Avon Products, Inc. And U.S. Subsidiaries v. United States

Citations: 97 F.3d 1435; 20 Employee Benefits Cas. (BNA) 1969; 78 A.F.T.R.2d (RIA) 6682; 1996 U.S. App. LEXIS 26328; 1996 WL 571477Docket: 96-5003

Court: Court of Appeals for the Federal Circuit; October 8, 1996; Federal Appellate Court

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The case involves Avon Products, Inc. and its Mexican subsidiary, Avon Cosmetics, S.A. de C.V., concerning the tax treatment of employee profit-sharing payments (EPP payments) made by the subsidiary. The Court of Federal Claims had ruled in favor of the government, determining that Avon Mexico improperly deducted certain EPP payments in the year they were made instead of in the year the employees rendered services. The Federal Circuit vacated this judgment, stating that the government was not entitled to summary judgment on this matter and remanding the case for further proceedings.

Avon, as an accrual-basis taxpayer following the calendar year, must comply with Mexican law requiring EPP payments to employees within five months after the end of its taxable year. These payments are pivotal due to their effect on the foreign tax credit under Section 902 of the Internal Revenue Code, which allows U.S. taxpayers to credit foreign taxes paid by a subsidiary against their U.S. tax liability. The credit amount depends on the relationship between dividends paid to the parent company and the subsidiary's after-tax accumulated profits.

From 1967 to 1981, Avon Mexico made EPP payments either in early March or May of the following year. The IRS allowed deductions for March payments in the prior year’s profits, while for May payments, the IRS mandated deductions be recorded in the year of payment.

In 1980, Avon Mexico did not distribute dividends to Avon, preventing Avon from claiming a foreign tax credit for that year. To increase its foreign tax credits, Avon sought to deduct Employee Profit Participation (EPP) payments from Avon Mexico's profits for both 1980 and 1981. Avon Mexico delayed the EPP payments for 1980 until March 26, 1981, arguing that since these payments were made after March 15 of the following year, they qualified as deferred compensation and were deductible in 1981 under section 404(a)(5) of the Internal Revenue Code. For the EPP payments made for 1981, which were completed before March 15, 1982, Avon claimed they constituted current compensation and were deductible in 1981 under section 162.

The IRS accepted the deduction for the payments made before March 15, 1982, but disallowed the deduction for the March 26, 1981 payments, asserting that as an accrual-basis taxpayer, Avon was required to deduct the EPP payments in the year they accrued, which was 1980, according to the Mexican statute. Following this reassessment and payment of the deficiency by Avon, an action for a refund was filed in the Court of Federal Claims, which upheld the IRS's decision.

The statutory framework includes several relevant sections of the Internal Revenue Code: Section 162(a) allows deductions for necessary business expenses incurred during the taxable year; Section 446(a) mandates that taxable income be computed using the taxpayer’s regular accounting method; and Section 446(c)(2) allows accrual-method accounting. Under this method, deductions are typically taken in the year expenses accrue. Current compensation is deductible in the accrual year, while deferred compensation is governed by Section 404, which provides different tax treatment for various deferred compensation arrangements. Section 404 applies broadly to compensation related to employee benefit plans, including stock bonuses, pensions, and profit-sharing plans.

Section 404 of the Internal Revenue Code states that for deferred compensation not part of qualified plans, employer payments are deductible in the year the employee includes them in gross income, not when the obligation to pay arises. Avon claims its EPP payments, delayed until March 26, 1981, qualify as deferred compensation under section 404, thus allowing for deduction in 1981. The government counters that Avon’s EPP payments do not comply with section 404's requirements for a 'plan,' asserting that the payments were not 'deferred' since they were made shortly after the end of the 1980 tax year. Additionally, the government argues that Avon's treatment of these payments constituted an improper change in accounting method.

In addressing the government's claim, it is noted that if the interpretation of section 404 were accepted, it would lead to an illogical outcome where payments made arbitrarily could be deducted in the previous taxable year, while those made under a deferral plan would not. The language and legislative history of section 404 suggest that deductibility principles apply to any arrangement where compensation rights were established by the end of the taxable year, even without a formal deferral plan. Section 404(b) clarifies that the deduction rules apply broadly, encompassing cases with no formal plan, as long as there is a method of employer contributions resembling a plan deferring compensation.

Section 404(b) of the Internal Revenue Code, enacted in 1954, originally referred to a 'method' of employer contributions and included a narrower catch-all clause for 'similar plans' deferring income. Legislative history indicates a broad interpretation was intended, establishing that any arrangement deferring compensation should be governed by section 404 for deductibility. In 1955, the IRS issued Revenue Ruling 55-446, allowing deduction of bonus payments in the year of accrual if the payment obligation was fixed and made promptly after the taxable year, indicating that significant delays would classify payments as 'deferred compensation,' deductible only in the payment year. Amendments in 1978 and 1984 expanded the statute's scope by replacing 'similar plan' with 'other plan' to encompass all methods deferring compensation, clarifying that any arrangements resulting in deferral would be subject to section 404's deduction-timing rules. Legislative reports emphasized that deferred compensation, including year-end bonuses not paid timely, falls under these rules, reinforcing the statute's broad applicability and supporting the argument that corporate decisions to accrue payments on a deferred basis fall within section 404's jurisdiction.

Section 404(b) was amended in 1984 to broaden the scope of deferred compensation plans by including the term 'arrangement,' ensuring that all employer compensation methods that defer payment are subject to specific deduction-timing rules. The House committee indicated that this amendment clarifies existing law, applying to all compensation arrangements deferring receipt by employees or independent contractors. The conference committee emphasized that section 404 encompasses all deferred compensation payments, with the exception of specifically exempted categories. A bonus or similar compensation is considered current, not deferred, if paid within 2.5 months after the end of the taxable year in which the obligation accrued. In 1986, the Treasury Department issued regulations to reflect these statutory changes, detailing when employers can deduct accrued compensation payments, such as year-end bonuses. If payments are made more than 2.5 months after the end of the taxable year, they are presumed to be deferred. Taxpayers can challenge this presumption by demonstrating that avoiding deferral was impracticable and unforeseeable at year-end.

The temporary regulations are not applicable to the years in question, but they, along with a 1955 revenue ruling, indicate that the government views salary or bonus payments not made shortly after the year-end as deferred compensation, subject to section 404's deduction-timing rules. Historically, Avon Mexico's Employee Profit Participation (EPP) payments were treated differently based on their timing; payments made before March 15 were deductible for the taxable year, while those made in May were required to be deducted in the year paid, reflecting the IRS's stance that delayed payments constitute deferred compensation. The government’s current position appears inconsistent with its previous treatment of Avon Mexico's payments. The government cites cases allowing deductions in the year of accrual for compensation paid late the following year, but these either pre-date or fall outside the purview of section 404, or did not address payment timing. A Tax Court decision clarifies that any employee compensation postponed beyond a short period after the accrual year must be deducted in the payment year. Consequently, the argument that EPP payments made on March 26, 1981, cannot be classified as deferred compensation due to lack of a deferral plan is rejected. Lastly, the government argues that the March 26 payments were too soon after the close of the 1980 taxable year to qualify for deduction under section 404, suggesting that a longer delay would have sufficed to trigger the rules.

Prior to the issuance of temporary regulations in 1986, the IRS differentiated between current and deferred compensation through a series of revenue rulings. Specifically, Revenue Ruling 55-446 mandated that for bonuses to be deductible in the year of accrual, they must be paid "as soon after the close of the taxable year as is administratively feasible." The IRS determined that bonuses paid shortly after the year-end, once financial conditions allowed, were deductible as current compensation, provided they were paid before the company’s tax return due date, typically within two and a half months of the taxable year-end.

In Revenue Ruling 57-88, the IRS clarified that amounts allocated and promptly paid to employees were also considered current compensation, stating that this classification relied on the absence of any intention to defer payment beyond when it was administratively feasible. Additionally, Revenue Ruling 61-127 reiterated that bonuses fixed in one year and paid in the next could be deducted in the year of accrual, provided payments were made within the two and a half months after the taxable year-end.

The government argued that compensation payments are classified as current if made within a reasonable timeframe after the close of the taxable year, citing Avon Mexico's EPP payments for 1980 as compliant since they occurred within three months of the taxable year-end. Conversely, Avon contended that these payments were deferred, as they exceeded the two and a half-month threshold. While Avon's stance aligns with current regulations, the relevant law at the time consisted solely of the aforementioned revenue rulings, which suggested that bonuses paid promptly after accrual could be deducted in the accrual year, thus avoiding characterization as deferred compensation.

The central issue in this case is whether Avon's payment on March 26, 1981, was made as soon as it was administratively feasible or if it was deferred beyond that date. Avon presented evidence indicating earlier feasibility for the payments, while the government argued this evidence contradicted Avon's prior admission of no intention to delay payment once feasible. Consequently, the court could not resolve this dispute without further trial proceedings, leading to the vacating of the government's summary judgment and remanding the case for a determination of whether the 1981 payments should be classified as deferred compensation under section 404.

Additionally, the government contended that Avon improperly changed its accounting method without IRS approval by reporting 1980 EPP payments on its 1981 return. The court found that Avon did not change its accounting method but simply chose to time the payment to influence tax consequences, similar to common practices among taxpayers. The court emphasized that structuring a transaction for tax purposes does not render it impermissible.

Furthermore, the government's argument conflicted with the IRS's historical treatment of Avon's EPP payments, which had often been deducted in the subsequent year following their payment. Thus, Avon's decision to delay the 1980 EPP payments until after March 15, 1981, was consistent with prior IRS practices and did not amount to an unauthorized change in accounting method. Each party is responsible for its own appeal costs, and the case has been vacated and remanded for further proceedings.