INDUCTOTHERM INDUSTRIES, INC. Appellant v. UNITED STATES of America, United States Court of Appeals, Third Circuit., 351 F.3d 120, No. 02-4292., Dec. 8, 2003., Argued July 31, 2003
INDUCTOTHERM INDUSTRIES, INC. Appellant v. UNITED STATES of America
United States Court of Appeals, Third Circuit.
351 F.3d 120
Dec. 8, 2003.
Argued July 31, 2003.
Filed Dec. 8, 2003.
Ronald L. Glick, (Argued), Stevens & Lee, Cherry Hill, N.J., for Appellant.
Eileen J. O'Connor, Assistant Attorney General, Gilbert S. Rothenberg, Francesca Ugolini, (Argued), Department of Justice, Tax Division, Washington, D.C., for Appel╜lee.
Before SCIRICA, Chief Judge, RENDELL and AMBRO, Circuit Judges.
OPINION OF THE COURT
AMBRO, Circuit Judge.
This appeal involves a dispute between a taxpayer and the Internal Revenue Service about the proper time to recognize income and losses. The taxpayer maintains that it was not required to recognize the proceeds from the sale of goods as income in the year it received those proceeds because the funds were subject to a governmental blocking order and, under the Claim of Right Doctrine, it did not have unfettered discretion as to the funds. It also seeks to deduct the manufacturing costs of other goods in a year prior to that in which it sold those goods, reasoning that the Iraqi Sanctions Regulation then in place - which prohibited the taxpayer from selling those goods - either was in effect a confiscation or deprived the goods of any market value. The District Court held in favor of the Government as to both claims. We affirm.
In 1989; taxpayer Inductotherm Indus╜tries, Inc. ("Inductotherm"), through its subsidiary Consarc, 1 contracted with Iraq to manufacture three vacuum furnaces. One furnace ("Furnace A") is an Induction Skull Melting Furnace. The other two ("Furnaces B and C") are Electron Beam Furnaces - a technology that tater became disfavored and apparently is no longer in widespread use today. Iraq represented that the furnaces would be used to manu╜facture prosthetics for veterans of the Iran-Iraq war. It later came to light that Iraq instead intended to use the furnaces in its nuclear weapons program. Inductot╜herm was unaware of Iraq's true intentions.
1. ═ For convenience, we refer to Inductotherm and Consarc throughout this opinion simply as Inductotherm.
As the three furnaces were about to be exported to Iraq, it invaded Kuwait. In response, on August 2, 1990, President George H.W. Bush entered an Executive Order - the Iraqi Sanctions Regulation -blocking all property in which Iraq had an interest. As applied to Inductotherm, the Executive Order precluded the sale or transfer of the three furnaces without the permission of the Office of Foreign Assets Control ("OFAC"). Moreover, all funds in which Inductotherm had an interest due to the Iraqi contract were blocked pursuant to the Executive Order unless OFAC is╜sued a license unblocking them. See 31 C.F.R. ╖ 575.201, et seq. At the time, those funds in which Iraq potentially had an interest included a $6.4 million letter of credit ("LC") and Iraq's $1.1 million de╜posit for the three furnaces. Moreover, because Inductotherm had received this $1.1 million deposit, OFAC took the posi╜tion that Iraq had a property interest in all three furnaces and thus they were blocked property.
To mitigate its losses, Inductotherm at╜tempted to find new buyers for the fur╜naces. It sold Furnace A to Mitsubishi in its 1991 tax year for approximately $1.8 million. 2 Rather than place the sale pro╜ceeds in a blocked account, Inductotherm commingled them with other corporate funds. It was unable to sell Furnaces B and C in that year. Eventually, however, Inductotherm sold the furnaces in 1997 to Reading Alloys for what Inductotherm al╜leges was less than its production and carrying costs.
2. ═ Inductotherm's tax year ends on April 30.
When the Government learned of the Mitsubishi sale, it directed Inductotherm to block the sale proceeds. On June 17, 1991, during Inductotherm's 1992 tax year, the Government confirmed those instruc╜tions by issuing a "Directive License," which specifically applied the Executive Order to Inductotherm. Inductotherm disputed, inter alia , the applicability of the Executive Order to the sale proceeds, and protracted litigation ensued in the United States District Court for the District of Columbia and then in the United States Court of Appeals for the District of Colum╜bia Circuit. Ultimately, the D.C. Circuit held that the furnaces, and the proceeds therefrom, were blocked property but could be released if Inductotherm placed the $1.1 million deposit in a blocked ac╜count - a procedure clearly contemplated in the Executive Order. Consarc Corp. v. United States Treasury Dep't Office of Foreign Assets Control, 71 F.3d 909 (D.C.Cir.1995).
Meanwhile, when filing its tax returns, Inductotherm did not record the 1991 Fur╜nace A sale proceeds as taxable income in 1991, reasoning that, as a result of the Executive Order and the Directive Li╜cense, it did not have unfettered discretion to dispose of the proceeds. It urges that, under the Claim of Right Doctrine (dis╜cussed in Section II below), if a taxpayer does not have unfettered discretion with respect to funds, those funds need not be recognized as income. The IRS disputed Inductotherm's reasoning and assessed. a tax deficiency. Inductotherm paid the back taxes on Furnace A as the IRS re╜quired and fried suit in the United States District Court for the District of New Jer╜sey to recover the alleged overpayment. The Court held against Inductotherm on this issue, granting summary judgment in favor of the Government.
In its 7991 and 1992 tax years, Inductot╜herm took deductions on account of the production costs of Furnaces B and C, despite the fact that it did not sell them until 1997. Inductotherm argued that, while normally costs may be deducted only in the year that an item is sold, see United States v. Catto, 384 U.S. 102, 109, 86 S.Ct. 1311, 16 L.Ed.2d 398 (1966), in its case an exception should apply: as a result of the Executive Order, the furnaces, in effect, were no longer Inductotherm's property and indeed were confiscated from it. The IRS disallowed this deduction. Again, In╜ductotherm paid the required tax deficien╜cy and filed suit to recover. The District Court granted summary judgment in favor of the IRS on this claim as well.
Inductotherm appeals both rulings. 3
3. ═ The District Court had jurisdiction under 28 U.S.C. ╖ 1331. We exercise jurisdiction pur╜suant to 28 U.S.C. ╖ 1291. Because the is╜sues in this appeal are questions of law, our review is plenary. Epstein Family P'ship v. Kmart Corp. , 13 F.3d 762, 765-66 (3d Cir. 1994).
A. Furnace A
Inductotherm argues that it was not required to treat the sale proceeds for Furnace A as income in 1991 tinder the Claim of Right Doctrine. That Doctrine, set out in North American Oil Consolidat╜ed v. Burnet, 286 U.S. 417, 52 S.Ct. 613, 76 L.Ed. 1197 (1932), holds that funds re╜ceived by a taxpayer will be considered income if (1) "a taxpayer receives earnings under a claim of right" and (2) "without restriction as to its disposition," "even though it may still be claimed that [the taxpayer] is not entitled to retain the mon╜ey, and even though [the taxpayer] may still be adjudged liable to restore its equiv╜alent." Id. at 424, 52 S.Ct. 613.
Here, Inductotherm has conceded that it received the Furnace A proceeds under a "claim of right," i.e., it acknowl╜edged its entitlement to the proceeds. However, it disputes that it held the Fur╜nace A proceeds without restriction as to disposition in 1991. Inductotherm reasons that the Executive Order, issued during its 1991 tax year, required it to place the funds in a blocked account (which, howev╜er, it did not do) and thus restricted its discretion as to those funds in 1991. In╜ductotherm relies principally on a line of cases holding that public utilities were not required to recognize as income customers' deposits, prepayments, or "overrecover╜ies," which those utilities clearly were obli╜gated to return, despite the fact that the utilities commingled the funds (as Induc╜totherm did). See, e.g., Commissioner v. Indianapolis Power & Light Co., 493 U.S. 203, 110 S.Ct. 589, 107 L.Ed.2d 591 (1990) (customer deposits made to assure prompt payment of future bills not income; even though funds commingled with general funds, deposits represent merely loans be╜cause customers are entitled to demand return of fiends under specified circum╜stances); Mutual Tel. Co. v. United States, 204 F.2d 160, 161 (9th Cir.1953) (monies utility held in reserve a, the direction of the Public Utilities Commission were not income because "it cannot be said that the receipts came into the possession of [the utility] subject to its 'unfettered command' and that it was free to enjoy the receipts at its option"); Florida Progress Corp. v. Commissioner, 114 T.C. 587, 599, 2000 WL 889750 (2000) ("Because the time and method of refunding overrecoveries is con╜trolled by [agencies] rather than by Flori╜da Power, [it] does rot have complete do╜minion over the overrecoveizes and is not required to recognize them as income when received."); Houston Indus. Inc. & Subs. v. United States, 32 Fed. Cl. 202, 210 (Fed.Cl.1994) ("overrecoveries" for fuel costs are not income because "[every dollar of overrecovery must eventually be re╜paid.").
The Government argues that these utili╜ty cases are not analogous because the first prong of the Claim of Right Doctrine was not satisfied: the utilities did not claim that they were entitled to the funds for their own benefit. Rather, they con╜ceded at all times that they held the funds in a fiduciary capacity or, at least, with a clear obligation to return the funds. Moreover, as to the second prong, the utilities' discretion with respect to the funds was at all times limited by extensive regulatory oversight by state administra╜tive agencies. The Government directs our attention instead to James v. United States, 366 U.S. 213, 81 S.Ct. 1052, 6 L.Ed.2d 246 (1961), which held that money embezzled must be included in income, even though it likely would have to be disgorged in the future. Just as Inductot╜herm argues that, its commingling of the Furnace A proceeds is not dispositive un╜der the utility cases, the Government cites James for the proposition that Inducot╜herm's legal duty to block the proceeds under the Executive Order is likewise not dispositive. In James, it was clear that the embezzler had no right to the funds at issue. Nonetheless, because the embez╜zler treated the funds as his own during the relevant tax year, he was required to recognize those funds as income.
We agree with the Government. As already noted, Inductotherm's concession (no doubt correct) that it asserted title to the proceeds of Furnace A's sale in 1991 answers the first prong of the Claim of Right Doctrine.
As to the Doctrine's second prong (no disposition restriction on the sale pro╜ceeds), Inductotherm, having commingled the funds instead of blocking them, placed itself in a position of complete do╜minion over those funds (at least during the 1991 tax year). In this context, the Executive Order was "a potential or dor╜mant restriction ... which depends on the future application of rules of law to present facts [and therefore was] not a 'restriction on use' within the meaning of North American Oil v. Burnet. " Healy v. Commissioner, 345 U.S. 278, 284, 73 S.Ct. 671, 97 L.Ed. 1007 (1953). The Government was entitled to prosecute Inductotherm for failure to comply with the Executive Order. However, as with any regulation or criminal law, the Govern╜ment had the discretion not to pursue In╜ductotherm's Executive Order violation. Thus, Inductotherm's control over the Furnace A proceeds was analogous to that of the embezzler in James. 4 See also Continental Illinois Corp. v. Commis╜sioner, 998 F.2d 513 (7th Cir.1993) (be╜cause bank's obligation to refund interest paid over a known percentage is contin╜gent on the fulfillment of conditions by the debtor, and thus the obligation is un╜certain, bank must treat interest as in╜come in year received).
4. ═ While we do not suggest that Inductot╜herm's behavior was criminally culpable (as was that of the taxpayer in James ), its posi╜tion for tax purposes is legally indistinguish╜able.
That Inductotherm was required after the conclusion of the 1991 tax year to block the Furnace A proceeds is in no wav rele╜vant to the analysis. There are numerous cases in which a taxpayer treated funds as its own in one year, only to find that it was required to disgorge them in a later year. In all these cases, courts required the tax╜payer to recognize the funds as income in the year received, notwithstanding the la╜ter disgorgement. See, e.g., Healy, 345 U.S. 278, 73 S.Ct. 671, 97 L.Ed. 1007 (sala╜ry a taxpayer earned in one year from a closed corporation in which he was an offi╜cer and stockholder, which had to be re╜turned to the company in a subsequent year because it was excessive compensa╜tion, was income in the year the salary was earned); Wentworth v. Commissioner, 510 F.2d 883 (6th Cir.1975) (taxpayer whose stock was illegally redeemed was required to recognize proceeds from redemption in year he received them, despite later duty to return proceeds); United States v. Le╜soine, 203 F.2d 123 (9th Cir.1953) (taxpayer properly included dividend as income in the year it was received, even though it was later determined that dividend had to be repaid to corporation because there was insufficient surplus for payment); Saun╜ ders v. Commissioner, 101 F.2d 407 (1939) (sums taxpayers received from the sale of corporation's capital stock were income, although taxpayers returned money to cor╜poration on advice of counsel, who said that taxpayers were not entitled to receive funds).
In this context, the Claim of Right Doc╜trine does not shield the Furnace A pro╜ceeds from being income in 1991.
B. Furnaces B and C
Inductotherm sold Furnaces B and C in 1997. However, it sought to deduct production costs of those furnaces in its 1991 and 1992 tax years. In the District Court, Inductotherm claimed that the Ex╜ecutive Order was in effect a confiscation that deprived it of its property rights in those two furnaces and thus, under ╖ 165(a) of the Internal Revenue Code, 5 it was entitled to deduct the costs of the furnaces when the Executive Order went into effect.
5. ═ 26 U.S.C. ╖ 165(a) provides that "[t]here shall be allowed as a deduction any loss sus╜tained during the taxable year and not com╜pensated for by insurance or otherwise."
26 C.F.R. ╖ 1.165-1 sets out a two-prong test for determining whether a tax╜payer may recognize a loss under ╖ 165(a) in a given year. There must be: (1) a closed and completed transaction fixed by identifiable events and (2) no reasonable prospect of recovery. Inductotherm con╜tends that the promulgation of the Execu╜tive Order was a closed and completed transaction with respect to Furnaces B and C, and in 1991 and 1992 there was no reasonable prospect that it would recover the furnaces.
This argument fails. First, other courts have held, as a matter of law, that a block╜ing order is not a closed and completed transaction because it is merely a tempo╜rary restriction on the use of property. See, e.g., Tran Qui Than v. Regan, 658 F.2d 1296, 1301 (9th Cir.1981) ("The block╜ing of the assets . . . does not affect the interest, right or title to them which [the taxpayer] may possess. The blocking ac╜tion merely suspends indefinitely the right to transfer those funds.") (internal citation omitted); Nielsen v. Sec'g of Treas., 424 F.2d 833, 843-44 (D.C.Cir.1970) ("The blocking of accounts is generally recog╜nized as different from taking, though raising a problem of taking 'if continued indefinitely.' "). Moreover, we note that a taxpayer may not recognize a loss unless it has exhausted its remedies to reduce its loss. Investors Diversified Servs., Inc. v. Commissioner, 325 F.2d 341, 350 (8th Cir. 1963). In this case, Inductotherm could have sought a license from OFAC to un╜block Furnaces B and C. See 31 C.F.R. ╖╖ 575.202(c), 575.203(c). Yet it did not do so.
On appeal, Inductotherm sets out what it acknowledges is a new theory for de╜ducting the costs of Furnaces B and C in 1991 and 1992. It argues that, because electron-beam furnaces such as Furnaces B and C used a disfavored technology, the Executive Order's promulgation deprived it of the only available market for the furnaces - Iraq, leaving the furnaces with little or no resale value. In this context, Inductotherm contends that it was entitled to recognize a loss under 26 C.F.R. ╖ 1.471-2, which directs companies to val╜ue their inventory at the lower of cost or market value and allows write-downs based on declines in inventory value ( e.g. , for obsolescence). 6
6. ═ Regulation ╖ 1.471-2 complements ╖ 471 of the IRC, which sets out the general rule for valuing inventories.
Ironically, Inductotherm expressly dis╜claimed reliance on this theory before the District Court. In response to an inter╜rogatory from the Government, Inductot╜herm stated, "Plaintiff claims the deduc╜tions taken in fiscal years 1991 and 1992 because of the lack of control over the assets as a result of the freeze on the assets as issued by President Bush, not because there was an actual loss of value to the actual assets." The response went on explicitly to state, "Plaintiffs do not assert that the deductions were taken pur╜suant to Section 471."
In light of Inductotherm's express disclaimer in the District Court, we decline to entertain this new argument on appeal. 7 Moreover, considering this argument would require calculating the decline in market values of Furnaces B and C that the Executive Order caused. Yet Induc╜totherm has failed to enter into the record any data that would enable us (or the District Court on remand) to perform this inquiry. 8 Having failed to meet its burden, we decline to give Inductotherm a second turn at bat. 9
7. ═ Inductotherm also makes essentially the same argument under IRC ╖ 165, contending that because of the Executive Order Furnaces B and C were unsaleable on the open market and therefore it was permissible to recognize their decline in value in 1991 and 1992. Be╜cause Inductotherm's response to the Govern╜ment's interrogatory stated that it did not claim "an actual loss of value to the actual assets," which is the factual underpinning of this new ╖ 165 argument, we deem this argu╜ment waived on appeal as well.
8. ═ Inductotherm argues that it provided this information in its position letter to the IRS, attached to the complaint. However, the po╜sition letter contains no "evidence" as such, but rather Inductotherm's arguments that the end-of-year value of Furnaces B and C was $0 because the Executive Order deprived them of any market value. These assertions, without more, do not provide a basis for a court to calculate Furnaces B and C's decline in value.
9. ═ While we will consider arguments raised for the first time on appeal "where a gross mis╜carriage of justice would occur," Kahn v. United States, 753 F.2d 1208, 1222 n. 8 (3d Cir.1985), this is not such a case.
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Under the Claim of Right Doctrine, In╜ductotherm was required to recognize proceeds from the sale of Furnace A in the year it received those proceeds, 1991. Moreover, Inductotherm did not adequate╜ly prove its entitlement to deduct costs associated with Furnaces B and C in 1991. and 1992. We therefore affirm the Dis╜trict Court's grant of summary judgment in favor of the Government.