Before Newman, Michel, and Lourie, Circuit Judges.
The opinion of the court was delivered by: Michel, Circuit Judge.
Appealed from: United States Court of Federal Claims Judge Christine O. C. Miller
Plaintiff-Appellant Dana Corporation ("Dana") appeals from the grant of partial summary judgment to the government by the United States Court of Federal Claims in Dana Corp. v. United States, 38 Fed. Cl. 356 (1997), upholding as within the Internal Revenue Service's ("IRS's") discretion its requirement that Dana's subsidiary recalculate its income taxes for certain years using the accrual, rather than the cash, method of accounting. The government cross-appeals from the trial court's granting in part of Dana's motion for summary judgment, upholding the deductibility, as an ordinary and necessary business expense, of a certain year's legal retainer fee, even though applied, as a contractual obligation, as an offset against capital acquisition legal expenses in that year. The appeal was orally argued on October 5, 1998. We hold that requiring one of Dana's domestic subsidiaries, Potomac Leverage Leasing ("Leverage Leasing"), to recalculate its federal income taxes using the accrual method of accounting was an abuse of the Commissioner's discretion under I.R.C. § 446(b) (1984). Congress permits deductions for advance payment of accrued interest and this, as reflected in Dana's cash method of accounting, is what must determine the deductibility of the interest payments actually made by Leverage Leasing on its loans. Yet the Commissioner required the change in tax accounting method on the ground that the cash method distorted the relationship between such payments and receipts and hence the calculation of taxable income. What is authorized by Congress cannot be within the Commissioner's discretion to deny.
As to the government's cross-appeal, we grant it, holding the 1984 retainer fee non-deductible due to the use of the retainer fee to pay non-deductible legal services. Dana has a sixteen year history of paying annual retainer fees, in part to prevent its law firm from representing other companies in attempted acquisitions of Dana, and in part to receive the benefit of having the law firm represent it in various matters with the contractual right to offset any later fees against the annual retainer fee for a given year. The right of offset was unlimited and, thus, covered both deductible and non-deductible fees for legal services. In most years Dana was allowed to deduct the retainer fee as an ordinary business expense, but we hold that, despite this history, because in 1984, the sole tax year in question, the annual retainer fee was applied toward non-deductible fees for legal services involving a capital acquisition under a provision of the retainer agreement requiring such offset, the 1984 retainer fee is not deductible as an ordinary and necessary business expense.
Accordingly, we grant both the appeal and the cross-appeal, reversing both judgments.
Dana is an Ohio corporation engaged, in part, in real estate leasing. For both the 1984 and 1985 tax years, the only years at issue, Dana and its domestic subsidiaries filed a consolidated federal income tax return, reporting earnings and expenses on a calendar year basis.
Two issues are presented for our review. One involves the method of accounting used for federal income tax purposes for Leverage Leasing. In consolidated federal income tax returns for 1984 and 1985, Leverage Leasing's receipts and expenses were reported using the cash method of accounting, while Dana and its other domestic subsidiaries reported gross income and expenses using the accrual method. It is undisputed both that Leverage Leasing used the cash method solely to obtain tax benefits, and that such tax motive is not controlling.
During 1984 and 1985, Leverage Leasing was a party to a number of leases under which it was entitled to receive accrued rents, in arrears. In turn, Leverage Leasing was obligated to pay interest, also in arrears, on loans related to the properties for which rents were received in 1984 and 1985. It did so. In December 1984, however, Leverage Leasing also paid interest in arrears that accrued in 1984 but was not actually due for payment, under the terms of the financing arrangements, until 1985. In December 1985, Leverage Leasing likewise paid interest in arrears that had accrued in 1985, but was not due to be paid until 1986. Under the cash method of accounting, receipts are recognized in the year in which received and expenses in the year in which paid. *fn1 As a consequence of Leverage Leasing's payments of interest in the taxable year before payment was due, its ordinary and necessary business expenses, i.e., interest payments, exceeded its gross income for both 1984 and 1985. It, therefore, had no tax liability. The IRS then determined that, for the tax years 1984 and 1985, the cash method of accounting did not clearly reflect Leverage Leasing's income, stating that the cash method caused excess interest deductions. Under the applicable statute, Internal Revenue Code section 446(b), the IRS accordingly required that Leverage Leasing's federal income tax be recalculated using the accrual method of accounting. This requirement effectively eliminated the deductions for the advance payments.
Using the accrual method of accounting, Leverage Leasing had taxable income for both 1984 and 1985, resulting in additional income tax owing and due the IRS from Dana. Because Dana had paid nothing on account of Leverage Leasing, it was required to pay the full tax so assessed. After paying this deficiency, Dana sought a corresponding refund from the IRS. When Dana challenged the IRS denial in the Court of Federal Claims, the court held that the IRS acted within its discretion in requiring Dana to substitute the accrual method in calculating Leverage Leasing's taxable income. See Dana Corp., 38 Fed. Cl. at 366. Dana appeals that decision here.
The other issue involves the deductibility of Dana's payment in 1984 of a law firm retainer fee. Dana first entered into a retainer agreement with the law firm of Wachtell, Lipton, Rosen and Katz ("Wachtell") in 1976. This one year agreement was automatically renewable and was in fact renewed annually through 1991. Pursuant to the retainer agreement, Dana paid Wachtell a retainer fee of $100,000 on January 1, 1984 and certain other years.
According to the stipulated facts, the agreement's express purposes included keeping Wachtell from representing adverse clients targeting Dana in takeover situations and standing by to represent Dana, both in hostile takeovers and in other legal matters. The retainer agreement, however, also entitled Dana to an offset of any charges incurred through the use of Wachtell's legal services against the retainer fee paid for the corresponding year. In 1984, Dana acquired Warner Electric Brake and Clutch Company ("Warner"). Wachtell billed Dana $265,000 for services rendered in the acquisition, and then offset this charge by the $100,000 retainer. Dana thus paid Wachtell $165,000 in legal fees and capitalized that amount as part of the acquisition cost of Warner. But the $100,000 retainer fee it nevertheless deducted.
In 1985, Dana again paid the annual $100,000 retainer fee but did not use Wachtell's services. Dana again deducted the entire retainer fee as an ordinary and necessary business expense. The IRS, however, classified the 1984 retainer fee as a non-deductible capital cost of the Warner acquisition although it allowed the deduction of the 1985 retainer as an ordinary and necessary business expense. The IRS and Dana agree that the 1984 retainer fee would have constituted a proper deduction as much as the 1985 fee had it not later been offset against the legal services fee for the Warner acquisition.
The Court of Federal Claims granted in part Dana's motion for summary judgment, approving the deductibility of the 1984 retainer fee and holding that the retainer fee was indeed an ordinary and necessary business expense in 1984, despite its use to offset legal services fees related to the capital acquisition. See ...