U.S. Manufacturers and Advance Trade Discounts | Accounting

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Currently, a normal course of business is the practice of sellers providing payments to buyers with the promise (i.e. contractual agreement) of certain volume purchases over a period of time. These payments or as the industry calls them “Advance Trade Discounts” have been considered standard practice for many years as a way of assuring volume purchases of products. But in recent times, this common practice has come under fire partly due to two court cases and the position the IRS has taken in response of the verdicts. The issue that most observers, the court and the IRS seem to struggle with is; “whether or not a default of the promise (i.e. contractual agreement) to purchase a certain volume of products over a period of time shifts the ATD payment to gross income or loan status”. If one relies on the courts, we see divided verdicts. The Ninth Circuit Court in Westpac Pacific Foods, basically reversing a Tax Court decision, held that ATD’s were not considered gross income when received because the buyer (taxpayer) had an obligation to repay the discounts and therefore had no accession to wealth. On the other hand, the Third Circuit Court in Karns Prime & Fancy Food, Ltd., held that the a taxpayer must recognize an ATD as gross income because of the ability of the taxpayer to control whether it was entitled to keep the discounts. However, to make matters complicated, days prior to the Karns verdict, the IRS issued Rev. Proc. 2007-53 announcing it would follow the Westpac verdict insofar as it would allow taxpayers to follow their financial treatment of certain ATD payments.
The key sits with the position or phrase the IRS has taken in Rev. Proc 2007-53 stating that; “In general the IRS will follow Westpac….”, leaving the door open to continuous challenges, while having a split court. Cautiously, arguments from both sides of the isle do maintain merit as to the ATD being considered either gross income or loan proceeds. If considered gross income, the proceeds would constitute an accession to wealth and taxable by the IRS. Considering the ATD as a loan would negate taxation because the receipt of the loan is offset by the obligation to repay. At this point, is where we believe the Ninth Circuit Court may have errored, thus, allowing the IRS to ultimately challenge ATD’s where it believes transactions merit review.
To understand accession to wealth, we need to only look at the definition of Gross Income as stated in the Internal Revenue Code Section 61 (a) “All income from whatever source derived…”. Meaning, if the taxpayer receives an influx of capital that is under their control to utilize in any form or fashion, there is now an accession to wealth not previously held. Now, contrast the Gross Income definition with the decision in Noguchi v. Comm’r, 992 F.2d 226, 227 (9th Cir.1993), where the court remarked that a loan must be an existing, unconditional and legally enforceable obligation for the repayment of a principle sum. Although, the ATD is conditioned with a promise (i.e. contractual agreement) for volume purchases, it is provided as an incentive to buy products and not a pre-conditioned loan obligation. In addition, the IRS could view this scenario as a tax deferral, because the taxpayer could utilize the ATD agreement to stall tax obligations for a period of time before defaulting on the transaction. To this reason, it is believed that the IRS took a stance by keeping their options open to pursue transactions it deems could have accessions to wealth far beyond the Westpac decision.

About the Author

Luis M. Rodriguez is a CPA and a Sr. Partner with Gaetan, Johannes and Vaasco, LLP. The firm is based in New York City with four offices around the country

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