COMMISSIONER OF INTERNAL REVENUE, PETITIONER V. INDIANAPOLIS POWER AND LIGHT COMPANY No. 88-1319 In The Supreme Court Of The United States October Term, 1989 On Writ Of Certiorari To The United States Court Of Appeals For The Seventh Circuit Reply Brief For The Petitioner 1. The thrust of respondent's argument is that security deposits to guarantee the payment of future utility bills cannot be income because they are not "'accessions to wealth, clearly realized, and over which the taxpayers have complete dominion'" (Br. 10, quoting Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955)). It is undisputed that respondent had complete dominion and control over the deposits, and it is clear that any income was "realized" when it was received in cash. Thus, respondent's argument is that the receipt of the deposit is not an "accession to wealth" because it was "unequivocal(ly)" (Br. 22) or "unconditionally subject to refund" (Br. 19) -- either directly or by applying the amount of the deposit to a future bill for services -- or, alternatively, was subject to refund upon the satisfaction by the customer of certain conditions. See Resp. Br. 9-13, 24-30. Hence, respondent concludes that the deposit should be viewed as the property of the customer until it is applied to an outstanding bill. This analysis is flawed. Rather, as we explained in our opening brief, the cash receipt of a deposit that is designed to secure the payment of future bills for utility services, and eventually to be applied to satisfy outstanding bills, is an "accession to wealth" in precisely the same way as any other advance payment for goods or services, and it should be taxed accordingly. Respondent's position ultimately rests on semantics that should not be determinative of the correct tax treatment. This can be illustrated by comparing two arrangements that a landlord might make to ensure full payment of rent. He could require the tenant to deposit one month's rent in advance with the proviso that the deposit would be returned when the full year's rent has been paid. Alternatively, he could require the tenant to pay the same sum in advance to be applied later as payment of the last month's rent after the tenant has paid the first 11 months' rent. Respondent's position appears to be that these two essentially identical arrangements should receive different tax treatment -- the first is a refundable deposit that is not taxable as income upon receipt and the second is an advance payment that is taxable as income upon receipt. /1/ See Resp. Br. 17-19, 24-30. There is no sound basis for such disparate treatment. In fact, respondent's own theory is difficult to square with that result. In arguing that security deposits are unconditionally refundable, respondent maintains that applying a deposit to satisfy a bill is "the full equivalent of a cash refund" (Br. 29). See also Wisconsin Electric Power Co., et al. Amicus Br. 11 & n.2. If so, then there is no justification for treating the case of a payment that is to be refunded after 12 months any differently from the case of a payment that is to be applied to the last month's rent. In both cases, the recipient of the payment recognizes the obligation to "refund" it later -- perhaps in the form of a credit for services rendered to the payor -- and therefore, under respondent's view, the payment cannot be income upon receipt. The difficulty with this approach is that it is squarely contrary to the now settled principles laid down by this Court, which make an advance payment of the last month's rent taxable upon receipt. Indeed, almost any advance payment can be regarded as "refundable" under respondent's analysis because the payment ultimately will be applied to satisfy the customer's obligation for goods or services to be provided in the future, yet advance payments are nonetheless taxable upon receipt. Respondent's approach is flawed theoretically by its assumption that a payment cannot be income if the recipient has some obligation to repay it. /2/ In a case like this, where the taxpayer receives a payment representing an income item and subject to his unfettered use and control, it is appropriate to recognize the income upon receipt, even though there is a contingent obligation to refund the money at some future time. As we note in our opening brief (at 21), the utility's contemplation at the time the deposit is paid is that it will be applied to an outstanding bill as payment for goods or services, not directly refunded; otherwise, the deposit would not be required in the first place. There is no fixed obligation to repay the funds. On the facts here, respondent's obligation to refund the deposit is a contingent one that turns on several conditions, and it is uncertain when the obligation will have to be fulfilled. For instance, the deposit may have to be refunded or applied to the customer's bill within a few months if he quickly terminates service; or it may be refunded in nine months to a year if he immediately establishes a good payment record; or it may be held for a much longer time if the customer maintains an erratic payment record; or, if the deposit goes unclaimed and ultimately escheats to the state, it will be held by respondent for more than seven years. For this entire, indefinite period during which the conditions for refund of the deposit or its application to the customer's bill have not been satisfied, respondent has full ownership and unrestricted use of the funds. It is not appropriate for respondent to defer recognition of income in the amount of the deposit for many months or years, simply because at some time the money will be credited against a bill or refunded (in conjunction with an equal payment by the customer for goods or services). The more sensible and accurate tax treatment is to treat the deposit as income when it is received -- when it becomes respondent's property subject to its full control and is indistinguishable from any other form of advance payment for future goods or services -- and then to allow a deduction in the future if the deposit is ever refunded. Contrary to respondent's assertion (Br. 24), the deposits at issue here are not correctly viewed as loans. A loan, which involves a promise to repay the principal, is an example of a cash payment that does not give rise to income upon receipt, but not every payment that is subject to a refund obligation is necessarily a loan. A loan, almost by definition, does not give rise to income. It is a self-contained transaction in which money changes hands for a period of time and is then repaid. Apart from the interest paid, the parties are in the same position at the end as when they started, and no income has been generated. By contrast, the deposits at issue here are to facilitate the production of income through the payment of bills for utility services; in the end, the utility has received income either through direct application of the deposit to an outstanding bill or by a separate payment from the customer that is required in order to permit refund of the deposit. /3/ Thus, the deposit operates like an advance payment -- in the words of Judge Sneed, it "must result in income either at the time of receipt, the time of performance, or both" (J. Sneed, The Configurations of Gross Income 50 (1967)). In contrast to a true loan, which is never recognized as income, the only question in the case of a deposit to secure the payment of future income is when should the amount of the deposit be recognized as income. /4/ The economic reality of the situation and this Court's decisions in the advance payment cases dictate the conclusion that it is appropriate to recognize the amount of the deposit as income when received. 2. Respondent argues (Br. 20 n.9, 31-32; see also American Information Technologies Corp., et al. (Telephone Companies) Amicus Br. 5-8, 10-12) that the inclusion in income of a deposit to secure the payment of future utility bills leads to double counting in the case of accrual-basis taxpayers. This argument is mistaken. The overcounting identified by respondent is inherent in the accrual method and will inevitably occur when a customer fails to pay a bill that has been accrued by the seller as income (see, e.g., Commissioner v. Hansen, 360 U.S. 446, 466-467 (1959)); the phenomenon has nothing to do with the Commissioner's proposed treatment of deposits. That the government's position does not create double counting is illustrated by the very example used by respondent (see Telephone Companies Amicus Br. 11-12). The customer makes a $50 deposit and is billed for $50 worth of service in November and December. Under the Commissioner's approach, the utility recognizes $100 in income in the first year, though it has provided only $50 worth of service. If the customer defaults on the payment of the November-December charges, the deposit is applied to his bill in January and the utility is entitled to a $50 deduction in the second year. It would appear at first glance, as respondent asserts, that $50 in income has been incorrectly shifted into the first year. But this "income shifting" is a direct result of the accrual of the November-December bill before it is paid; it has nothing to do with the treatment of the deposit. If the hypothetical is altered slightly to remove the deposit feature, we see that the same $50 income shift occurs. The taxpayer accrues $50 in income in the first year as a consequence of its billing for November-December charges, even though it receives no actual income in that year. When the customer defaults in the second year, the utility is entitled to a $50 deduction to reflect the fact that it never received the income that it had accrued in the first year. Respondent's attempt to lay the blame for this income shift at the doorstep of the Commissioner's treatment of the deposit is flawed because respondent is commingling two distinct concepts and two different utility bills. Under principles of accrual accounting, a taxpayer accrues income when all the events have occurred that establish its right to receive that income -- for example, when it has provided services -- even though it has not yet received cash payment. See generally United States v. General Dynamics Corp., 481 U.S. 239 (1987). For that reason, in respondent's example the utility accrues income for the November-December services before payment is made, and therefore it is entitled to an adjustment when the customer later fails to pay. Advance payments, on the other hand, must be taken into income when they are received (whether the recipient is on the cash or the accrual method), even though the goods or services for which the payment is made may not be furnished until the following year. Thus, the treatment of advance payments demands the inclusion in income of amounts that have not yet been earned by performance. That treatment is required by this Court's decisions in Schlude v. Commissioner, 372 U.S. 128 (1963); American Automobile Ass'n v. United States, 367 U.S. 687 (1961); and Automobile Club v. Commissioner, 353 U.S. 180 (1957); and respondent does not challenge the correctness of these decisions. See generally 4 B. Bittker, Federal Taxation of Income, Estates and Gifts Paragraph 105.3.4, at 105-60 to 106-64 (1981); Gov't Br. 12-13; see also RCA Corp. v. United States, 644 F.2d 881, 887-888 (2d Cir. 1981), cert. denied, 457 U.S. 1133 (1982). Under this well-settled rule, treating the deposits here as advance payments means that they are included in income when received, even though the utility bills to which they ultimately will be applied are for services to be rendered at some future time, many months or perhaps years after receipt of the payments. This is why, in respondent's example, the recognition of income in the amount of the deposit does not relate to any services that have already been provided by the utility. The recognized income relates to the services to be rendered in the future period to which the deposit is applied (either after termination or after the customer demonstrates his creditworthiness), and this is equally true whether the taxpayer reports on the cash or accrual method. In sum, the Commissioner's treatment of deposits held by accrual-basis taxpayers does not introduce any double counting or other distortion of income. /5/ 3. Citing Rev. Rul. 79-229, 1979-2 C.B. 210, and two court decisions, respondent argues (Br. 34-37) that the Commissioner seeks to apply a double standard by denying the payor a deduction for cash prepayments where he would require the recipient to include the payment in income upon receipt. But respondent fails to acknowledge that the ruling and the cited cases are directed at the possibility of "taxpayer abuse" by a cash basis taxpayer's accelerating his deductions into an earlier year by means of a year-end cash transfer. See Keller v. Commissioner, 79 T.C. 7, 29, aff'd, 725 F.2d 1173 (8th Cir. 1984). Under the cited authority, the acceleration of the deduction in this manner will not be allowed where the prepayment is made for a tax advantage, not for a valid business purpose. This problem of manipulation by the payor of prepayments to achieve a deduction in an earlier year is distinct from the problem presented here regarding the time at which the recipient of a payment must take it into income, and the tax treatment from the two perspectives is not necessarily the same. The situations involved in Rev. Rul. 79-229 and the cited cases have nothing to do with the "security" concerns that respondent believes must be controlling here; for example, in Schenk v. Commissioner, 686 F.2d 315 (5th Cir. 1982), the payment in question was not requested by the supplier and the payor received no benefit (other than the claimed tax deduction) for making it in advance. Respondent presumably would not dispute that such "nonsecurity" payments must be regarded by the recipient as advance payments that are recognized as income upon receipt, but these payments nonetheless may not be immediately deductible by the payor if they serve no purpose other than to obtain a tax advantage. 4. In our opening brief (at 24-34), we argue that the "facts and circumstances" test does not provide a reasoned basis for deciding advance deposit cases because the factors relied upon by the Seventh Circuit (almost exclusively interest) and by the Tax Court have little bearing on the correct treatment of a customer deposit. Respondent does not address the particulars of this argument, and does not explain why the presence or absence of certain facts should affect the taxability of individual utility deposits. Indeed, the inconsistent approaches taken by the various briefs filed in this case highlight the amorphousness and unworkability of the "facts and circumstances" test invoked by the courts below. /6/ In contrast to the unpredictable and erratic results that are invited by the "facts and circumstances" test, the Commissioner's approach of treating cash deposits to secure the payment of future bills as income upon receipt provides a basis for consistent decisionmaking that is soundly based in settled principles under the Code regarding the treatment of advance payments. Indeed, even if it would be within the Commissioner's discretion under the Code to rule to the contrary, the position he has taken in Rev. Rul. 72-519, 1972-2 C.B. 32, is well within his authority to choose among reasonable interpretations of the congressional mandate and to assure that taxpayers' accounting methods accurately reflect income. See, e.g., National Muffler Dealers Ass'n v. United States, 440 U.S. 472, 488-489 (1979); Commissioner v. Hansen, 360 U.S. at 467. /7/ For the foregoing reasons, and those stated in our opening brief, the judgment of the court of appeals should be reversed. Respectfully submitted. KENNETH W. STARR Solicitor General SEPTEMBER 1989 /1/ Respondent specifically concedes that if the deposit is described as securing the last month's rent, it is taxable upon receipt, even though it is designated as a security deposit (Br. 26-27). Respondent explains that this is because in that situation, "the landlord's duty to refund does not arise until he has received payment of the agreed month's rent, i.e., he does not divest himself of the cash until he receives an identical amount of cash" (Br. 27). It is not apparent why this observation is not equally applicable to -- and controlling in -- the instant case. Respondent is not obliged to make a refund until the customer makes the agreed payments establishing his creditworthiness or terminates service. /2/ Contrary to respondent's submission (Br. 10-11), this assumption is not supported by James v. United States, 366 U.S. 213, 219 (1961). The Court held in James that the proceeds of an embezzlement must be reported as income, explaining that the receipt of funds without restriction as to their use or recognition of an obligation to repay must be income. The absence of recognition of an obligation to repay was critical in James because recognition of such an obligation in that context would have meant that the embezzler did not hold the funds as his own. That is not true here or in other contexts involving advance payments for goods or services, however, and the Court in James did not suggest that the existence of an obligation to repay in these circumstances would be inconsistent with treating a payment as income upon receipt. /3/ Thus, there is no merit to respondent's attempt to distinguish these deposits from advance payments, and to equate them with loans, on the basis of their connection with the provision of goods or services. See Resp. Br. 12-13, 24-26. While there may not be the same kind of contractual connection between the deposit and a specific good or service to be provided in the future that exists in the case of an ordinary advance payment, it is manifest that the deposit is part and parcel of a larger transaction in which the recipient provides utility services in exchange for money. Without the promise and expectation of future utility services, the deposit would never be paid. Thus, the utility deposit is not materially distinguishable from an advance payment "exchange(d)" for a "promise() to provide goods or services" (Resp. Br. 12), and it is quite distinct from a loan, which is a self-contained transaction that has no connection with the provision of goods or services separate from the loan itself. /4/ Respondent's effort to equate utility deposits with ordinary or "compensating balance" bank customer deposits (Br. 30) is also flawed. It is undisputed in this case that the utility deposits are placed within the unfettered control of the utility when received; the funds become the utility's property at that time. The only question is whether they should nevertheless not be included in income until later because of the utility's obligation at some future time to refund or otherwise account for the amounts deposited. By contrast, the funds deposited in a customer's bank account clearly remain his property and are not within the unfettered control of the bank. While a bank has the power to invest funds that customers keep on deposit, that power is heavily regulated, and its use of the funds is clearly restricted. In sum, in contrast to a utility's control over customer deposits, a bank does not have ownership of or "complete dominion" (Commissioner v. Glenshaw Glass Co., 348 U.S. at 431) over funds that its customers keep on deposit, and hence the amounts deposited are not income to the bank. /5/ Respondent's argument (see Br. 7, 31-32) that the deposits here should not be viewed as securing future "income" because it is an accrual-basis taxpayer is wholly without merit. There can be little doubt that the "income" upon which respondent pays income tax is composed of the amounts paid by its customers in exchange for utility services. The deposits are applied to customer accounts as such payments for services, and therefore they are income in the same way as other customer bill payments. The fact that respondent's accrual accounting system makes an income entry when the bill is sent and reduces the "accounts receivable" entry when the bill is paid is a matter of bookkeeping, which is significant to the timing of income recognition but does not alter the fundamental truth that it is the payments, not the bills, that generate income to respondent. /6/ Respondent simply states that each case should turn on its own facts and circumstances and asserts that the circumstances of this case justify deferral of the receipt of income until the deposit is applied to a particular bill. To justify this conclusion, respondent lists the factors upon which the courts below relied without responding to the Commissioner's objections to the relevance of those factors. Br. 14-16. See also Wisconsin Power Amicus Br. 8, 16 n.4. With respect to interest, respondent states, without explanation, that it is a "significant factor" in the context of regulated public utilities. See Resp. Br. 19-23. Amicus El Paso Electric Co. argues (Br. 18-19) that the existence of an interest obligation reflects a restriction on the utility's ability to use the money that is necessarily inconsistent with treating the deposit as an advance payment. Amicus Oak Industries, Inc., on the other hand, maintains that the presence or absence of an interest obligation is completely irrelevant (Br. 8-13). Amicus Oak Industries also argues that the Tax Court erred in relying on any factor other than "respondent's control over the ultimate disposition of the deposits" (Br. 13). The ad hoc and essentially standardless nature of the "facts and circumstances" test is tellingly reflected in the brief of Amicus American Information Technologies Corp. (at 14), which simply describes some of the features of this case and announces without further explanation that these facts, considered in combination, should result in the deferral of income until the deposit is applied. /7/ Respondent repeatedly suggests (Br. 3, 23) that the Commissioner's position with regard to utility deposits represents a reversal of 50 years of administrative practice that did not challenge respondent's method of reporting these deposits. In fact, there has been no change in position by the Commissioner. Respondent neglects to mention that the advance payment cases upon which the Commissioner's published ruling is based were not decided until only a few years before Rev. Rul. 72-519 was issued in 1972. Until the treatment of advance payments was settled by those cases, culminating with the decision in Schlude v. Commissioner, supra, in 1963, there was no occasion for the Commissioner to consider the effect of those decisions upon the treatment of utility deposits.