Opposition Brief — Diebold, Inc. v. United States, 111 S. Ct. 73 (1990) (No. 89-1999)

Iu the Supreme Court of the United States

OCTOBER TERM, 1990

DIEBOLD, INC., PETITIONER

VU.

UNITED STATES OF AMERICA

ON PETITION FOR A WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE FEDERAL CIRCUIT

BRIEF FOR THE UNITED STATES IN OPPOSITION

KENNETH W. STARR

Solicitor General

SHIRLEY D. PETERSON

Assistant Attorney General

JONATHAN S. COHEN

CHARLES BRICKEN

Attorneys

Department of Justice

Washington, D.C. 20530

(202) 514-2217

QUESTION PRESENTED

Whether petitioner’s changing the characterization

of its modular spare parts for automated teller ma-

chines from inventory to assets subject to deprecia-

tion, in order to claim investment tax credits and de-

preciation deductions with respect to those parts, con-

stitutes a change in method of accounting for which

the prior consent of the Commissioner of Internal

Revenue is required under Section 446(e) of the In-

ternal Revenue Code.

(I)

TABLE OF CONTENTS

Page

i ks cal aces doe daghenhaantinkgasinpaopmaeie ‘@ 1

De aetangndaataduhavonkbacsGheanbis ee deas 1

Lala celeb mas nlpnbancbeaeles me 2

RESIS SER GEESE aR a CR 5

roti dek on ih canisinenasncoecadlaninamcnsesinnsiies penchiidetadaineniae 13 .

TABLE OF AUTHORITIES

Cases:

American Can Co. V. Commissioner, 317 F.2d 604

(2d Cir. 1963), cert. denied, 375 U.S. 993

KES BONS SEE ee Pe ae ae 8,9

Beacon Publishing Co. Vv. Commissioner, 218 F.2d

I ss sincatenanceangnaranesuncnsuens 12

Broida, Stone & Thomas, Inc. v. United States,

204 F. Supp. 841 (N.D. W. Va.), aff’d, 309 F.2d

ee es cacupndeiseanbiemaiecaasbaunn 9

Commissioner V. Van Raden, 650 F.2d 1046 (9th

ES TR Ea ae nen ae 6

Commissioner V. O. Liquidating Corp., 292 F.2d

225 (3d Cir.), cert. denied, 368 U.S. 898 (1961).. 9

Ed Smithback Plumbing, Inc. v. United States,

209 Ct. Cl. 743 (1976), adopting opinion of trial

judge, 37 A.F.T.R.2d 486 (1975) -......002..02202..... g

First National Bank of Gainesville Vv. Commis-

A ek Sy fee 9

H.F. Campbell Co. v. Commissioner, 538 T.C. 439

(1969), aff’d, 443 F.2d 965 (6th Cir. 1971) ........ 9

Mamula v. Commissioner, 346 F.2d 1016 (9th Cir.

STARR ASAD FSR oT Me ADS CO 10, 11

Poorbaugh v. United States, 423 F.2d 157 (3d Cir.

a a eeamaneeiaine 8

Schuster’s Express, Inc. v. Commissioner, 66 T.C.

588 (1976), aff’d, 562 F.2d 39 (2d Cir. 1977) .... 10

Southern Pacific Transportation Co. v. Commis-

SE i A OE | nes 9

(III)

IV

Cases—Continued : Page

Thompson-King-Tate, Inc. v. United States, 296

ie 8 Lt | | neem 12

Thor Power Tool Co. v. Commissioner, 439 U.S.

Se I cca ae 6

United States v. Kliefgen, 557 F.2d 1293 (9th Cir.

STITT aces ttcosicessendsnisiceretindaaandetblandessiodinetagaliaasboaemnmnincieaabee 8

W.A. Holt Co. v. United States, 368 F.2d 311 (5th

ae Re 9

Wayne Bolt & Nut Co. v. Commissioner, 93 T.C.

ee ee os aaenannian 9

Witte v. Commissioner, 513 F.2d 391 (D.C. Cir.

on a eran 8, 9

Wright Contracting Co. Vv. Commissioner, 316 F.2d

249 (5th Cir.), cert. denied, 375 U.S. 879

SUUITIIIEET “p-siacchesstisducsciendasasoeoubensdseadinediadiatbaccasmeatpicaebsanuncameenenen 8,9

Statutes and regulations:

Internal Revenue Code of 1954 (26 U.S.C.) :

| __ STRESRLCE ECON ICE EET ne eee TED 6

RE eee CO Ca Tae 10, 11, 13

§ 446 (e) ............ pidhiaalasicaniaenciaipameameee 3, 5, 7, 9, 11, 12

Treas. Reg. 111 (1939 Code) § 29.41-2 0.000000... 11-12

Treas. Reg. (26 C.F.R.) :

§ 1.446-1(e) ...0000002.. Dain Peenarenonts sicpaicanedeura Sha 5

I a acetal 7

Be BEE Lee | \ cee. ee enee 3, 4,5

Oe ee I ices nsrcessnacenancanconstions 6, 7, 10

§ 1.446-1(e) (2) (iii) -.....2... a a 7

Miscellaneous:

G.C.M. 39,328 (June 8, 1984), JRS Positions [1984-

1985 Transfer Binder] CCH) £1610 _... 13

Rev. Rul. 90-38, 1990-18 I.R.B. 7. 13

In the Suprenw Court of the United States

OCTOBER TERM, 1990

No. 89-1999

DIEBOLD, INC., PETITIONER

v.

UNITED STATES OF AMERICA

ON PETITION FORA WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE FEDERAL CIRCUIT

BRIEF FOR THE UNITED STATES IN OPPOSITION

OPINIONS BELOW

The opinion of the court of appeals (Pet. App. la-

8a) is reported at 891 F.2d 1579. The opinion of the

Claims Court (Pet. App. 9a-53a) is reported at 16

Cl. Ct. 193.

JURISDICTION

The judgment of the court of appeals was entered

on December 19, 1989. A petition for rehearing was

denied on March 26, 1990 (Pet. App. 54a). The peti-

tion for a writ of certiorari was filed on June 22,

1990. The jurisdiction of this Court is invoked un-

der 28 U.S.C. 1254(1).

(1)

2

STATEMENT

1. Petitioner began manufacturing automated

teller machines (ATMs) and selling them to banks

and other financial institutions in 1974. Petitioner

also maintained and repaired the ATMs under serv-

ice contracts with the ATM purchasers. Petition-

er’s ATMs were composed of several separate sub-

assemblies or “modules,” each of which performed a

discrete function. This modular construction facili-

tated rapid on-site repairs: a malfunctioning module

that could not be repaired quickly would be replaced

with a functional module. The faulty module would

then be repaired at petitioner’s repair center and

placed in the pool of spare service modules for use in

future ATM repairs. Pet. App. 2a.

During the 1974-1979 period, petitioner accounted

for the spare service modules as inventory, 7.e., as

non-depreciable assets. In October 1980, petitioner

filed amended federal income tax returns for 1976

and 1977, the years in issue (as well as for 1978

and 1979), claiming tax refunds resulting from de-

preciation deductions and investment tax credits

based on treating the spare service modules as de-

preciable property instead of as inventory. The In-

ternal Revenue Service (IRS) disallowed petitioner’s

refund claims. Pet. App. 2a-3a.

2. Petitioner then commenced this refund action in

the United States Claims Court, contending that the

spare service modules are properly accounted for as

depreciable assets, not as inventory as petitioner had

treated them on its original returns. The govern-

ment moved for summary judgment on the ground

that the change petitioner sought to make was a

change of accounting method for which petitioner

3

had failed to request or obtain the prior consent of

the Commisioner, as required by Section 446(e) of

the Internal Revenue Code.’

The Claims Court granted the government’s mo-

tion for summary judgment (Pet. App. 9a-53a).

The court explained that, because the change in ques-

tion affected the time at which petitioner would re-

cover the cost of manufacturing the spare service

modules, it amounted to a change in the treatment of

a “material item,” and hence of accounting method,

within the meaning of Treas. Reg. § 1.446-1(e) (2)

(ii) (a) (26 C.F.R.). The court then rejected peti-

tioner’s various proffered grounds for avoiding this

conclusion. The court stated that petitioner’s change

was not simply the “correction of mathematical or

posting errors,” which would not require the consent

of the Commissioner, but rather was a change that

“drastically altered deduction timing” (Pet. App.

21la-22a). The court proceeded to reject petitioner’s

contention that Section 446(e) is not applicable

whenever the original method of accounting being

changed is incorrect (Pet. App. 22a-32a). The court

also rejected petitioner’s contentions that a taxpayer

does not need consent to correct an accounting error

in the first year in which it uses that method of ac-

counting (id. at 32a-38a), that the policies of Sec-

tion 446(e) would be frustrated by applying it to

petitioner here (Pet. App. 38a-41la), that the audit

report reflected the Commissioner’s consent to the

change (id. at 4la-46a), and that considerations of

fairness required the Commissioner to allow the

1 Unless otherwise noted, all statutory references are to the

Internal Revenue Code (26 U.S.C.), as amended (the Code or

I.R.C.).

4

change even though petitioner did not request a

change of accounting method (id. at 46a-50a).*

3. The court of appeals affirmed (Pet. App. la-

8a). It ruled that the change from inventory treat-

ment to depreciation treatment satisfied the regula-

tions’ definition of a change in the treatment of a

material item because it “involves the proper time

for the inclusion of an item in income or the taking

of a deduction” (id. at 6a, quoting Treas. Reg.

§ 1.446-1(e) (2) (ii) (a)). Further, the court spe-

cifically rejected petitioner’s contention that it was

merely correcting a “posting error,” and stated that

petitioner’s “argument that it seeks to correct a sub-

stantive error independent of its choice of account-

ing procedures is simply wrong” (Pet. App. 6a). The

court also agreed with the Claims Court that, even

if petitioner haa sought to change from an incorrect

to a correct accounting method, that would still be a

change in method of accounting requiring the Com-

missioner’s prior consent (iu. at 6a-7a).

2 In light of these legal conclusions, the court found it un-

necessary to resolve the disputed issues whether petitioner’s

original method of inventory accounting was a permissible one

and whether petitioner commenced this method in 1976 or, as

the Commissioner contended, in 1974 (Pet. App. 50a-53a).

5

ARGUMENT

The court of appeals correctly held that petition-

er’s attempt to recharacterize its spare service mod-

ules as depreciable property, instead of nondepreci-

able inventory, was a change of accounting method

for which the Commissioner’s prior consent was re-

quired, without regard to whether the change was

from an incorrect to a correct method of accounting.

This holding is fully consistent with the governing

statute and regulations, and it does not conflict with

any decision of this Court or of another court of ap-

peals. Accordingly, there is no reason for review by

this Court.

1. Section 446(e) of the Code provides: “Except

as otherwise expressly provided in this chapter, a

taxpayer who changes the method of accounting on

the basis of which he regularly computes his income

in keeping his books shall, before computing his tax-

able income under the new method, secure the con-

sent of the Secretary.” Treas. Reg. § 1.446-1(e) im-

plements this provision and defines a change in ac-

counting method in detail. Treas. Reg. § 1.446-1(e)

(2) (11) (a) provides in part as follows:

A change in the method of accounting includes

a change in the overall plan of accounting for

gross income or deductions or a change in the

treatment of any material item used in such

overall plan. * * * A material item is any item

which involves the proper time for the inclusion

of the item in income or the taking of a deduc-

maa ***

The regulation also provides that “correction of

mathematical or posting errors,” or the adjustment

of items that do not involve the proper time for the

inclusion of an item in income or the taking of a de-

6

duction, do not constitute changes of accounting

method (Treas. Reg. § 1.446-1(e) (2) (ii) (b)). The

question here is the application of these provisions

to the particular facts of this case—namely, peti-

tioner’s decision to recharacterize its spare service

modules as depreciable assets instead of inventory.

As both courts below concluded, the change at is-

sue here—from inventory to depreciable assets—

easily falls within the plain terms of the provisions

of the regulations. Inventory accounting takes into

account the cost of items of inventory in computing

the cost of goods sold in a given year. See Thor

Power Tool Co. vy. Commissioner, 439 U.S. 522, 545

(1979) ; Commissioner v. Van Raden, 650 F.2d 1046,

1048 n.1 (9th Cir. 1981). Treating an asset as de-

preciable property, on the other hand, permits the

taxpayer to deduct the cost of the asset in increments

over a period of years. See IR.C. § 167. Changing

from inventory to depreciable asset treatment, there-

fore, manifestly involves the proper time at which a

deduction (or reduction of income) may be taken for

the cost of the property. Thus, the change affects

“the treatment of any material item,” and accord-

ingly constitutes a change of accounting method as

defined in the regulations. Indeed, the regulations

make clear that starting to depreciate an asset that

previously had been treated as nondepreciabie con-

stitutes an accounting method change (Treas. Reg.

$ 1.446-1(e) (2) (ii) (b) ):

[F Jor example, a correction to require deprecia-

tion in lieu of a deduction for the cost of a class

of depreciable assets which has been consistently

treated as an expense in the year of purchase in-

volves the question of the proper timing of an

item, and is to be treated as a change in method

of accounting.

7

2. Petitioner seeks to avoid the plain import of

the governing definition by arguing (Pet. 5-11) that

when a taxpayer changes from an incorrect method

of accounting to a correct one, Section 446(e) does

not require that he obtain the prior consent of the

Commissioner. This contention finds no support in the

statute, and it is directly contrary to the terms of

the regulation. Moreover, this contention has re-

peatedly been rejected by the courts of appeals.

Section 446(e) states that any change of account-

ing method must be approved in advance by the Com-

missioner, ‘‘[e]xcept as otherwise expressly provided

in this chapter.” Petitioner points to no provision

in the Code that even arguably excludes the change

in this case from the purview of Section 446(e), and

therefore its contention is refuted by the plain statu-

tory text. Moreover, the applicable regulation ex-

plicitly states that a taxpayer who wishes to change

his method of accounting must secure the prior con-

sent of the Commissioner “whether or not such

method is proper or is permitted under the Internal

Revenue Code or the regulations thereunder” (Treas.

Reg. § 1.446-1(e) (2) (i)). Indeed, several of the ex-

amples given in the regulation clearly identify the

taxpayer’s original method of accounting as one that

is not permissible under the Code, but a change of

the method is nonetheless identified there as a change

that requires the Commissioner’s approval. Treas.

Reg. 1.446-1(e) (2) (iii), Examples 1, 6-8.° Thus,

there can be no doubt that the governing regulation

* Moreover, the regulation’s specific reference to a change

in treatment of an asset from nondepreciable to depreciable

describes the assets in question as depreciable, and thus also

contemplates a change from an improper to a proper method

of accounting. See Treas. Reg. § 1.446-1(e) (2) (ii) (b) ; page

6, supra.

8

has long required a taxpayer to obtain the Commis-

sioner’s consent before he changes from an imper-

missible or improper method of accounting to a per-

missible or proper one.

The courts of appeals have repeatedly recognized

the validity of this aspect of the regulation. In Witte

v. Commissioner, 513 F.2d -3891, 394 (D.C. Cir.

1975), the court unequivocally rejected the position

advanced by petitioner here as “contrary to the ap-

plicable Treasury regulations and subversive of the

underlying purpose of section 446(e)’s consent re-

quirement.” The court explained the error of peti-

tioner’s approach as follows (ibid.) :

The purpose of the consent requirement is to

enable the Commissioner to prevent distortions

of income that often accompany changes in ac-

counting methods by conditioning consent on the

taxpayer’s agreement to make correcting adjust-

ments in his income tax payments. The danger

of distsrtion of income detrimental to govern-

mental revenues exists regardless of whether the

change in method is from one proper method to

another or from an improper method to a proper

one. The consent requirement has as much vi-

tality in the latter case as in the former.

The court’s holding in Witte fully accords with the

decisions of several other courts of appeals. See

United States v. Kleifgen, 557 F.2d 1293, 1297 n.9

(9th Cir. 1977); Ed Smithback Plumbing, Ine. vy.

United States, 209 Ct. Cl. 743 (1976), adopting opin-

ion of trial judge, 37 A.F.T.R.2d 486, 495-496

(1975); Poorbaugh v. United States, 423 F.2d 157,

163 (3d Cir. 1970); American Can Co. v. Commis-

sioner, 317 F.2d 604, 606 (2d Cir. 1963), cert. de-

nied, 375 U.S. 993 (1964); Wright Contracting Co.

v. Commissioner, 316 F.2d 249, 254 (5th Cir.), cert.

SE

9

denied, 375 U.S. 879 (1963); Commissioner v. O.

Liquidating Corp., 292 F.2d 225 (3d Cir.), cert. de-

nied, 368 U.S. 898 (1961); Broida, Stone &: Thomas,

Inc. y. United States, 204 F. Supp. 841, 843 (N.D.

W. Va.), aff’d, 309 F.2d 486 (4th Cir. 1962) .*

3. Disregarding this consistent line of authority,

petitioner contends (Pet. 5-11) that the decision be-

low creates a conflict in the circuits. The cases re-

lied upon by petitioner, however, are in no way in-

consistent with the decision below. They do not

purport to disagree with the rule that Section 446(e)

is applicable even where the original method of ac-

counting is incorrect. Rather, in those cases the

courts concluded that there was no change in ac-

counting method, based on facts substantially differ-

ent from those here.

In W. A. Holt Co. v. United States, 368 F.2d 311

(5th Cir. 1966), for example, the court held that the

* The Tax Court sometimes has not required the consent of

the Commissioner to change from a clearly incorrect account-

ing method to a correct one, notwithstanding the stricter ap-

proach taken by the regulations and the courts of appeals.

See Southern Pacific Transportation Co. v. Commissioner, 75

T.C. 497, 682 n.208 (1980). When the Tax Court’s decisions

in these cases have been appealed, however, they have been re-

versed. See Witte v. Commissioner, supra; American Can Co.

v. Commissioner, supra. Moreover, the Tax Court has not

consistently adhered to the position described in Southern

Pacific and, more recently, seems to have abandoned it. For

example, in First National Bank of Gainesville v. Commis-

sioner, 88 T.C. 1069, 1085 (1987), the Tax Court stated that

“Twlhere the correction of an error results in a change in

accounting method, the requirements of section 446(e) are

applicable.” See also, e.g., Wayne Bolt & Nut Co. v. Commis-

sioner, 93 T.C. 500, 510-512 (1989); H. F. Campbell Co. v.

Commissioner, 58 T.C. 439, 447-448 (1969), aff’d, 4438 F.2d

965 (6th Cir. 1971).

10

taxpayer’s practice of taking bad debt deductions in

respect of accounts receivable that were not, in fact,

worthless was not a method of accounting. In Schus-

ter’s Express, Inc. v. Commissioner, 66 T.C. 588

(1976), aff’d, 562 F.2d 39 (2d Cir. 1977), the court

held that the taxpayer’s practice of deducting esti-

mated insurance expenses in excess of the insurance

expenses actually incurred did not amount to a

method of accounting. The conclusions in both of

these cases follow directly from the definition in the

regulation. As we have noted (pages 5-6, supra), the

adjustment of an item that does not involve the

proper time for including an item in income or tak-

ing a deduction is not a change in method of account-

ing. Treas. Reg. § 1.446-1(e) (2) (ii) (b). The cor-

rection of the taxpayers’ erroneous practices in both

Holt and Schuster’s Express plainly did not impli-

cate the timing of deductions; the taxpayers had

taken deductions to which they were not entitled at

any time.

Here, by contrast, petitioner plainly incurred the

cost of producing its spare service modules, and it

was entitled to recover that cost ultimately through

reductions in income. The issue implicated by the

change from inventory to depreciable asset treatment

is when the cost recovery would occur—upon sale or

abandonment of the modules or, alternatively, in an-

nual increments under a method of depreciation.

Since the change at issue here does involve a matter

of timing it manifestly falls within the regulatory

definition of a change of accounting method.

Even more readily distinguishable from this case

is Mamula v. Commissioner, 346 F.2d 1016 (9th Cir.

1965). That case does not address Section 446 or

even discuss the question of a change of method of

accounting. In Mamula, the taxpayer sold real prop-

ee

11

erty on an installment basis and incorrectly took the

position that he could report the gain on a “deferred

basis,” 7.e., that he did not have to report any gain

at all until he had recovered the entire cost of the

property. The IRS disallowed this treatment of the

gain and required the taxpayer to recognize all of his

gain in the year of the sale; the IRS thus declined to

permit him to elect the installment method of re-

porting gain, which he clearly could have elected in

the first instance. The court of appeals reversed,

holding that the taxpayer’s decision to report the

sale income on a “deferred basis” should not be

viewed as a binding election because it was set aside

“Tal|t the insistence of the government, not the tax-

payer” (346 F.2d at 1019). Once the government

had disallowed the taxpayer’s original method of re-

porting the gain, the court held, the taxpayer should

still be entitled to elect between the two permissible

methods of reporting. That decision plainly has no

relevance here, where the Commissioner did not dis-

allow petitioner’s inventory treatment of the spare

service modules (and, indeed, has not contended that

inventory treatment was impermissible (see Pet.

App. 22a n.3)). Petitioner here chose to change its

method of accounting, and the courts below correctly

held that Section 446(e) required it to obtain the

Commissioner’s approval.°

5 Petitioner also cites (Pet. 10-11) two decisions decided

under the predecessor of Section 446 contained in the 1939

Code. As the Claims Court explained (Pet. App. 24a-27a),

those cases are not relevant here because the statutory scheme

was different. The prior statute did not contain an express

provision requiring the prior consent of the Commissioner

for a change in accounting method, nor did the regulations

thereunder define a change of the kind at issue here as affect-

ing treatment of a “material item” that constitutes a method

of accounting. See Section 29.41-2, Treasury Regulations 111

12

4. Petitioner’s contention (Pet. 12-14) that this

Court should grant certiorari because the decision be-

low “‘has the potential for vastly expanding the Com-

missioner’s power” (Pet. 12) is entirely without

merit. The decision in this case works no change in

the law; it simply applies the terms of an estab-

lished regulation to a fact Situation that is plainly

governed by those terms. And, as we have noted

(pages 8-9, supra), the decision is fully in accord with

the decisions of several courts of appeals that have

considered and rejected petitioner’s position. The au-

thority of the Commissioner to withhold consent to a

change of accounting method, subject to review for

abuse of discretion, has long been established by the

text of Section 446(e). And, contrary to petitioner’s

implication (Pet. 14), the decision of the court of ap-

peals does not restrict the right of taxpayers to file

amended returns to correct errors, substantive or

procedural, if the correction of the error does not rise

to the level of a change of accounting method." There

is no reason for further review.

(1939 Code). In any event, those cases are distinguishable.

In Thompson-King-Tate, Inc. v. United States, 296 F.2d 290

(6th Cir. 1961), the court concluded that the taxpayer had

erred in the application of its established ccmpleted contract

methed of accounting; by correcting the error, it was not

changing its accounting method. See id. at 294-295; Pet. App.

29a. Similarly, in Beacon Publishing Co. v. Commissioner,

218 F.2d 697, 701-702 (10th Cir. 1955), the court held that

the taxpayer was not changing its method of accounting, but

was merely correcting an error in the application of its exist-

ing accrual method of accounting.

® Petitioner errs in asserting (Pet. 13) that a recent revenue

ruling demonstrates that ‘“‘[t]he Internal Revenue Service has

already begun to take advantage of the new power vested in it

by the Federal Circui\.” While the instant case, along with

13

CONCLUSION

The petition for a writ of certiorari should be

denied.

Respectfully submitted.

KENNETH W. STARR

Solicitor General

SHIRLEY D. PETERSON

Assistant Attorney General

JONATHAN S. COHEN

CHARLES BRICKEN

Attorneys

AUGUST 1990

many others, is cited in support of Rev. Rul. 90-38, 1990-18

I.R.B. 7, it plainly does not form an independent basis for the

issuance of that ruling. Rather, the ruling is based on general

principles under Section 446 long established by the applicable

regulation and the case law. Indeed, the rulings recently re-

voked or modified by Rev. Rul. 90-38 were identified some

years ago by the IRS’s technical staff as “incorrect statements

of the law.”” See G.C.M. 39,328 (June 8, 1984), IRS Positions

[1984-1985 Transfer Binder] (CCH) { 1610, at 5191, 5201.

WY U. S. GOVERNMENT PRINTING OFFICE; 1990 262202 20072

eee ill