COMMISSIONER OF INTERNAL REVENUE, PETITIONER V. INDIANAPOLIS POWER & LIGHT COMPANY No. 88-1319 In the Supreme Court of the United States October Term, 1988 On Writ of Certiorari to the United States Court of Appeals for the Seventh Circuit Brief for the Petitioner TABLE OF CONTENTS Question Presented Opinions below Jurisdiction Statutory provisions involved Statement Summary of argument Argument: A deposit to secure the payment of future income is essentially indistinguishable from an advance payment for future goods or services and therefore is taxable as income upon receipt A. An advance payment for goods or services to be provided in the future is taxable as income upon receipt B. Deposits to secure the payment of future income, such as the utility customer deposits here, are equivalent to advance payments and should be taxed accordingly C. The court of appeals incorrectly rejected the approach of the Revenue Ruling in favor of an undue emphasis on the existence of an interest obligation D. The Tax Court's "facts and circumstances" test is erroneous and unworkable Conclusion OPINIONS BELOW The opinion of the court of appeals (Pet. App. 1a-18a) is reported at 857 F.2d 1162. The opinion of the Tax Court (Pet. App. 19a-39a) is reported at 88 T.C. 964. JURISDICTION The judgment of the court of appeals (Pet. App. 40a) was entered on September 20, 1988. On December 12, 1988, Justice Stevens extended the time within which to petition for a writ of certiorari to and including February 8, 1989. The petition was filed on February 7, 1989, and was granted on April 24, 1989. The jurisdiction of this Court is invoked under 28 U.S.C. 1254(1). STATUTORY PROVISIONS INVOLVED Section 61(a) of the Internal Revenue Code (26 U.S.C.) provides in pertinent part: General Definition Except as otherwise provided in this subtitle, gross income means all income from whatever source derived * * *. Section 451(a) of the Internal Revenue Code (26 U.S.C.) provides: General Rule The amount of any item of gross income shall be included in the gross income for the taxable year in which received by the taxpayer unless, under the method of accounting used in computing taxable income, such amount is to be properly accounted for as of a different period. QUESTION PRESENTED Whether customer deposits required by a public utility to insure the payment of future bills are income to the utility upon receipt. STATEMENT 1. Respondent is an Indiana corporation engaged in the business of generating, distributing, and selling electricity and steam in Indianapolis, Indiana, and its vicinity. It is a public utility, subject to regulation by the Public Service Commission of Indiana (PSCI). As part of its customary method of conducting business during the years in issue, 1974-1977, respondent required approximately five percent of its commercial and residential customers to pay a deposit as a precondition to receiving service. The customers required to pay deposits were chosen based upon their creditworthiness, and the stated purpose of the deposits was "to insure prompt payment" of the customers' future utility bills. Pet. App. 2a. The details of respondent's deposit program changed during the years at issue because of amendments made by PSCI to its rules of service on March 10, 1976. Prior to that time, respondent determined on an ad hoc basis when it would require a customer deposit, based on a creditworthiness analysis made by its own employees. The amount of the required deposit ordinarily was twice the customer's estimated monthly bill. Respondent refunded these deposits prior to termination of service only if the customer specifically requested a review and demonstrated his creditworthiness. Upon termination of service, respondent refunded the deposits by means of a credit to the final bill or, if requested by the customer, by cash or check. In addition, respondent was required to pay interest at the rate of three percent per year on deposits held at least six months. This interest was payable upon return of the deposit, or annually upon demand in writing by the customer. Pet. App. 2a-3a, 21a-22a. The PSCI amended its rules of service concerning utility customer deposits in 1976, largely in order to reduce arbitrariness in the system. Under the amended rules (see Ind. Admin. Code tit. 8, r. (8-1-2-4)-A42 (Burns Supp. 1978)), respondent was required to determine the creditworthiness of each residential applicant or existing residential customer according to objective criteria. /1/ Deposits could be required of new customers only if they failed a creditworthiness test furnished by the PSCI; deposits could be required of existing customers only if they had a history of late payments. The amended rules also specified that interest would have to be paid at the rate of six percent, but only on deposits held for more than 12 months. Pet. App. 3a, 22a. The amended rules of service also defined when a customer had reached a point at which his credit record was such that retention of a deposit should no longer be necessary. In compliance with those rules, respondent refunded residential customers' deposits after timely payment for a period of either nine successive months or ten out of any twelve consecutive months (provided that the two delinquent months were not consecutive), or if the customer subsequently satisfied the credit test. These refunds generally were made by cash or check, unless the customer requested that they be credited against his bill. When a customer requested termination of service, however, respondent usually applied the deposit as a credit to the customer's final bill. In the event of an involuntary termination of service, respondent used the deposit to cover any unpaid balance in the customer's account and returned any surplus to the customer. Generally, an involuntary termination of service occurred when 90 days had elapsed after a bill was sent with no payment for the charges included on that bill or a later one. Pet. App. 3a, 23a. During the years in issue, 57.7% to 69% of the amounts refunded were in the form of credits against the customer's bill (id. at 25a). /2/ The customer deposits received by respondent were not segregated from its other assets in any manner; they were subject to its unfettered control and were used in the ordinary course of its business. Respondent, an accrual basis taxpayer, treated the deposits on its books as current liabilities, and it did not report them on its income tax returns as gross income. When the deposits were refunded or applied against a customer's bill, respondent made appropriate accounting adjustments. Pet. App. 3a-4a, 23a. 2. On audit of respondent's returns for the years 1974 through 1977, the Commissioner issued a notice of deficiency asserting that the customer deposits should be treated as advance payments and that they constituted income upon receipt. See Rev. Rul. 72-519, 1972-2 C.B. 32. Accordingly, he determined that respondent was required to include in its income for 1975 the balance of customer deposits outstanding at the end of the year (less the amount of deposits on hand at the end of 1954), and to adjust its income for each succeeding year by the amount of the increase or decrease in deposits on hand at the end of the year. /3/ Respondent filed a petition in the Tax Court seeking redetermination of the asserted deficiencies. The Tax Court ruled in favor of respondent in a reviewed decision (Pet. App. 19a-39a). The court followed the approach that it had taken in City Gas Co. v. Commissioner, 74 T.C. 386 (1980), rev'd, 689 F.2d 943 (11th Cir. 1982), and explicitly rejected the Eleventh Circuit's holding in City Gas that deposits paid to insure the payment of future utility bills are income upon receipt if they are under the control of the utility. /4/ The Tax Court concluded that, in determining whether a deposit to secure the payment of future bills is income upon receipt, it is necessary "to examine all of the facts and circumstances surrounding a deposit to evaluate the rights retained by the depositor and the rights acquired by the holder of the deposit" (Pet. App. 34a). Under this approach, the Tax Court found that the following factors indicated that the deposits should not be treated as income: because only five percent of the customers were required to make the deposits and they were chosen on the basis of creditworthiness, the deposits were not intended as "advance payments"; the customers controlled the ultimate disposition of the deposits, in that they could obtain a refund by timely payment and could choose whether to apply the refund as an offset or to receive a check; respondent's rights in the ultimate disposition of the funds were "minimal" and did not arise unless the customer failed to pay; respondent treated the deposits on its books as the customers' property; and respondent paid interest when it refunded a deposit. Pet. App. 34a-36a. The court concluded that "the deposits were not advance payments of income but were temporarily held by the petitioner to secure payment of the bills and were not therefore includable in gross income" (id. at 36a). 3. The court of appeals affirmed (Pet. App. 1a-18a). Although it recognized that, "in terms of the recipient's cash flow, deposits to secure income items and advance payments are essentially the same" (id. at 9a), the court declined to follow the Eleventh Circuit's holding in City Gas that a sum given primarily to secure the performance of an income producing covenant is taxed as an advance payment. Using a rental agreement as an example of an income-producing covenant, the court acknowledged that "(t)he functional similarity between an advance payment of rent and a deposit to secure the payment of rent suggests that they should be taxed similarly" (id. at 10a), but the court concluded that it did not necessarily follow "that a deposit to secure an income payment must always be taxed as an advance payment" (id. at 11a). The court of appeals sought to explain its departure from the tax treatment suggested by this "functional similarity" by means of an analysis of the economic benefit that flows to the utility from temporary use of the customer's funds (Pet. App. 11a-17a). The court identified two principal reasons why a deposit is "valuable" to a utility: (1) as security against possible delinquency; and (2) for the ability to obtain a "return" (for example, by investment) on the utility's possession of the funds (id. at 13a-14a). The court dismissed the "security factor" as insignificant to the inquiry, noting that it was equally present in the case of security deposits made to insure against property damage, which undisputedly are not treated as advance payments (see id. at 11a n.9, 14a). With respect to the "return factor," the court posited what it described as an "extreme case" in which the utility was required to invest the deposits in a particular manner and to refund to its customers every penny of the interest earned (id. at 14a-16a). In that situation, the court stated that there would be no return benefit at all, only a security benefit, and "this benefit alone * * * does not constitute 'the use' of the proceeds in a manner sufficient to justify immediate taxation of the deposit" (id. at 14a). Because of this "extreme case," the court concluded "that deposits to secure the payment of an income item such as rent can be a distinct category from advance payments for tax purposes" (id. at 16a). Having decided that a court is not "automatically required" to regard a deposit to secure an income payment as income upon receipt, the court held that it should "retain the traditional approach of analyzing the facts and circumstances to determine whether the principal purpose of a 'deposit' is to secure future performance or to serve as an advance payment of income" (Pet. App. 16a-17a). Applying this analysis, the court held that the Tax Court's decision that the deposits in this case "served as security and were not prepayments of income is not clearly erroneous" (id. at 17a). The court explained that the primary factor supporting this conclusion was the payment of interest. It also found it significant that the customer (through his payment record) "'controlled' the timing of the refund" (ibid. (quoting id. at 34a)), and that respondent did not intend that the deposits serve as prepayments (id. at 17a-18a). SUMMARY OF ARGUMENT A. It is well settled that payments made in advance for goods or services to be provided in the future are taxable as income upon receipt; the recognition of such payments as income cannot be deferred until a later year when they are earned by performance. See, e.g., American Automobile Ass'n v. United States, 367 U.S. 687 (1961). Thus, it has generally been held that an advance payment of rent is taxable as income upon receipt. On the other hand, a payment to secure the performance of nonincome-producing covenants, such as a covenant to maintain the property in good condition, is not taxable as income upon receipt. The Commissioner and the Eleventh Circuit have correctly concluded that, under this framework, a utility customer deposit to secure the payment of future bills is equivalent to an advance payment and should be taxed as income upon receipt. B. A deposit to secure the payment of future income is not meaningfully different from an advance payment, and there is no justification for according disparate tax treatment to the two kinds of payments. As the court below recognized (Pet. App. 9a), "in terms of the recipient's cash flow, deposits to secure income items and advance payments are essentially the same." The deposit is taken into the unrestricted possession and control of the utility at the time it is received, and it serves to pay future customer bills. If the customer defaults on a payment, the deposit is used to cover the bill, and it is identical to an advance payment. If the customer does not default, the refund may be made in the form of a credit against future bills or it may be made in the form of a payment to the customer. Only in the latter event is it even superficially different from an advance payment. But the economic reality of such a refund payment is no different from applying the deposit as a credit to the customer's bill. The customer simply "buys back" the deposit through a formalistic check exchange in which he pays all his bills and then receives a check from the utility in the amount of the deposit. The purpose and operation of both an advance payment and a deposit to secure future income are the same. The security deposit is required by the seller because he believes there is a substantial risk that future bills will not be paid. Thus, the contemplated disposition of the deposit is to apply it to a future unpaid bill; indeed, that is the sole purpose for the deposit requirement. And, as noted earlier, even if the customer does not default, the manner in which the deposit is refunded -- either through a credit to the customer's account or through an exchange of checks -- does not serve to remove it from the category of an advance payment. In the case of both a deposit to secure the payment of future income and an advance payment, the recipient has ensured that it will receive payment for future services by the simple act of taking the money in advance. There is no sound reason for the tax system not to treat the "security deposit" as an advance payment. The distinction drawn by the Commissioner and the case law between a deposit to secure the payment of future income and a deposit to secure the performance of nonincome-producing covenants is a sound one. There is a significant difference between these two kinds of deposits with respect to the general income-recognition principles of our tax system. A security deposit to guarantee the performance of nonincome-producing covenants is never converted into income; it either is refunded or is used to compensate for a loss. A deposit to secure the payment of future income, on the other hand, clearly is designed to yield income, and the only issue is the timing of the recognition of that income for tax purposes. Here, there is no contention that the deposits were for a purpose other than to secure the payment of future income, and therefore they should be taxed as income upon receipt. C. The court of appeals erroneously held that whether a deposit should be treated as an advance payment turns almost exclusively on the presence or absence of an obligation to pay interest to the customer on the deposit. But an interest obligation is not a logical guidepost for distinguishing between an advance payment and a deposit to secure the payment of future income. It is simply a means of accounting for the time value of money in a given transaction, which is equally relevant for an advance payment (where it often takes the form of a discount to the customer) as for a deposit to secure future income. The presence of an interest obligation is particularly insignificant in this case, where the terms of the obligation were such that no interest at all was paid on many of the deposits. Thus, the interest obligation clearly did not substantially interfere with respondent's control over the deposited funds or with its ability to earn a considerable investment return on its use of them. Here, the payment of interest reflects an obligation to compensate customers for the loss of the use of their money that the utility has required to be deposited in advance; it is plainly not inconsistent with taxation of the deposited funds as income upon receipt. D. The Tax Court's "facts and circumstances" test is erroneous and unworkable because it directs the courts to distinguish between different deposit arrangements on the basis of factual details that are largely irrelevant to the question of the correct tax treatment. More fundamentally, the approaches of both courts below are flawed because they direct the courts to make a factbound determination of whether a particular payment is intended as a deposit to secure the payment of future income or as an advance payment of that future income, even though the "functional similarity" (Pet. App. 10a) between these two kinds of payments is such that they are not meaningfully different. ARGUMENT A DEPOSIT TO SECURE THE PAYMENT OF FUTURE INCOME IS ESSENTIALLY INDISTINGUISHABLE FROM AN ADVANCE PAYMENT FOR FUTURE GOODS OR SERVICES AND THEREFORE IS TAXABLE AS INCOME UPON RECEIPT A. An Advance Payment For Goods Or Services To Be Provided In The Future Is Taxable As Income Upon Receipt It is well settled that payment made in advance for goods or services to be provided in the future is taxable as income in the year of receipt. See Schlude v. Commissioner, 372 U.S. 128 (1963); American Automobile Ass'n v. United States, 367 U.S. 687 (1961); Automobile Club v. Commissioner, 353 U.S. 180 (1957). This is so even though the income is not truly earned by the recipient until the goods or services are provided, and, indeed, even though the recipient presumably would be obligated to refund the advance payment if it defaulted on its promise to provide the goods or services. Moreover, the advance payment is taxable in the year of receipt even though generally accepted principles of financial accounting would not include it in income until earned by performance. As this Court explained, the deferral of the advance payment for accounting purposes "doubtless presents a rather accurate image of the total financial structure, but fails to respect the criteria of annual tax accounting and may be rejected by the Commissioner" (American Automobile Ass'n v. United States, 367 U.S. at 692). See also Schlude v. Commissioner, 372 U.S. at 132. Thus, "the general rule for income tax accounting purposes remains that a taxpayer may not defer the inclusion in income of prepayment received during the taxable year for the furnishing of goods and services in later years." Stanger, Vander Kam & Polifka, Prepaid Income and Estimated Expenses: Financial Accounting Versus Tax Accounting Dichotomy, 33 Tax Law. 403, 416 (1980). /5/ A series of early cases in the lower courts delineated the application of this general principle to monies paid "up front" as part of a rental agreement. Even prior to this Court's decisions in the area, it was well settled in the lower courts that an advance payment of rent was taxable as income upon receipt. See, e.g., Astor Holding Co. v. Commissioner, 135 F.2d 47 (5th Cir. 1943); Mantell v. Commissioner, 17 T.C. 1143, 1147-1148 (1952). Even where the payment was referred to as a "deposit" and where it was possible that it would be applied for some purpose other than the payment of rent, the courts recognized that the payment should be taxable as income upon receipt so long as the payment's primary purpose was as an advance payment of rent. See Gilken Corp. v. Commissioner, 176 F.2d 141 (6th Cir. 1949); Hirsch Improvement Co. v. Commissioner, 143 F.2d 912 (2d Cir. 1944). On the other hand, the courts also held that payments made for the purpose of securing the performance of covenants under the lease, such as a covenant to maintain the property in good condition, were not taxable as income upon receipt, even though the money might be applied to the final rent payment if there was no occasion for applying it otherwise. See Clinton Hotel Realty Corp. v. Commissioner, 128 F.2d 968 (5th Cir. 1942); Warren Service Corp. v. Commissioner, 110 F.2d 723 (2d Cir. 1940); Mantell v. Commissioner, supra. /6/ The general rule that emerged from these decisions was cogently summarized by the Tax Court as follows (J. & E. Enterprises, Inc. v. Commissioner, 36 T.C.M. (P-H) Paragraph 67,191, at 1033 (1967)): If a sum is received by a lessor at the beginning of a lease, is subject to his unfettered control, and is to be applied as rent for a subsequent period during the term of the lease, such sum is income in the year of receipt even though in certain circumstances a refund thereof may be required. * * * If, on the other hand, a sum is deposited to secure the lessee's performance under a lease, and is to be returned at the expiration thereof, it is not taxable income even though the fund is deposited with the lessor instead of in escrow and the lessor has temporary use of the money. * * * In this situation the acknowledged liability of the lessor to account for the deposited sum on the lessee's performance of the lease covenants prevents the sum from being taxable in the year of receipt. In 1972, the Commissioner applied this analytical framework to the issue of customer deposits required by utilities as a condition of providing service. Rev. Rul. 72-519, 1972-2 C.B. 32. The situation described in the Revenue Ruling was that of a water company that required each new customer to make a deposit in an amount exceeding one month's bill. The stated purpose of the deposit was to guarantee the payment of a customer's future bills for water supplied by the company, but the company had unrestricted use of the deposited funds. When the account was terminated, the deposit was applied by the water company against any unpaid balance in the customer's account, and the difference was refunded. The water company paid annual interest on the deposit. The ruling stated the governing principle as follows (id. at 33): "when the purpose of the deposit is to guarantee the customer's payment of amounts owed to the creditor, such a deposit is treated as an advance payment, but when the purpose of the deposit is to secure a property interest of the taxpayer the deposit is regarded as a true security deposit" that is not recognized as income upon receipt. The ruling then concluded that the customer deposit paid to the water company was essentially an advance payment for water because it was "received as security for the payment of amounts owed to (the company) for water and is to be applied against the customer's ending balance when the contract is terminated." Ibid. The ruling specifically noted that "(t)he fact that (the company) pays annual interest on the 'deposit' does not outweigh its primary characteristics as an advance payment." Ibid. /7/ The Eleventh Circuit in City Gas Co. v. Commissioner, 689 F.2d 943 (1982), approved the Commissioner's approach to the question of including utility customer deposits in income. The court stated that the line of rental cases stood for the proposition that if "the deposit more closely resembles a prepayment for goods and services rather than security for property or performance of nonincome-producing covenants, then the payment will be taxable" upon receipt (id. at 947). And the court stated that a deposit intended to secure the payment of future income, and hence "intended to be applied against income items" (id. at 948 n.7), is equivalent to a prepayment for goods or services (id. at 948-949). The court concluded by observing that the fact that "the customer might pay the final bill without regard to the deposit, thus requiring a refund," does not alter the essential character of such a deposit as a prepayment of income (id. at 950). B. Deposits To Secure The Payment Of Future Income, Such As The Utility Customer Deposits Here, Are Equivalent To Advance Payments And Should Be Taxed Accordingly The position taken by the Commissioner in Rev. Rul. 72-519 and approved by the Eleventh Circuit in City Gas -- namely, that a deposit to secure payments that will be due in the future after goods or services are provided is equivalent to an advance payment -- properly reflects both the purpose and the economic effect of such a deposit. Indeed, the logic of the Commissioner's approach was explicitly recognized by the court of appeals below. The court acknowledged what it termed a "functional similarity" (Pet. App. 10a) between an advance payment for goods or services and a deposit to secure the payment of future income, specifically finding that "in terms of the recipient's cash flow, deposits to secure income items and advance payments are essentially the same" (id. at 9a). The court elaborated on this observation by considering the example of a rental agreement where one month's rent is paid "up front," either as an advance payment or as a rental payment security deposit. In both cases, if "the lessee does not default, the lessor receives the sum up front and has discretion over the use of the money during the lease term" (ibid.). In the case of the advance payment, the lessee does not pay the last month's rent. In the case of the security deposit, the lessee may pay the last month's rent, but at the same time his deposit in the amount of one month's rent is returned to him. As the court of appeals recognized (id. at 10a), this is just an economically meaningless "exchange of checks"; indeed, for convenience, the lessor may simply elect to have the deposit applied to the last month's rent, thereby eliminating even this superficial difference. /8/ And, as the court further acknowledged, "(t)he situations are also similar if the lessee defaults" (ibid.). Whether the original payment is termed an advance payment or a security deposit, the lessor is entitled to apply it to the payment on which the lessee defaulted, and he is still entitled to the remaining payments under the lease (ibid.). The court of appeals' recognition of a "functional similarity" (Pet. App. 10a) between an advance payment and a deposit to secure the payment of future income actually understates the case; in fact, these two terms describe payments that are basically identical. From the perspective of both the payor and the recipient, these two kinds of payments are intended to serve the same function and to operate in essentially the same manner. There is no justification for according them different tax treatment. Whenever a vendor sells goods or services to a purchase, the issue of the timing of payment arises. Each party's natural preference is to receive its end of the bargain first. In the terminology of the court of appeals, this promotes both a "security" interest in knowing that the other side has already adhered to its agreement, and a "return" interest in that inflation and investment opportunity generally make it advantageous for a person to receive money or property sooner, rather than later -- i.e., the time value of money. When goods are purchased in a retail store, there is often a simultaneous exchange. In other contexts, however, especially where there is a continuing relationship between the parties, the exchange may not be simultaneous; one party will perform its end of the bargain with the expectation that the other will satisfy its reciprocal obligation as agreed. And the extent to which a party will agree to deviate from the model of simultaneous exchange, of course, reflects in large part the degree to which it trusts the other party to fulfill its obligations. A vendor that trusts a customer to pay its debts ordinarily will be amenable to furnishing the goods or services in question along with a bill for future payment. If the vendor does not trust the customer to pay, however, it will not want to part with its product unless it is paid first. If simultaneous exchange is impractical, the vendor will insist on payment in advance from that customer. This advance payment alleviates the vendor's "security" concern -- i.e., the fear that it will not be paid for the goods or services it supplies. Although the purpose of this advance payment is to give the vendor "security" by protecting him against default, it is well settled that the payment is taxable as income upon receipt (see pages 12-14, supra). An advance payment that is labelled a "security deposit" because it is intended to secure the future payment of bills for goods or services, such as the utility customer deposits in this case, is not meaningfully different from an ordinary advance payment collected with the understanding that it will be applied to pay for goods or services to be delivered in the future. In both cases, the taxpayer has insured that it will receive payment for these goods or services by the simple act of taking the money in advance. The superficial difference is that the "security deposit" is designed to be refunded if all payments are made in a timely fashion, whereas the ordinary "advance payment" is designed to be applied to some future debt. Given the fungibility of cash, however, this difference is meaningless in economic terms, and it should be similarly meaningless for tax purposes. First, the possibility of refund is not unique to the "security deposit." Any advance payment is made on the assumption that the goods or services covered by the payment will be provided to the purchaser; if payment has been made and the seller fails to provide the services, the advance payment will be refunded. When a security deposit is refunded, it is for the same reason -- i.e., to satisfy the requirement that a payment ultimately be matched to a commensurate provision of services. Because of the customer's complete payment record, there remains no outstanding provision of goods or services for which payment is due, and therefore the deposited amount should be returned. Second, even when a cash security deposit ultimately is refunded upon full payment of a customer's debt, that does not destroy the deposit's essential character as an advance payment. Economically, the situation is the same as if the deposit had been applied to pay the customer's outstanding bill. In both cases, the seller has had unrestricted use of the deposited funds and the purchaser has been deprived of the funds for some period of time prior to the provision of the goods or services paid for by those funds. The only difference is that in one case the deposited funds are applied directly by the seller to pay for the services in question; in the other case, the customer directly pays for the services and then has the amount of the deposit returned by the seller. This variation is purely a matter of form; the "return of the deposit" simply involves an exchange of checks that makes no practical difference and should not yield different tax treatment. See, e.g., Pet. App. 10a; August v. Commissioner, 17 T.C. 1165 (1952). /9/ In essence, the customer "buys back" the advance deposit by making payment in the same amount for services provided. It therefore should make no difference in the tax treatment of deposits to secure future payments for goods or services whether the deposit will be applied to pay for the final period of service, or instead will be fully refunded either upon complete payment of the final bill or upon a determination that the customer is sufficiently reliable that retention of a deposit is no longer deemed necessary to guarantee future payment. See generally Burke & Friel, Tax-Free Security: Reflections on Indianapolis Power & Light, 12 Rev. Tax'n Individuals 157, 167-168 (1988) ("There seems little substantive difference between a deposit that may be applied to reduce future rents and a deposit that must be returned once the future rent has been paid."). Moreover, the practical congruence of an ordinary advance payment and a deposit to secure the payment of income items, such as a utility customer deposit, is not merely some type of economic coincidence; rather, it is inherent in the rationale for requiring such a security deposit. Regardless of the label that is attached, from the outset of the transaction the customer's deposit payment is intended by the recipient to be applied as a payment for goods or services. That is the sole purpose of the deposit requirement. The seller believes that there is a substantial risk that the customer will default in payment after service is provided. Therefore, it collects the security deposit in advance to apply to the bill for the period in which the customer defaults. Thus, the contemplation and intention of the taxpayer is that the deposit will function as an advance payment of a future bill. Indeed, on the facts of this case, in every year at issue the majority of the "security deposits" were not refunded, but were applied as a credit to the customer's bill for future services, and hence they undeniably operated as an ordinary advance payment. See Pet. App. 24a. Only if the seller's expectation is not fulfilled and the customer turns out to be reliable can the deposit fail to be applied to a payment for goods or services. And even in that case, the deposit may be applied for that purpose or, if it is returned, it is in conjunction with a payment by the customer for services so that the practical effect of the deposit remains as an advance payment. Thus, treating the deposit as something other than an advance payment fails to recognize its basic purpose and effect. The economic reality of the "deposit" to secure future income has been cogently summarized in a comment criticizing the Tax Court's decision in this case: "It is, in theory, perfectly appropriate to tax on receipt a deposit that the taxpayer is permitted to apply to future rent, utility charges, or any other income item, regardless of whether such application is mandatory, at the taxpayer's option, or is permitted only in the event of future nonpayment by the other party. The deposit, in all these instances, provides a clear economic benefit in the sense that, to the extent of the deposit, 'future' income has been assured." Burke & Friel, supra, 12 Rev. Tax'n Individuals at 173-174. In short, whether the deposit must be applied to future rent obligations or whether it is refundable through an exchange of checks in which the customer directly pays the rent obligations, the deposit operates as an advance payment and should be taxed accordingly. Contrary to the court of appeals' view (Pet. App. 11a n.9), the distinction drawn in Rev. Rul. 72-519 between a deposit to secure the payment of future income and a deposit to secure the performance of nonincome-producing covenants is a sound one. There is a significant difference between these two kinds of deposits with respect to the general income-recognition principles of our tax system. As we have explained, a deposit to secure the future payment of funds that will become income is essentially the same as an advance payment of income. That is not true of a deposit to secure the performance of nonincome-producing covenants, such as to protect the owner against property damage, because the deposit is never converted into income. If there is no property damage, the deposit is returned to the renter. If there is property damage, the deposited funds are used to repair the property, which does not yield income to the holder of the deposit either (unless the amount retained exceeds the repair costs). Thus, the deposit to secure against property damage or the performance of other nonincome-producing covenants is akin to a loan, which does not generate income. The critical difference is that the consideration for an advance payment for goods or services (even if termed a security deposit) is "a commitment to render income-producing services in the future"; therefore, "an advance payment for income-producing services to be rendered in the future must result in income either at the time of receipt, the time of performance, or both." J. Sneed, The Configurations of Gross Income 50 (1967). By contrast, the loan or the deposit to secure against property damage need never give rise to income, and therefore it is not appropriate to tax such a deposit or loan as income upon receipt. /10/ There is no doubt that the customer deposits in this case must be taxed as income upon receipt under the approach of the Revenue Ruling and the Eleventh Circuit in City Gas. It has never been suggested that the deposits were intended to secure the performance of any nonincome-producing covenants. Their sole purpose was to secure the payment of future utility bills by getting the money "up front." Since respondent had unrestricted use of the deposited funds, they should be regarded as advance payments and taxed as such. C. The Court Of Appeals Incorrectly Rejected The Approach Of The Revenue Ruling In Favor Of An Undue Emphasis On The Existence Of An Interest Obligation The court of appeals provided no adequate explanation for its departure from the logical tax consequences of the acknowledged similarity between advance payments and deposits to secure the payment of future income. The court's approach was to seek to discredit the absolute statement that such a deposit "must always be taxed as an advance payment" (Pet. App. 11a (emphasis added)). The court did this by positing what it described as "an extreme case" (id. at 16a). In the court's hypothetical, the utility is required to keep the deposited funds in its corporate savings account and to repay the deposits with the same interest received by the utility (see id. at 14a). The court concluded that such deposits are not advance payments because the utility can receive no benefit from the payment other than the "security" against nonpayment; any return from the utility's use of the money must be forwarded to the customer. From its determination that, because of this "extreme case," deposits to secure income should not always be taxed as advance payments, the court of appeals leaped to the conclusion that the functional similarity between the two concepts could be ignored. Instead, the court stated that the tax treatment of the deposit should turn on an inquiry into the facts and circumstances of each individual case, and it held that the payment of interest on the deposit is a particularly significant -- indeed, almost dispositive -- factor demonstrating that the deposit should not be taxed as an advance payment. Id. at 15a-17a & nn. 11-12. The court of appeals' analysis is flawed in several respects. First, the hypothetical posited by the court is not merely an "extreme case"; it is a completely different case that has no bearing at all on the treatment of the typical utility deposit, such as the ones paid to respondent. In the court of appeals' hypothetical, the use of the deposited funds was severely restricted because the utility was required to invest the funds in a specified manner and to turn over all of the proceeds of that investment to the depositor. In effect, the funds were escrowed, and, as a practical matter, were not within the control of the utility at all. The conclusion that such funds should not be taxed as income sheds no light upon the issue in this case -- whether utility customer deposits over which the utility exercises unfettered control (see Pet. App. 23a) and which can generate a significant investment return to the utility should be treated as advance payments. Moreover, even if the court of appeals is correct that some "extreme case" would warrant deviation from a rule "automatically requir(ing)" (id. at 16a) a deposit to secure future income to be treated as an advance payment, that hardly justifies the court's leap to a rule that completely ignores the acknowledged similarity in less extreme circumstances between the two types of payments and, indeed, that in most cases would result in treating the "security deposit" differently from the economically equivalent advance payment. The standard established by the court of appeals for determining when a security deposit must be treated as an advance payment is wholly unsatisfactory. The court characterized its decision as "retain(ing) the traditional approach of analyzing the facts and circumstances" (Pet. App. 16a), with the payment of interest "a very important factor" (id. at 17a n.12). Upon closer examination, however, the court's opinion strongly suggests its view that the payment of anything more than a nominal amount of interest automatically forecloses treatment of the deposit as an advance payment. The court stated that the reason that an advance payment is taxable as income upon receipt is "because typically the entire return generated during the interim will accrue to the recipient without an offsetting interest payment" (id. at 15a). And the court found that the "presence or absence of the payment of interest substantially reconciles the line of cases addressing the taxability of customer deposits" (id. at 15a n.11). /11/ See B. Bittker, Federal Taxation of Income, Estates and Gifts Paragraph 105.3.4, at S105-37 (Supp. 1989) (court of appeals decision in this case "makes presence or absence of interest determinative"). Thus, the court of appeals' opinion strongly suggests a rule that a taxpayer is required to include an advance payment in income only when the taxpayer can obtain a full investment return of its own on that payment during the time it holds it. In its application of a "facts and circumstances" analysis to the facts here, the court of appeals relied almost exclusively on the mere existence of an interest obligation, without making any analysis of the extent to which that obligation restricted respondent's ability to use the deposited funds and to derive a substantial economic benefit from that use. In fact, the impact of the particular interest obligation in this case appears to have been relatively insubstantial. Prior to the amendment of the PSCI rules in March 1976, respondent paid only three percent interest on the deposits, and no interest at all if the deposits were held for less than six months. After the amendment of the rules, the interest rate rose to six percent, but respondent was not required to pay any interest at all on deposits unless they were held for twelve months. During the post-March 1976 period covered by the amended PSCI rules, it would appear likely that respondent paid little interest on deposits. Respondent was required to refund the deposit of a customer who timely paid nine consecutive bills or ten out of twelve consecutive bills. Thus, the deposits to which the interest requirement would actually attach would be the relatively small group belonging to customers with erratic patterns of payment -- namely, those who were neither consistently timely (which would have entitled them to a refund before twelve months) nor consistently untimely (which would have resulted in their termination as customers and the application of their deposits to their unpaid bills). Thus, it seems clear that, despite the presence of an interest obligation, respondent was required to turn over to its customer only a relatively small portion of the investment profit that it made upon the use of the deposited funds. /12/ The court of appeals' focus on the existence of an interest obligation is theoretically unsound. Interest is a means of adjusting the burdens and benefits of a particular financial transaction to account for the time value of money; it is not a benchmark for identifying a nontaxable security deposit. An advance payment, just as much as a security deposit, implicates the time value of money. In the case of an advance payment, that value may more often be reflected by a discount to the customer for advance payment, rather than by a subsequent interest payment to him, but there is no meaningful economic distinction between the two types of adjustments. "(A)ll deferred payment transactions include interest, either explicitly or impliedly," and that principle applies equally to sales on credit and to "advance payment transactions," i.e., transactions in which "the party who gives cash performs first and the party who gives a nonmonetary consideration performs second" (Lokken, The Time Value of Money Rules, 42 Tax L. Rev. 1, 11 & n.5 (1986)). See also Halperin, Interest in Disguise: Taxing the "Time Value of Money", 95 Yale L.J. 506, 515-519 (1986). The extent to which the recipient of the benefit of the time value of money in a deferred payment transaction incurs a reciprocal interest obligation is a function of the relative strengths of the parties' bargaining positions (or, as in this case, a requirement of law). The presence or absence of such an obligation, however, provides no basis for distinguishing between an advance payment of income and a nontaxable security deposit. /13/ Thus, the Eleventh Circuit correctly recognized the immateriality of an interest obligation in the utility deposit context, finding that "interest may reflect compensation for the advance payment of income items as well" as for the use of a security deposit (City Gas Co. v. Commissioner, 689 F.2d at 948 n.7). That observation accords with the view of other courts that have found interest not to be a significant factor in this context. See United States v. Williams, 395 F.2d 508, 511 (5th Cir. 1968); Commissioner v. Lyon, 97 F.2d 70, 74 (9th Cir. 1938). /14/ Here, respondent required its customers to make payments in advance of their receipt of services. The payment of interest reflects an obligation to compensate those customers for having lost the use of their money. It does not, however, mean that the deposited funds remain the customer's money, and therefore the interest obligation is not inconsistent with taxation of the funds as income to the utility upon receipt. In sum, the court of appeals erred in attaching overriding significance to the presence or absence of an obligation to pay interest to the customer on payments deposited with the utility. That factor provides no logical or economic basis for distinguishing between an advance payment for services to be provided in the future and a deposit to secure the payment of future bills for such services. Moreover, the presence of an interest obligation is particularly insignificant in this case, where the level of the interest obligation was such that it clearly did not substantially interfere with respondent's control over the deposited funds and its ability to earn a considerable investment return on its use of them. Thus, respondent's payment of interest in this case plainly does not justify the court's departure from the logical import of its recognition that an advance payment and a deposit to secure the payment of future income are essentially the same thing. D. The Tax Court's "Facts and Circumstances" Test Is Erroneous And Unworkable The Tax Court did not purport to hold that the tax treatment of utility customer deposits turns exclusively on an interest requirement. Instead, the court stated that whether a utility deposit is to be treated as income upon receipt must depend on an examination of "all of the facts and circumstances surrounding a deposit to evaluate the rights retained by the depositor and the rights acquired by the holder of the deposit" (Pet. App. 34a). In this context, however, such an approach would not only detract from predictability; it would also lead to unwarranted disparities in tax treatment because the factual differences among various utility deposit programs do not outweigh the common truth that such deposits cannot meaningfully be distinguished from advance payments. For example, the factors cited by the Tax Court in this case do not support the conclusion that the payments in question should be treated as nontaxable security deposits. The court regarded as "very significant" the fact that the payments were required from only the segment of respondent's customers found not to be creditworthy (Pet. App. 34a). But that fact is equally consistent with viewing the deposits as advance payments. As we have noted (page 18, supra), a vendor ordinarily is most interested in obtaining payment in advance from a customer whom the vendor does not trust to pay his bills. The focus on creditworthiness shows only that respondent's concern was with collecting its income; it does not suggest that the deposit should not be regarded as an advance payment of that income taxable upon receipt. The Tax Court also adverted to the control that the customers could exercise over the ultimate disposition of the deposit -- namely, that those customers who established their creditworthiness could choose whether to have the deposit credited against a bill or refunded by cash or check (see Pet. App. 35a). This element of "control" is insignificant. First, as we have noted, there is no meaningful difference between applying the deposit to the customer's account or exchanging a check from the utility in the amount of the deposit with a check from the customer making full payment of the outstanding bill. In any event, even if there were more significance to this choice, it is difficult to see why the customer's control over the mode of repayment is relevant to the tax question here. Surely, if respondent's practice were invariably to return the deposit by check to a customer who has demonstrated his creditworthiness, it is inconceivable that the absence of the opportunity for the customer to choose to have the deposit applied to his account would justify a difference in tax treatment in the two cases. /15/ Finally, the Tax Court noted that respondent "consistently treated the deposits as belonging to the customers" in its accounting and in describing the payment as a deposit on a receipt provided to the customer (Pet. App. 35a-36a). The court erred in relying on this factor. Clearly, the correct tax treatment must turn on the substance of the payment, not its label. As the Second Circuit stated in considering whether a particular payment was an advance payment of rent or a deposit to secure the performance of lease covenants (Hirsch Improvement Co. v. Commissioner, 143 F.2d at 915): "It is * * * unimportant how taxpayer regarded or treated it. Its character turns on the terms of the lease itself." Respondent's accounting practices are also of little relevance. It is well established that financial accounting does not necessarily control tax accounting, in part because "financial accounting has as its foundation the principle of conservatism," which skews its techniques toward "understatement * * * of net income" (Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 542 (1976) (internal quotation marks omitted)). See also Commissioner v. Idaho Power Co., 418 U.S. 1, 15 (1974); American Automobile Ass'n v. United States, 367 U.S. at 692-693. Indeed, the question of deferral of income -- in particular, the treatment of advance payments -- is one area where it is recognized that there is "a large gap between generally accepted principles of financial accounting and the tax rules of accounting" (Stanger, Vander Kam & Polifka, supra, 33 Tax Law. at 416). In sum, the Tax Court's approach is a "non-test." It invites courts to treat essentially identical deposit programs differently, depending upon the significance that each court believes should attach to various diverse factual details -- all of which have little bearing on the correct tax treatment of the transaction. /16/ The more fundamental flaw in the Tax Court's approach is that it directs the courts to make a factbound determination of whether a particular payment is intended as a deposit to secure the payment of future income or as an advance payment of that future income -- when there is no practical difference between the two choices. In contrast, the Commissioner and the Eleventh Circuit have correctly determined that a deposit to secure the payment of future income, such as the typical utility customer deposit, must be treated as an advance payment for goods or services to be provided in the future and therefore taxed as income upon receipt. CONCLUSION The judgment of the court of appeals should be reversed. Respectfully submitted. KENNETH W. STARR Solicitor General JAMES I.K. KNAPP Acting Assistant Attorney General LAWRENCE G. WALLACE Deputy Solicitor General ALAN I. HOROWITZ Assistant to the Solicitor General JONATHAN S. COHEN WILLIAM A. WHITLEDGE Attorneys JUNE 1989 /1/ Commercial customers continued to be evaluated for creditworthiness on a case-by-case basis (Pet. App. 3a). /2/ If a refundable deposit was unclaimed, it escheated to the state after seven years. During the period in issue, $1,197,629 in deposits was refunded by cash, check, or credit, and less than $9,324 in deposits escheated to the state. Pet. App. 24a-25a. /3/ This adjustment followed Rev. Rul. 72-519, supra, which specifies that when customer deposits are treated as advance payments, such an adjustment is one attributable to a change in method of accounting governed by the provisions of Section 481 of the Internal Revenue Code (26 U.S.C.). The amount of the adjustment in the notice of deficiency was later recomputed to reflect the parties' agreement as to the applicability of Treas. Reg. Section 1.451-5, which provides that the inclusion in income of certain advance payments for inventoriable goods may be deferred for up to two years after receipt and specifies certain cost offsets. The parties then stipulated that respondent's returns should be adjusted by these recomputed amounts "should the (Tax) Court determine that the customer deposits received by (respondent) are advance payments" (Stip. para. 30). /4/ The Tax Court is a court of national jurisdiction and is not bound to follow a court of appeals decision that reversed the Tax Court in an earlier case. The Tax Court does follow court of appeals decisions in the circuit to which an appeal in the case at hand would lie. See Commissioner v. Portland Cement Co., 450 U.S. 156, 164 (1981); Golsen v. Commissioner, 54 T.C. 742, 756-758 (1970), aff'd, 445 F.2d 985 (10th Cir.), cert. denied, 404 U.S. 940 (1971). /5/ This rule governing the tax treatment of advance payments accords with the "claim of right doctrine," set forth by the Court in North American Oil Consolidated v. Burnet, 286 U.S. 417, 424 (1932) as follows: "If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent." See Automobile Club v. Commissioner, 353 U.S. at 188-189. /6/ The court explained in Clinton that there were "many things to which (the payment) might become applicable besides the tenth year's rent" and the lease reflected the parties' "intention was that it stand as a security for the lessee's performance in all respects of the lease." 128 F.2d at 970. /7/ The ruling contrasted the situation of the utility customer deposit with the situation of a fuel supplier who delivers fuel to service stations who store it in their tanks. The fuel, however, remains the property of the supplier until it passes through a meter when it is being delivered to a motorist. The supplier requires the service station operator to make a deposit to protect the supplier's title and interest in the fuel stored on the service station's premises. In that situation, the ruling stated that the purpose of the deposit is to protect the supplier's property interest in the fuel prior to its sale, not to secure payment of amounts due from the service station for purchased fuel. Accordingly, the ruling concluded that the deposit is not an advance payment. /8/ This exchange of checks is similarly meaningless for tax purposes. If he has previously treated the deposit as income, the lessor is entitled to a deduction for its return (as well as for any interest that may be paid). If the deposit is instead applied to the last rent payable, there is of course no deduction for its return, but there is no corresponding payment by the lessee that yields income. Thus, the "return of the deposit" through an exchange of checks simply yields an offsetting addition to both income and deductions in the same amount. /9/ The "exchange of checks" in the utility deposit context is not as tidy as it is in a situation, such as a lease, where the amount due for each time period is fixed in advance. That uncertainty concerning the charge for each month, however, does not alter the fact that there is no practical difference between return of the deposit after full payment and direct application of the deposit to satisfy the bill for services. See City Gas Co. v. Commissioner, 689 F.2d at 949; Van Wagoner v. United States, 368 F.2d 95 (5th Cir. 1966) (deposit premiums designed to secure the payment of future insurance premiums that varied according to actual usage of the insured machinery). /10/ The court of appeals noted that the distinction between deposits to secure the performance of nonincome-producing covenants and deposits to secure the payment of future income is blurred because, as a practical matter, the former type of deposit also may be applied in the event of a rent default. See Pet. App. 12a n.9. The correct treatment of such a "dual purpose" security deposit has been explored in the rental cases, and the Revenue Ruling and the Eleventh Circuit in City Gas have adopted the rule set forth in those cases -- namely, the court will look to the primary purpose of the payment, and a payment that is primarily intended to secure the performance of nonincome-producing covenants will not be treated as an advance payment solely because it might be applied as a rent payment (or a payment for goods and services) if there is no prior occasion for applying the deposit. See 689 F.2d at 946; Gilken Corp. v. Commissioner, supra; Hirsch Improvement Co. v. Commissioner, supra; Mantell v. Commissioner, supra. In this case, there is no question of such a dual purpose deposit; it is clear that the only purpose for the deposits required by respondent was to secure the payment of future income. /11/ The court of appeals also stated that once a reasonable rate of interest is paid on the deposit, the value of the deposit then relates predominantly to what it termed the "security factor," and therefore the deposit should be treated like a deposit to secure against property damage or a loan, notwithstanding that the utility can still use the money as it chooses and obtain an economic benefit from that use by achieving a return greater than the prescribed interest rate (Pet. App. 14a). /12/ Moreover, even with respect to the interest that respondent did pay over to its customers, it was entitled to take a deduction for the amount of that payment and to retain the investment return that it earned on that interest while it was in respondent's possession. /13/ The irrelevance of an interest obligation to the question presented in this case is further evidenced by the treatment of security deposits in state statutes regulating rental agreements, which vary widely in the extent to which they require landlords to account to tenants for interest earned on security deposits. Florida and New York require deposits to be held in escrow accounts with title to the funds remaining vested in the tenant. See Fla. Stat. Ann. Section 83.49 (West 1987); N.Y. Gen. Oblig. Law Section 7-103 (McKinney 1989) (landlord may deduct administration fee). Other states specify that interest must be paid on return of the deposit. See, e.g., Md. Real Property Code Ann. Section 8-203 (1988) (escrow account and four percent interest owed on return of deposit); Va. Code Ann. Section 55-248.11 (1986) (unrestricted use but obligation to pay five percent interest to tenant); Pa. Cons. Stat. Section 250.511 (1988) (option of escrow account or bond, but payment of interest required). N.H. Rev. Stat. Ann. Section 540A:6 (1988) (escrow account or bond option, five percent interest). Other states require deposits to be placed in a trust account, but do not require the landlord to pay any interest earned to the tenant. See Iowa Code Ann. Section 562A.12 (West 1989) (expressly providing that interest is the property of the landlord); Ky. Rev. Stat. Section 383.580 (Baldwin Supp. 1988); Me. Rev. Stat. Ann. tit. 710-A, Sections 6033, 6038 (1988). Michigan and Georgia give the landlord the option of holding the funds in an escrow account or of posting a bond and then using the funds for its own purposes with retention by the landlord of the investment return. Mich. Comp. Laws Ann. Sections 554.601 to 554.604 (West 1988); Ga. Code Ann. Section 44-7-30 to 44-7-36 (1982). Moreover, the definition of security in these statutes sometimes explicitly covers both deposits to protect against property damage and prepayments of rent. See Cal. Civil Code Section 1950.5(b) (West 1988); Mich. Comp. Laws Ann. Section 554.601(e) (West 1988); Fla. Stat. Ann. Section 83.49 (West 1987); Va. Code Ann. Section 55-248.4(l) (1986); Md. Real Prop. Code Ann. Section 8-203(a) (1988). /14/ Indeed, the Tax Court in its original decision in City Gas Co. v. Commissioner, 74 T.C. 386, 392 n.7 (1980), discounted the significance of an interest obligation as a basis for distinguishing between taxable advance payments and nontaxable security deposits. /15/ The Tax Court's reliance on the escheat of unclaimed deposits to the state (see Pet. App. 35a) is similarly misplaced. It is true of every deposit or advance payment that the payment should be returned to the purchaser if the seller fails to provide the agreed-upon services or if the purchaser otherwise has fully paid for the services provided. That possibility of return of the advance payment has never been regarded as a ground for failing to treat the payment as income upon receipt. When the circumstances justifying such returns arise, it is surely of no consequence to the tax treatment of the original payments to the seller whether the money is always paid over to the purchaser or, alternatively, whether, in a small percentage of the cases, the money is paid over to the state. /16/ The peculiar results that are likely to arise under this approach are illustrated by Oak Industries, Inc. v. Commissioner, 52 T.C.M. (CCH) 1556 (1987). In that case, the Tax Court held that a large deposit required by a subscription television company, which could be applied either for the repair of damage to equipment or to cover unpaid fees and charges, was taxable as income upon receipt. In this case, the Tax Court distinguished Oak Industries on the ground that the deposits in that case "were credited to final bills for between 61 and 70 percent of all customer terminations" (Pet. App. 36a n.6). In the instant case, between 57.7% and 69% of the amounts deposited were credited to customer bills (id. at 25a). The Tax Court also noted two other purported factual distinctions between this case and Oak Industries, which have been described as of "questionable significance" (Burke & Friel, supra, 12 Rev. Tax'n Individuals at 173 n.67) -- that the television company had a well developed delinquent account collection system and that it required all customers to make deposits (Pet. App. 36a n.6).