Opposition Brief — Albertson's, Inc. v. Commissioner

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JUL TM 1995

ALBERTSON S, INC., PETITIONER

Vv.

COMMISSIONER OF INTERNAL REVENUE

ON PETITION FOR A WRIT.OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

BRIEF FOR THE RESPONDENT IN OPPOSITION

Drew S. Days, III

Solicitor General

LORETTA C. ARGRETT

Assistant Attorney General

JONATHAN S. COHEN

STEVEN I. FRAHM

Attorneys

Department of Justice

Washington, D.C. 20530

(202) 514-2217

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ABLE COP

QUESTIONS PRESENTED

1. Whether petitioner is entitled to current de-

ductions for annual increases, which it characterizes

as “interest,” in its obligations to make future pay-

ments to selected executives under deferred com-

pensation agreements that do not otherwise qualify for

immediate deductions under the Internal Revenue

Code, even though the executives concerned report no

income under those agreements until the years in

which payments are actually received.

2. Whether the “sole justification” for petitioner’s

installation of heating, ventilating, and air condi-

tioning systems in its retail grocery stores was to

provide the temperature and humidity necessary to

operate refrigerated food cases, so that the cost of

those systems qualified for the tax credit formerly

available for investments in certain personal property.

TABLE OF CONTENTS

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SAE SERS ESE SR SAL i po PR ce SPR a BONS Ne PE RD

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TABLE OF AUTHORITIES

Cases:

Autenreith v. Commissioner, 115 F.2d 856

IS vassncon ic owdceussober

Bell v. Commissioner, 76 T.C. 232 (1981) ..................08.

Clayton v. United States, No. 92-712T (Ct. Fed. Cl.

Tee ee iad sinennebniicandeioes

Commissioner v. National Alfalfa Dehydrating &

BRI in AS Eas BOW CREED scecidasccsisciacacsccvscsacsvecces

Commissioner v. Oates, 207 F.2d 711 (7th Cir. 1953) .....

Commissioner v. Park, 113 F.2d 352 (3d Cir. 1940) ......

Deputy v. du Pont, 308 U.S. 488 (1940) .......... ee.

Estate of Arbury v. Commissioner, 93 T.C. 136 (1989).

Garvey, Inc. v. United States, 726 F.2d 1569

(Fed. Cir.), cert. denied, 469 U.S. 823 (1984) ...............

Good Samaritan Hosp. v. Shalala, 113 8S. Ct. 2151

a a dada dubdduaaeunagenevaens

Horn v. Commissioner, 90 T.C. 908 (1988) ...................

Knetsch v. United States, 364 U.S. 361 (1960) .............

Martin v. Commissioner, 96 T.C. 814 (1991) ................

NationsBank of North Carolina, N.A. v. Variable

Annuity Life Ins. Co., 115 S. Ct. 810 (1995) ....... ee.

Old Colony R.R. v. Commissioner, 284 U.S. 552 (1932) .

Piggly Wiggly Southern, Inc. v. Commissioner,

Ee Ae EE GE, BONO) oc svc ccencvayacenacacecasescoceavenss

Publix Supermarkets, Inc. v. United States,

os eS auguintbanabuanakenessnes

11, 13

13, 14

12, 18

24, 25

Statutes and regulations: Page

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

§§ 1-1399 (1988 & Supp. V 1998)...................cccceccsssccceees 18

BNE Sidisgasdienis basite one bnsinansacanncoudauiecataladcanecsentoinis 16

BF Ca iwrcltiacticcdaatie tos cavccceesssbeinetiuh: ienctudgubers alata: 7, 21

ee RD ptchctaeticavekdaiaitesneadaardatectaranauteaces 21

SD re iindikicetscnaar tense ockaiicaseeisiuldoiiesndaiec kde netaaiat ane 17, 18

§ 163 (1988 & Supp. V 1998)................. 4, 6, 11, 12, 13, 16, 17

DD paketit ticiscasiaivelasntichsacksidkccdiackaaiieetnmdtnensirss 11, 12

§ 163(e) (1988 & Supp. V 1998) ...............cccccccsssssssecssees 14

ROR ea Ly cc tae eer SWE TEE 17, 18

Fee iedassikanibas i pcnusnseaiedciaal cats tess btebdcoadasadecwssiokaans 19

S 40](a) CIOSB & Bump. V UGB) ...ccccscccssccccccascseccccscccesss 10, 17

CRE Cire Ae I, F TIUE vs ssctievecscs sa veicnosaicietssoiines 10

S G06 CHOIRS © Batak V WGI) vv scsccsccsceciscccncucnccsnesntincs passim

I ke 17

ERE I or Pte Ne atl ast tN RR ee AO Re CD 10, 16

OF MII ccicucetisipiasatinsisdaiowsiannaicubkaealoaiateddicd iiaesatatlDk Steal tae 10

i ar ad 19

BE Ce aE ir one Me NR Pets POUMEN IOS e Se” NRT 14

SE SRD eT ae SOT CARTON CHE RAD Rae Te OLIN AME 19

ER Cie eign NEETU aie Nae RTT LS NINE EN 14

| RR eh Sik SE A RS oot oe gee He DP ate: NEI ENA 10

§§ 1271-1275 (1988 & Supp. V 19938) ...............cccccccsseceeeee 14

DURE aaiisdbncabeiadaisacnddccse ck cicoicam in ciiabe oat a 14

Revenue Act of 1942, ch. 619, § 162(b), 56 Stat. 863 (26

SF ane Se GRIMOIEEE ic cecleseccptadeadbinlicnsivestetcoutdesedesthoabene: 16

Tax Reform Act of 1986, Pub. L. No. 99-514, § 211,

Fe es MI aanite Seca cinch tisbcinntncdadpatildscctushusisisies 25

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

I er a 21

SRR ea seep Cen See Oe GEM 7

TE, 8, 22

= RE 3B ictsnuibibsediddteieiiths deuctiindeiive tat giae eee 14

Miscellaneous:

2 B. Bittker & L. Lokken, Federal Taxation of Income,

Estates and Gifts (2d ed. 1990) .............ccccceeeeeeee 10, 11, 12, 17

H.R. Rep. No. 2333, 77th Cong., 2d Sess. (1942) .............. 17

BEOY,. CRM Gh, FE Gils BU hn tccncenssskeccaccnsvdesscecsccecducs 3, 11

Rev. Rul. 70-435, 1970-2 C.B. 100 .......cccccccocccsccccessscoccoevess 3, 11

Miscellaneous—Continued: Page

S. Rep. No. 1631, 77th Cong., 2d Sess. (1942) .......cccccccsee. 17

S. Rep. No. 313, 99th Cong., 2d Sess. (1986) .........cccce0000-. 19

§n the Supreme Court of the United States

OCTOBER TERM, 1995

No. 94-1796

ALBERTSON S, INC., PETITIONER

COMMISSIONER OF INTERNAI. REVENUE

ON PETITION FOR A WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

BRIEF FOR THE RESPONDENT IN OPPOSITION

OPINIONS BELOW

The initial opinion of the court of appeals (Pet. App.

20a-40a) is reported at 38 F.3d 1046. That court’s

opinion on rehearing of the deferred compensation

issue (Pet. App. la-19a) is reported at 42 F.3d 537.

The opinion of the United States Tax Court on the

deferred compensation issue (Pet. App. 41a-69a) is

reported at 95 T.C. 415. That court’s memorandum

opinion on the investment tax credit issue (Pet. App.

70a-8la) is reported unofficially at 56 T.C. Memo.

(CCH) 928.’

JURISDICTION

The judgment of the court of appeals was originally

entered on December 30, 1993. That court’s judgment

on rehearing of the deferred compensation issue was

entered on December 5, 1994. Further petitions for

rehearing were denied on February 2, 1995. Pet. App.

92a. The petition for a writ of certiorari was filed on

May 1, 1995. The jurisdiction of this Court is invoked

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

STATEMENT

This case involves deficiencies in petitioner’s

federal income taxes for petitioner’s taxable year

ending February 3, 1983. During that year petitioner

operated more than 400 retail food and drug stores

throughout the western, southern, and southeastern

United States. See Pet. App. 21a n.1.

1. a. Beginning no later than 1974, petitioner

entered into “deferred compensation” agreements

with eight of its senior executives and one outside

director. Pet. App. 2a, 27a. Under the agreements,

the employees elected to defer payment and receipt of

part of their yearly salary, bonuses, or director’s fees

until they retired or otherwise terminated their

employment with petitioner (and thereafter, at each

participant’s option, for up to fifteen additional years).

Id. at 2a-3a. At the end of the deferral period the

| The court of appeals also affirmed (Pet. App. 22a-26a) the

Tax Court’s decision that petitioner was not entitled to certain

work incentive credits. That decision (id. at 82a-9la) is

reported informally at 59 T.C. Memo. (CCH) 186. Petitioner

does not seek review of the work incentive credit issue.

participants were entitled to receive the amounts

originally deferred, in a lump sum or periodically,

plus “a further sum of money equal to the amount of

interest accrued which shall be calculated by applying

a rate of interest to the total accumulated amount of

deferred compensation including accrued interest.”

Id. at 3an.1, 27a n.9. The “rate of interest” used was

either petitioner’s average long term borrowing rate

for the appropriate year, or a published rate for cer-

tificates of deposit over $1 million. Jd. at 2a-3a & n.1,

27a & n.9; Stip. of Facts, Exhs. 4-D through 12-L.

Petitioner did not fund (through present con-

tributions to a trust, escrow account, or similar

arrangement) any portion of its contractual obliga-

tion to make future payments under the deferred

compensation agreements. The obligation was an

unsecured promise, reflected only in bookkeeping

entries. Pet. App. 42a-43a. Since 1960, the Internal

Revenue Service has permitted employees who enter

into such agreements before rendering services, and

who otherwise compute their income and tax liability

on the basis of cash receipts and disbursements, to

defer recognition of any income until the years that

payments under the agreement are actually received.

Rev. Rul. 60-31, 1960-1 C.B. 174, modified by Rev. Rul.

70-435, 1970-2 C.B. 100.

Petitioner is an accrual-basis taxpayer (Pet. App.

2lan.1). Before 1983, petitioner claimed no deduc-

tions, either for amounts that participants elected to

defer or for any “further sum[s] of money” to be paid

eventually under the agreements, unless payments

were actually made to a participant during the year.

Pet. App. 45a. For the taxable year at issue, however,

petitioner contended for the first time that the

“further sum[s] of money” accrued on its books, but

not paid out, under the agreements constituted “in-

terest * * * on indebtedness” that was currently

deductible under Section 163 of the Internal Revenue

Code, 26 U.S.C. 163 (1988 & Supp. V 1993). Pet. App.

45a. The Commissioner of Internal Revenue

disallowed the deduction, id. at 46a, and petitioner

sought review of that determination in the United

States Tax Court.

b. The full Tax Court upheld the Commissioner’s

position. Pet. App. 41a-60a. The nine-judge majority

concluded that the amounts petitioner sought to

deduct were not “interest” on “indebtedness” for

purposes of Section 163. Pet. App. 48a-58a. Because

participants entered into deferred compensation

2 In 1982, petitioner requested permission “to change its

method of accounting for interest accrued on deferred com-

pensation from the cash basis to the accrual basis.” Stip. of

Facts, Exh. 18-R, App. A; see Pet. 4. The IRS’s letter

granting that permission, which focused largely on the

accounting mechanics of the change, made clear that “(t]he

taxpayer|’s] belie[f]” that the amounts in question “should be

characterized as interest” was “a material representation upon

which [the] letter [was] issued.” Stip. of Facts, Exh. 20-T, at 1.

The letter granted permission to deduct any interest expense

“as it [was] properly incurred” (id. at 2), and explicitly stated

that the letter “should not be construed as a determination as to

the proper timing for the accrual of interest expense on

deferred compensation or to its characterization as a liability to

the taxpayer” (id. at 3). The IRS later issued a technical

advice memorandum which concluded that the amounts

petitioner had designated as “interest” were instead

“compensation for personal services rendered” and,

accordingly, revoked its approval of the change in accounting

method. Stip. of Facts J 41. Petitioner expressly abandoned

below any argument that the Commissioner’s decision to revoke

the prior permission and to disallow the deductions at issue

here was impermissibly “retroactive.” Pet. App. 46a-47a.

agreements before performing the services for which

the compensation was rendered. they never had a

legal right to demand payment of that compensation

in the year they rendered the services. Because they

did not receive payment, either actually or con-

structively, they were not required to report the

compensation as income for that year. Correspond-

ingly, however, “[p]etitioner could not have ‘borrowed’

something from the * * *- participants that the

* * * participants never had the right to possess.”

Id. at 50a. Thus, additional amounts computed and

eventually to be paid under the terms of the agree-

ments were not “interest” on “indebtedness,” but

rather “an integral part of the method used by peti-

tioner to calculate the total amount of deferred

compensation to be paid” under those agreements. /d.

at 53a.

Four concurring judges agreed that petitioner was

not entitled to a current deduction, but preferred not

to rest their analysis on whether the additional

amounts at issue represented “interest” on money

constructively “borrowed” from employees who en-

tered into deferred compensation agreements. Pet.

App. 61a-63a. The concurrence focused instead on

Section 404 of the Code, “the plain purpose of [which]

is to require matching of income inclusion and

deduction as between the employee and employer” in

such arrangements. Pet. App. 62a. The opinion

concluded that, even if the time-value component. of a

deferred compensation payment were to be labelled as

“interest,” “allow[ing] an accrual method employer to

deduct interest in advance of inclusion by employees

would frustrate the matching principle apparent in

the statute.” Jd. at 63a.

Five judges dissented, concluding that the amounts

at issue were deductible as interest under Section

163, without limitation by Section 404. Pet. App. 64a-

69a.

ce. The court of appeals at first “reluctantly”

reversed. Pet. App. 27a-37a; id. at 29a. The court

concluded that the “additional amounts” specified in

the deferred compensation agreements represented a

fair measure of the time value of money, and therefore

qualified as “interest” for purposes of Section 163 of

the Code. Pet. App. 29a-32a. Although sympathetic to

the argument that Congress intended the timing

restrictions of Section 404 to apply to all payments

under a deferred compensation plan (Pet. App. 37a; see

also id. at 4a-5a), the court concluded (id. at 32a-37a)

that the language of Section 404 did not prohibit the

cvrrent deduction of accrued amounts that were

properly characterized as “interest” for purposes of

Section 163.

The same panel of the court of appeals subsequently

granted the government’s petition for rehearing,

vacated its earlier opinion, and affirmed the Tax

Court’s decision. Pet. App. la-19a. On rehearing, the

court declined to reach the question whether the

additional amounts payable under petitioner’s de-

ferred compensation agreements should be charac-

terized as “interest.” See id. at 4a-5a, 19a. Instead,

the court focused on Section 404’s principle of

“ensurling] matching of income inclusion and

% Judge Hamblen indicated agreement with both the

majority and concurring opinions. Pet. App. 60a, 63a. Judge

Whalen did not participate in the decision. Jd. at 60a.

deduction between employee and employer” under

deferred compensation schemes like petitioner’s. Pet.

App. 11a; see id. at 1la-18a. The court concluded that

“[wJhether or not the additional amounts constituted

interest” (id. at 19a), allowing the deductions sought

by petitioner would “contravene the clear purpose of

the taxation scheme Congress created to govern de-

ferred compensation plans” (id. at 8a). In particular,

it would undercut the statutory incentives that

Congress created to encourage employers to create

“qualified” deferred compensation plans (which must

generally be broadly available to the sponsor’s

employees, pre-funded, and administered through a

special trust), by providing similar or even greater

incentives to create “nonqualified” arrangements like

petitioner’s deferred compensation agreements with a

few of its highly compensated executives. See id. at

8a-10a, 12a-15a. The court therefore rejected peti-

tioner’s argument that Section 404 authorized de-

duction of the additional amounts before they were

actually paid out under the agreements in question.

Pet. App. 19a.

2. On audit of its return for the 1982-1983 tax year,

petitioner claimed the investment tax credit (ITC),

formerly available under Section 38 of the Code (see

Pet. App. 93a-95a), with respect to heating, venti-

lating, and air conditioning (HVAC) systems that it

had installed in 33 of its stores. See Pet. App. 38a,

76a. Under the applicable Treasury Department reg-

ulation, HVAC systems were generally considered

“structural components” of the buildings in which

they were installed, and therefore did not qualify for

the ITC. Treas. Reg. § 1.48-1(e) (1982) {reprinted at

Pet. App. 97a-99a). Under the same regulation,

however, HVAC systems could qualify for the ITC

under an exception applicable to “machinery the sole

justification for the installation of which” was that it

was “required to meet temperature or humidity

requirements which [were] essential for the opera-

tion of other machinery.” Treas. Reg. § 1.48-1(e)(2)

(1982) (Pet. App. 98a).

Petitioner claimed that it was entitled to the ITC

because its “sole justification” for installing the

HVAC systems was meeting the temperature and

humidity requirements for its refrigerated food

display cases and computerized checkout equipment.

Pet. App. 38a. The Commissioner disallowed the

claimed credits, and petitioner sought review in the

Tax Court.

The Tax Court found that the HVAC systems in

petitioner’s stores maintained the temperature and

humidity conditions appropriate for the proper func-

tioning of open-front refrigerated food display cases.

Pet. App. 8la; see id. at Tla-74a. Finding the

existence of an HVAC system “crucial” to the

operation of petitioner’s stores, and any benefits

related to customer comfort merely “incidental,” the

court concluded that those systems met the “sole

justification” test of the regulations. Jd. at 81a.

The court of appeals reversed. Pet. App. 37a-40a.

The court pointed out that petitioner’s HVAC

systems “play[ed] an important role in ventilating its

supermarkets,” thus keeping them clean, pleasant,

and safe. Jd. at 38a-39a. Moreover, in the court’s

view, air conditioning and heating “clearly provide[d]

a comfortable shopping environment for [petitioner’s]

customers” in stores located from Florida to Idaho.

Id. at 39a. Indeed, the court noted that petitioner “had

already installed HVAC systems in most of its

supermarkets [during the 1950s], well before it was

aware of any interrelationship between HVAC

Systems and the proper functioning of its other

equipment.” Jbid. Under those circumstances, the

court concluded that the Tax Court had committed

“clear error” in finding that petitioner’s HVAC

systems satisfied the “sole justification” test. Id. at

39a-40a.

ARGUMENT

1. Petitioner contends (Pet. 12-13, 15-23) that the

court of appeals erred in rejecting petitioner’s

attempt to take current deductions for deferred

compensation payments that will not be made, or

included in its employees’ income, for years to come.

_ The court’s decision is correct, and the matter does

not warrant further review.

a. Before 1942, employers using the accrual basis

of accounting could generally accrue’ deferred

compensation and deduct it, as an “ordinary and

necessary business expense,” in the year in which the

obligation to make a particular payment first arose.

See Pet. App. 55a. Most employees, by contrast,

compute income on the basis of cash receipts and

disbursements. Thus, by entering into a properly

structured deferred compensation agreement with an

employee, an accrual-basis employer could receive

immediate deductions without any current cash

outlay, while the employee could receive a vested

right to future payments without reporting any

current income. See id. at 10a. This asymmetry in

tax accounting led to “considerable abuse.” Jd. at 55a-

56a.

To address this situation, Congress amended what

is now Section 404 of the Internal Revenue Code.

Under Section 404 (and related provisions), employers

and employees may achieve the dual advantages of

current deductibility and deferred inclusion only by

maintaining a so-called “qualified” deferred compen-

sation plan. Among other requirements, such a plan

must not discriminate in favor of highly compensated

individuals; the employer must generally make con-

tributions in trust for the sole benefit of plan

participants (thus placing the funds beyond the

control of the employer in the year of contribution

and deduction); and the employer’s contributions must

generally meet certain minimum standards in re-

lation to the benefits promised under the plan. If a

plan meets all the requirements for “qualification,”

then the employer receives a current deduction for

amounts contributed to the trust, the trust itself is

exempt from tax, and employee participants are not

taxed, either on the employer’s contributions or on

the trust’s earnings, until they actually receive

benefits paid by the trust under the plan. See

generally 26 U.S.C. 401(a), 402(a), 404, and 501(a) (1988

& Supp. V 1993); 2 B. Bittker & L. Lokken, Federal

Taxation of Income, Estates and Gifts 4 60.1, at 60-2

(2d ed. 1990) (hereafter Bittker & Lokken). .

An employer may enter into a deferred compensa-

tion agreement with any of its employees without

complying with the nondiscrimination, trust, funding,

or other conditions necessary to create a “qualified”

plan. Since 1942, the Code has provided that when an

employer incurs an obligation for future payment

under such a “nonqualified” arrangement, it is not

entitled to a deduction until the year in which an

equivalent amount is includible in the income of the

employee concerned. See Pet. App. 10a-lla, 56a; 26

U.S.C. 404(a)(5) and (b). The year of inclusion for a

cash-basis employee is determined under principles of

actual or “constructive” receipt. Under longstanding

practice, if an employee agrees in advance to defer

compensation for services to be rendered in the

future, the employee generally will not be treated as

having constructively received the compensation so

deferred until payment is actually made. See, e.g.,

Rev. Rul. 60-31, 1960-1 C.B. 174, modified by Rev. Rul.

70-435, 1970-2 C.B. 100; Martin v. Commissioner, 96

T.C. 814 (1991); Commissioner. v. Oates, 207 F.2d 711

(7th Cir. 1953); Bittker & Lokken 4 60.2.1, at 60-4.

b. As the Tax Court correctly recognized (Pet.

App. 48a-53a), against this background, the “further

sum[s] of money” provided for in petitioner’s deferred

compensation agreements (see id. at 3a n.1) are not

properly viewed as “interest * * * on indebtedness”

that is deductible under Section 163(a) of the Code.

We do not dispute that those amounts are intended to

reflect the time value of money. See Pet. App. 30a-

31a. While all interest reflects time value, however,

not all reflections of time value are “interest” for

purposes of Section 163.‘

The essential relationship between an employer and

an employee with whom it enters into a deferred

compensation agreement remains that of employer

and employee; it does not become that of borrower and

lender. All amounts that the employee agrees to

receive in the future—in exchange for services to be

4 See, e.g., Garvey, Inc. v. United States, 726 F.2d 1569, 1574

(Fed. Cir.) (purchase of property in exchange for private

annuity was a capital expenditure, and time-value component

of annuity was not deductible “interest”), cert. denied, 469

U.S. 823 (1984); Autenreith v. Commissioner, 115 F.2d 856, 858

(3d Cir. 1940); Estate of Arbury v. Commissioner, 93 T.C. 136,

141 (1989); see also Bell v. Commissioner, 76 T.C. 232, 237

(1981).

rendered after the date of the agreement—are

therefore properly and accurately characterized as

compensation for those services, no matter when paid

or how denominated in the agreement. Moreover,

while the additional amounts under petitioner’s

agreements were computed on the basis of stated

interest rates, similar agreements may reflect “time

value” through adjustments based on, for example, the

consumer price index, an index of stock or bond

market returns, returns on the employer’s own stock,

or returns on the actual investment of the deferred

payments. See Bittker & Lokken § 60.2.1, at 60-11.

Petitioner’s theory would presumably require that all

such amounts be treated as “interest” for purposes of

Section 163. That result is not an obvious inter-

pretation of the statutory language. Compare Pet. 15-

16.

Nor is it obvious on what “indebtedness” petitioner

would be paying “interest,” under its theory, for

purposes of Section 163(a). Certainly this case does

not involve any borrowing by petitioner, or any loan

by its employees, in the ordinary sense of those

terms. Cf. Old Colony R.R. v. Commissioner, 284

U.S. 552, 561 (1932) (“We cannot believe that

Congress used the word [‘interest’] having in mind

any concept other than the usual, ordinary and

everyday meaning of the term.”). In its first opinion,

the court of appeals treated petitioner’s contractual

obligation to make payments under the deferred

compensation agreements as, in itself, “indebtedness”

for these purposes. Pet. App. 32a. The court reached

that conclusion, however, by applying a general

incitement laiicaiatali il

definition taken out of context. And while “an

indebtedness is an obligation, an obligation is not

necessarily an ‘indebtedness’ within the meaning of”

Section 163(a). Deputy v. du Pont, 308 U.S. 488, 497

(1940).

The Code does treat some contractual obligations

as including an implicit time-value component that

must be given separate effect for tax purposes. And,

as some of the opinions below point out (see Pet. App.

30a n.14, 61a, 65a n.4), Congress has in recent years

required taxpayers to identify and account for such

“hidden” or “implicit” interest in a variety of situa-

tions. Even in cases (unlike this one) involving trans-

actions that clearly involve “indebtedness,” however,

it has generally done so by enacting specific and often

° The court cited (Pet. App. 32a) the statement in Horn v.

Commissioner, 90 T.C. 908, 938 (1988), that “{iJndebtedness has

been defined as ‘an unconditional legally enforceable obligation

for the payment of money.’” Horn, in turn, was quoting

Autenreith v. Commissioner, 115 F.2d 856, 858 (3d Cir. 1940),

and cited Knetsch v. United States, 364 U.S. 361 (1960). Horn

rejected the validity, for tax purposes, of sham “promissory

notes” signed by investors in an abusive tax shelter scheme.

See 90 T.C. at 938-940. Autenreith refused to recognize as

“indebtedness” for purposes of Section 163 the obligation

(unconditional and presumably enforceable) of three sons to

make annual “interest” payments to their mother, on the

ground that the payments were actually principal payments

for partnership interests acquired from their father after his

death. See 115 F.2d at 858. Autenreith relied on Commissioner

v. Park, 113 F.2d 352 (8d Cir. 1940), which held, un-

remarkably, that an interest-bearing demand note was

“indebtedness” within “the ordinary meaning of the word.”

And Knetsch refused to recognize, for tax purposes, the

“interest” paid on “loans” that were part of a structured tax-

shelter transaction. See 364 U.S. at 364-366. None of those

decisions has much to do with the situation at issue in this case.

technically complex provisions. See, e.g., 26 U.S.C.

467 (leases with deferred payment provisions), 483

(certain amounts under deferred-payment sales

contracts are to be “treated as interest”), 1271-1275

(1988 & Supp. V 1993) (“original issue discount” on

debt instruments, including those issued in

consideration for the sale or exchange of property),

7872 (loans with below-market interest rates); see

also 26 U.S.C. 163(e) (1988 & Supp V_ 1993)

(coordinating interest deduction and original issue

discount rules). In the absence of such a provision

applicable to deferred compensation agreements,

there is no reason to stretch the normal meaning of

the statutory terms “interest” and “indebtedness” to

include any part of the compensation promised under

petitioner’s agreements. See, e.g., Deputy v. du Pont,

308 U.S. at 493 (deductions are to be allowed only as

clearly provided by law).°

6 If petitioner was concerned with the deductibility of any

“time value” component of its deferred payments, it could

have structured its affairs differently to ensure that result.

Had petitioner paid compensation to its executives and then

borrowed it back (see, e.g., Pet. 15), or paid its employees with

a non-forfeitable promissory note with terms similar to those

of the deferred compensation agreements, then its interest

deductions would not be in doubt. Of course, either of those

arrangements would presumably have required the employees

to recognize current income, which would have made the

arrangement less attractive to them. See Treas. Reg. § 1.61-

2(d)(4); see also Pet. App. 5la n.7. Petitioner used deferred

compensation agreements in order to avoid current taxation of

its employees. Having selected a particular form for its

transaction, petitioner is bound by that form’s collateral tax

consequences, Commissioner v. National Alfalfa Dehydrating

& Milling Co., 417 U.S. 134, 148-149 (1974), which in this case

include an equivalent deferral of its own deductions. As

We do not contend that the amounts in question in

this case could not be viewed as “interest” on “in-

debtedness” under any circumstances or for any

purpose. The question in this case is only whether

such a characterization is appropriate for purposes of

the deduction provided by Section 163 of the Code.

Compare NationsBank of North Carolina, N.A. v.

Variable Annuity Life Ins. Co., 115 S. Ct. 810, 816

(1995); cf. Clayton v. United States, No. 92-712T (Ct.

Fed. Cl. June 30, 1995) (payments from qualified trust

are not “compensation” for purposes of certain

source-of-income rules applicable to non-U-.S.

taxpayers) (reprinted in 1995 Daily Tax Rptr. (BNA)

No. 131, at K11, K22-K23 (July 10, 1995)). Having

considered the matter in light of the purposes of that

Section and the nature of petitioner’s deferred

compensation agree-ments, the Commissioner of

Internal Revenue has concluded (as did a majority of

the Tax Court, Pet. App. 47a-59a) that all payments

under those agreements should be treated as

“compensation” for purposes of Section 404, and that

no part should be treated as “interest” for purposes of

Section 163. That contextual interpretation is plainly

reasonable, and it is entitled to deference from the

courts. See, e.g., NationsBank of North Carolina, 115

S. Ct. at 816; Good Samaritan Hosp. v. Shalala, 113 S.

Ct. 2151, 2161-2162 (1993).

petitioner acknowledges (Pet. 4), for several years it adopted

exactly that approach to its obligations under the agreements

in question. In that light, petitioner’s contention that the

decision below “disappointed many taxpayers’ settled

expectations” (Pet. 20) would appear not to apply, in any

event, to petitioner itself.

ce. Both courts below also recognized (Pet. App.

7a-19a, 53a-63a) that, whether or not the “further

sum[s]” computed under petitioner’s deferred com-

pensation agreements could be viewed as “interest”

for purposes of Section 163, the recognition of

immediate deductions as those amounts accrued

would be inconsistent with the terms and purpose of

Section 404 of the Code.

Petitioner’s deferred compensation agreements

constituted a nonqualified, unfunded deferred com-

pensation plan benefitting only eight high-ranking

executives and one outside director. As discussed

above (see pp. 11-12, supra), the nature of the

relationship between an employer and an employee is

one of payment for services performed, whether that

payment is made currently, or deferred under an

express agreement entered into before the relevant

services are performed. Whether the amount to be

paid is adjusted for the delay by using an interest

rate, returns on the employer’s stock, a cost-of-living

factor, a stock or bond index, or some other factor, the

employee has not in fact invested in the employer’s

stock or bonds, or in some informal investment fund.

The essence of the relationship remains future

compensation for past services, and all amounts

payable under the agreement are_ therefore

“compensation” for purposes of Section 404. And

Section 404(a)(5) prohibits deductions for any such

“compensation” under a non-qualified plan until the

amount is actually paid to the participant and

includible in his income.

Section 404 has its origins in Section 162(b) of the

Revenue Act of 1942, ch. 619, 56 Stat. 863 (codified at

26 U.S.C. 23(p) (1946)). See Pet. App. 10a. In enacting

Section 23(p), Congress expressed its intention that

an employer’s deductions be matched in time with a

participant’s receipt of income: .

If an employer on the accrual basis defers

paying any compensation to the employee until a

later year or years under an arrangement having

the effect of a stock bonus, pension, profit-sharing,

or annuity plan, or similar plan deferring the

receipt of compensation, he will not be allowed

a deduction until the year in which the com-

pensation is paid.

H.R. Rep. No. 2333, 77th Cong., 2d Sess. 106 (1942)

(emphasis added); S. Rep. No. 1631, 77th Cong., 2d

Sess. 141 (1942). As the court of appeals recognized

(Pet. App. 1la-12a), that “matching” principle has

been widely acknowledged as “the key to section 404.”

See, ¢.g., Bittker & Lokken 4 60.1, at 60-2 (“The most

consistent feature of the rules for nonqualified plans

is that the employer is ordinarily allowed no

deduction for contributions, payments, or benefits

until they are taxed to the employee.”).

Petitioner argues (Pet. 18-19) that because the

version of Section 404(a) in effect in the year in

question (see Pet. App. 95a) explicitly prohibited only

deductions under Sections 162 (relating to business

expenses) or 212 (relating to other investment

expenses), Congress could not have intended to bar

deductions for interest expenses under Section 163.

As noted above, however, before Section 404’s pre-

cursor was enacted in 1942, accrual-basis employers

deducted deferred compensation, in advance of actual

payment, “as an ordinary and necess wry business

expense.” Pet. App. 55a. There is no indication that

Congress at the time thought of such payments,

either when accrued or when actually made, as

including any time-value component that could be

separated out analytically and treated as “interest”

for purposes of tax deductibility. Compare Old

Colony R.R. v. Commissioner, 284 U.S. at 560-561

(“(W]e think that in the common understanding

‘interest’ means what is usually called interest by

those who pay and those who receive the amount so

denominated in bond and coupon, and that the words of

the statute permit the deduction of that sum, and do

not refer to some esoteric concept derived from subtle

and theoretic analysis.”). Because Congress had no

reason to believe that an employer’s obligation to

make deferred compensation payments might be

deductible under any Code provision other than Sec-

tion 162 or 212, it is not surprising that Section 404 at

first explicitly addressed only deductions under those

two provisions.

In 1986—at a time when it had become thoroughly

familiar with the concept of implicit interest in the

tax context—Congress amended Section 404 to re-

place the specific references to Sections 162 and 212

with a general reference to deductions “under this

chapter” (that is, Code Sections 1-1399). See Pet.

App. 96a. The change was made retroactive to 1984,

and treated as a technical and clarifying amendment:

The bill clarifies that the deduction-timing

rules for deferred compensation arrangements

apply to any plan or method of deferring com-

pensation regardless of the section under which

the amounts might otherwise be deductible and

that the amounts shall be deductible under section

404(a)(5) and shall not otherwise be deductible

under any other section.

S. Rep. No. 313, 99th Cong., 2d Sess. 1013 (1986)

(emphasis added). Thus, when Congress has had

occasion to focus on the question, it has made clear

that all amounts payable under deferred compensation

agreements are to be treated as compensation, and

deducted and included by employer and employee at

the same time.’

Finally, as the court of appeals emphasized (€.g.,

Pet. App. 13a-16a), allowing petitioner a current de-

duction for “further sum[s]” accrued under its de-

ferral agreements would undermine the comprehen-

sive scheme that Congress has established to encour-

age employers to establish and maintain “qualified”

plans. The benefits and burdens of qualified plans are

carefully calibrated. See pp. 9-10, supra; Pet. App. 9a-

10a, 13a-15a. Recognition of petitioner’s claimed

deduction would upset that calibration. As the court

of appeals put it, if an employer “could simply retain

the funds and receive tax benefits similar to those [it]

would receive if those amounts were paid out, there

7 Similarly, the explicit reference in Section 457(a) to

“income attributable” to amounts deferred under a state or

local government’s deferred compensation plan (see Pet. 18)

merely reflects increased analytical sensitivity to implicit

interest issues on the part of the drafters who revised that

Section in 1986. Petitioner’s reliance (Pet. 22) on Section

467(g) of the present Code, first enacted in 1984, is similarly

misplaced; that Section does not apply to “any amount to which

section 404 * * * applies.” And the fact that Section 267 of

the Code prohibits a variety of schemes that would otherwise

result, like the analysis of deferred compensation that peti-

tioner urges, in the mismatching of deductions and income in

transactions between certain related taxpayers (see Pet. 22)

sheds little light on the proper interpretation of Section 404’s

specific rules regarding all deferred compensation agreements.

would clearly be little incentive to establish a quali-

fied plan.” Pet. App. 10a.

Depending on the deferral period and the rate used

to calculate additional amounts under a deferred com-

pensation agreement, the “additional” amounts due

under such an agreement could, as the court of

appeals recognized (Pet. App. 14a), easily exceed the

original “basic” amount an employee agreed to defer.

The court correctly reasoned that Congress could not

have intended to prohibit an.employer that maintains

a nonqualified deferred compensation plan from

deducting the basic amount before actual payment,

but to allow a current deduction for what might well

be the bulk of the package. /d. at 14a-15a. Moreover,

because an employer with a qualified plan could

deduct only the “basic” amounts actually contributed

to a trust for the benefit of plan participants, allowing

current deductions for “additional amounts” under

nonqualified plans could actually encourage the

establishment of nonqualified plans in preference to

qualified ones. There is no warrant for rejecting

the Commissioner’s reasonable construction of the

term “compensation” in Section 404, in favor of a

theoretical construct that would have the effect of

providing similar or even greater tax benefits to a

nonqualified plan that discriminates in favor of a few

highly compensated individuals and does not require

current funding or separate administration to secure

the future availability of any part of the benefits

promised under the plan.

d. As petitioner acknowledges (Pet. 23), there is no

conflict among the courts of appeals about the non-

deductibility of any amount payable under a deferred

compensation agreement. Indeed, this case appears to

be the first one to address the question. Had the

court of appeals accepted petitioner’s novel argument,

other taxpayers would undoubtedly have attempted to

claim similar deductions. The dramatic fiscal impli-

cations of that departure from the status quo would

have made the decision one of exceptional importance,

and might have warranted review even in the absence

of a conflict. See generally Pet. App. 100a-102a

(government’s petition for rehearing below). Because

the court of appeals ultimately reached the correct

decision, however, its judgment preserves, rather

than upsets, the reasonable expectations of both

Congress and taxpayers, and threatens no unwar-

ranted depletion of the fisc. Moreover, the retroactive

amendment to Section 404 discussed above forecloses

petitioner’s contention for all taxable years after

1984, and the issue is therefore of limited continuing

importance. Under the circumstances, there is no

reason for this Court to review the case.

2. a. Section 38 of the Code, as in effect during the

taxable year at issue, allowed a credit against tax for

a portion of a taxpayer’s investment in certain types

of “section 38 property.” The definition of “section 38

property” included “tangible personal property (other

than an air conditioning or heating unit).” 26 U.S.C.

48(a)(1)(A) (1982). Treasury regulations in turn

defined “tangible personal property” to include all

tangible property except land, buildings and other

inherently permanent improvements, and_ the

“structural components” of buildings ind similar

structures. Treas. Reg. § 1.48-1(c) (1982). The

regulations further defined “structural components”

to include “all components (whether in, on, or

adjacent to the building) of a central air conditioning

or heating system. ” Treas. Reg. § 1.48-1(e)(2) (1982).

Petitioner nonetheless claims (Pet. 23-26) that it is

eligible for the investment tax credit with respect to

HVAC systems installed in its grocery stores during

the tax year at issue in this case. Petitioner relies

entirely (see Pet. 23) on an exception set out in

Section 1.48-1(e)(2) of the regulations (reprinted at

Pet. App. 98a-99a), which provides:

[T]he term “structural components” does not

include machinery the sole justification for the

installation of which is the fact that such

machinery is required to meet temperature

or humidity requirements which are essential

for the operation of other machinery or the

processing of materials or foodstuffs. Machinery

may meet the “sole justification” test provided by

the preceding sentence even though it inciden-

tally provides for the comfort of employees, or

serves, to an insubstantial degree, areas where

such temperature or humidity requirements are

not essential. For example, an air conditioning

and humidification system installed in a textile

plant in order to maintain the temperature or

humidity within a narrow optimum range which is

critical in processing particular types of yarn or

cloth is not included within the term “structural

components.”

The government has never disputed that the HVAC

systems at issue here provided the temperature and

humidity necessary for the proper operation of the

refrigerated food cases in petitioner’s stores. The

dispute has centered instead on whether that effect

could plausibly have been the “sole justification” for

installation of those systems in petitioner’s retail

food stores. The court of appeals correctly held (Pet.

App. 37a-40a) that it could not. As the court pointed

out (id. at 38a), the HVAC systems played an

important role in the essential function of ventilat-

ing the supermarkets. In addition, as the court rec-

ognized (id. at 38a-39a), air conditioning in the

summer and heating in the winter provided a

comfortable year-round shopping environment for

petitioner’s customers. It is therefore hardly sur-

prising that, as the court observed (id. at 39a),

petitioner had installed HVAC systems in most of its

stores during the 1950s, well before it was aware of

any relationship between those systems and the

proper operation of its display cases.

The court of appeals properly concluded that, while

maintaining the proper temperature and humidity to

operate other equipment might have been one reason

for installing HVAC systems, it was not the “sole

justification” for installing them within the meaning

of the regulations. Pet. App. 40a. Whatever the pre-

cise contours of the “sole justification” test, a

particular justification cannot be the “sole” one if the

HVAC system in question would have been installed

in any case, even if that justification had somehow

been eliminated.*® In this case, it is abundantly clear

® The regulations provide that an HVAC system may meet

the “sole justification” test even if it “incidentally provides for

the comfort of employees.” Pet. App. 98a. As the court

pointed out (id. at 39a-40a), the example given to illustrate that

point is a narrow one, involving maintenance of a temperature

and humidity range “critical” to the production process in a

factory. Id. at 98a-99a. The example implies that if the system

were not required for the manufacturing process, the taxpayer

would not have installed it in any event, simply for the benefit

of the factory’s employees. The same cannot plausibly be said

of an HVAC system that maintains, among other functions, an

that petitioner would have installed air conditioning

and heating systems in its retail stores—located from

Florida to Idaho—in order to ensure proper venti-

lation and a comfortable customer environment,

whether or not those systems were necessary to the

operation of any other equipment in its stores. “That

is, indeed, little more than common sense.” Pet. 24.”

The decision below is plainly correct, and there is no

need to revisit it in this Court.

b. Petitioner argues (Pet. 13-14, 26) that the court

of appeals’ decision on the investment tax credit is-

sue conflicts with the decision in Piggly Wiggly

Southern, Inc. v. Commissioner, 803 F.2d 1572 (11th

Cir. 1986). In Piggly Wiggly, the court held that

“(t]he ‘sole justification’ test necessarily involves a

factual determination as to why the taxpayer made

particular expenditures.” Id. at 1576. The court re-

fused to “say as a matter of law that a supermarket’s

sole justification for installing a particular HVAC

system could not have been to meet temperature and

humidity needs of other equipment.” bid. On the

attractive and comfortable environment for retail grocery

store customers.

9 Petitioner argues (Pet. 5-6, 23-24, 25-26) that it keeps the

temperature in its stores lower than it otherwise would during

the summer because of the requirements of its display cases.

Even if those requirements provide the “sole justification” for

the thermostat setting that petitioner chooses, however, that

does not demonstrate that they provide the “sole justification”

for having heat or air conditioning in the first place. When the

outdoor temperature is over 90 degrees, petitioner’s customers

might prefer that the indoor temperature be maintained at 78

degrees rather than at 72 degrees, see Pet. App. 74a; but it is

difficult to believe that they would prefer (or even tolerate)

the absence of any air conditioning at all.

facts of the case before it, the court held that there

were “two permissible views of the evidence,” and

refused to characterize as “clearly erroneous” the

Tax Court’s “factual findings * * * that Piggly

Wiggly chose the particular HVAC system [involved

in that case] in order to meet equipment speci-

fications and that customer and worker comfort was

an incidental benefit.” Jd. at 1575, 1576.

In this case, applying the same legal standard to

similar facts, the court of appeals reached a different

factual conclusion. Pet. App. 38a-40a & n.25. One

other court has reached the same result as the court

below, after an exhaustive examination of the

particular facts of the case before it. Publix Super-

markets, Inc. v. United States, 26 Cl. Ct. 161 (1992).

Whatever the merits of Piggly Wiggly’s holding on

the facts of that case, there is no conflict among the

courts on the applicable legal standard; and any

variations in the ultimate factual determinations

reached in the few cases that have addressed the “sole

justification” issue in the supermarket HVAC con-

text do not warrant review by this Court.

Moreover, as petitioner acknowledges (Pet. 14), the

investment tax credit was repealed, with limited

transitional exceptions, by the Tax Reform Act of

1986, Pub. L. No. 99-514, § 211, 100 Stat. 2166-2170.

The repeal of the credit considerably diminishes the

importance of the “sole justification” test at issue in

this case. As petitioner points out (Pet. 14), the test

remains relevant for purposes of determining the

availability of certain accelerated depreciation deduc-

tions. If it becomes necessary for this Court to

consider the meaning or application of the test for

those purposes, however, it would surely be preferable

to await a case that presents specific issues of

continuing relevance in an appropriate —_ and

factual context.

CONCLUSION

The petition for a writ of certiorari should be denied.

Respectfully submitted.

DREW S. Days, III