their tax year "with whatever initial jackpot they chose and with whatever odds they liked. Then they could take a current deduction for the full amount even though payment of the jackpots might not occur for many years" (684 F.2d at 615). "If management's election among (such) options were dispositive for tax purposes, a firm * * * could decide unilaterally -- within limits dictated only by its accountants -- the tax it wished to pay" for a particular tax year (Thor Power Tool Co., 439 U.S. at 544). "Such unilateral decisions would not just make the Code inequitable; they would make it unenforceable" (ibid.). 4. The question presented in this case has substantial administrative importance. We are advised by the IRS that there are currently pending administratively within its Nevada District 36 cases, entailing potential tax liabilities of about $28 million, that present the same question as the instant case. Furthermore, if the decision below is not reversed, the IRS anticipates that a number of other Nevada gambling casinos, which previously agreed to tax deficiencies after the Ninth Circuit rendered its decision in Nightingale, will file claims for refund. The aggregate amount of such refund claims is expected to equal or exceed the $28 million at issue in the 36 cases now pending administratively. The above figures, moreover, do not take into account the impact of the Federal Circuit's decision on the casino industry in New Jersey. The IRS advises that the aggregate progressive slot machine liabilities of the New Jersey casino industry from its inception in 1978 through 1984 approximate $25 million. The IRS estimates that some $11 million in taxes is potentially at stake by reason of premature progressive jackpot accruals by New Jersey casinos. As these numbers show, the revenue involved is considerable within the casino industry alone. The Federal Circuit's decision, however, could have an even more significant impact in other tax contexts. Many of this Nation's businesses use the accrual method of tax accounting, and the "all events" test is one of the most frequently-recurring concepts in tax law. The Federal Circuit's open-ended construction of the "fixed liability" component of that test could be pressed into service by accrual-basis taxpayers seeking current deductions for a host of contingent future liabilities -- liabilities as diverse as employers' obligations on workmen's compensation claims and coal companies' obligations to restore strip-mined land. The Claims Court is a court of nationwide jurisdiction -- any taxpayer in the country can have his case heard there, with review in the Federal Circuit, simply by filing a refund suit. Accrual-basis taxpayers can thus be expected to make vigorous attempts to extend the Federal Circuit's reasoning well beyond slot machines and the gaming industry. CONCLUSION The petition for a writ of certiorari should be granted. Respectfully submitted, CHARLES FRIED Acting Solicitor General GLENN L. ARCHER, JR. Assistant Attorney General ALBERT G. LAUBER, JR. Assistant to the Solicitor General RICHARD FARBER Attorney SEPTEMBER 1985 /1/ Unless otherwise noted, all statutory references are to the Internal Revenue Code of 1954 (26 U.S.C.), as amended and as in effect for the tax years at issue (the Code or I.R.C.).