CCA 200031033: When disputed insurance reimbursements became accruable income

Plain-English summary

Chief Counsel analyzed when a manufacturer had a fixed right to insurance reimbursements for tort claims. Litigation over certain claims meant its right to payment from third-party insurers was not fixed in two years under review, but the right was fixed for other claims whose insurers had not denied liability. Its right to reimbursement from a captive insurer also was fixed because that insurer had not contested liability. A refund request changing the treatment of the disputed claims reflected a change in underlying facts, not an accounting method change. By contrast, changing the treatment of other tort reimbursements and reversing income accrued in an earlier year was an unauthorized accounting method change. For one environmental claim, a third-party insurer's counteroffer fixed the right to reimbursement up to the offered amount. The memo cautioned that more facts might show that some insurers had not disavowed liability, which would change the analysis for their payments.

Ruling snapshot

• Question: When were insurance reimbursements fixed for accrual, and which changes in treatment required accounting method consent?
• Outcome: Advice given on seven issues, with further factual development suggested for some insurers.
• Key authorities: IRC §§ 446, 451, and 461.

Full text (IRS public release)

                         DEPARTMENT OF THE TREASURY
                             I NTERNAL REVENUE SERVI CE
                                WASHINGTON, D.C. 20224




Number: 200031033
Release Date: 8/4/2000
CC:DOM:FS:FI&P
TL-N-4273-99

UILC: 446.00-00
      445.04-00
      451.07-00
                                                   May 4, 2000

MEMORANDUM FOR



FROM:                 DEBORAH A. BUTLER
                      ASSISTANT CHIEF COUNSEL (FIELD SERVICE)
                      CC:DOM:FS

SUBJECT:              Accrual of Insurance Reimbursement


       This Field Service Advice responds to your request dated February 3, 2000.
Field Service Advice is not binding on Examination or Appeals and is not a final
case determination. This document is not to be cited as precedent.

LEGEND

Taxpayer                 =
Year A                   =
Year B                   =
Year C                   =
Year D                   =
Year E                   =
Year F                   =
Year G                   =
Consumer product         =
State 1                  =
State 2                  =
                                           2


ISSUES

1. Whether Taxpayer’s right to receive insurance reimbursements from third-party
insurers, associated with liabilities for certain   tort claims, was fixed in the
final two of the years at issue (Years E and F).

2. Whether Taxpayer’s right to receive insurance reimbursements from third-party
insurers, associated with all other non-      liabilities, was fixed in the final two of
the years at issue.

3. Whether Taxpayer’s right to receive insurance reimbursements from its captive
insurer, associated with various tort claims, including    and non-
claims, was fixed in the years at issue.

4. Whether Taxpayer’s informal request for refund based on its attempt to change
the treatment of its insurance reimbursements for      tort claims was a change
in method of accounting.

5. Whether Taxpayer’s change in the treatment of its insurance reimbursements in
Year E for non-      tort claims was a change in method of accounting.

6. Whether Taxpayer’s reversal in Year E of previously accrued insurance
reimbursement income for all non-       tort claims was proper.

7. Whether Taxpayer’s right to receive an insurance reimbursement from a third-
party insurer, associated with a specific site environmental tort claim, was fixed in
Year E.

CONCLUSIONS

1. Because of litigation involving Taxpayer and its insurers over liability for certain
       tort claims, Taxpayer’s right to receive insurance reimbursement income for
the        tort claims was not fixed in Years E and F.

2. Because none of the insurers expressly denied liability for the non-        tort
liabilities, Taxpayer’s right to receive insurance reimbursement income for those
claims was fixed for all the years at issue (Years D, E, and F).

3. Because Taxpayer’s captive insurer never denied or contested liability for either
       or non-      tort claims in the years at issue, Taxpayer’s right to receive
insurance reimbursement income from the captive insurer was fixed for the years at
issue.
                                          3


4. Taxpayer’s informal request for a refund based on a change in treatment of its
insurance reimbursements for           tort claims (for amounts above the captive
insurer’s primary layer) was not a change in accounting method. While the change
in treatment affected timing, the change was caused by a change in underlying fact:
the dispute over liability engendered by the litigation between and among Taxpayer
and its insurers.

5. Taxpayer’s change in treatment of its insurance reimbursements in Year E for
non-medical tort claims was a change in method of accounting. The change in
treatment affected a material item which impacted on the timing of insurance
reimbursement income. Taxpayer made an improper change in method of
accounting without the Commissioner’s consent.

6. Taxpayer’s reversal in Year E of previously accrued insurance reimbursement
income for all non-       tort claims was improper. The reversal was based on an
improper and unauthorized change in accounting method.

7. Taxpayer’s right to receive an insurance reimbursement from a third-party
insurer, associated with a specific site environmental tort claim, was fixed in Year
E. In Year E, Taxpayer’s insurer had admitted, through a counter-offer, liability up
to a certain amount; such amount was fixed in that year.

FACTS

       Taxpayer is a manufacturer of various industrial and consumer products.
The years at issue are Years D through F. From Years A through B, Taxpayer had
a division which produced and sold a consumer product. In Year B, Taxpayer sold
the division. Under the sales agreement, Taxpayer agreed to indemnify the
acquiring company against any claims made against the consumer product prior to
the sale date.

      Taxpayer was heavily insured against product liability claims under its
general comprehensive insurance coverage. For many years, Taxpayer was
covered for all general comprehensive insurance first by a captive foreign
insurance subsidiary, which handled the first layer (up to $5 or $7 million).
Coverage above this primary coverage was issued in various layers, with various
insurers in each layer. Insurers would sign on for specific portions of each layer
and receive a corresponding share of the premium for that layer. Apparently, there
were over a hundred policies issued.

       For years through Year B and one year afterward, the general comprehen-
sive insurance was “occurrence” insurance coverage. Occurrence-based insurance
                                           4


indemnifies the insured for covered events that take place (occur) during the policy
period, regardless of when the claim or suit is brought. For all years since then,
Taxpayer had “claims-made” insurance coverage. Claims-made insurance
coverage generally limits indemnification to claims made during the policy period.

       Prior to the years at issue, an occasional claim for        tort liability was
made against Taxpayer related to the consumer product. Generally, Taxpayer
resolved those claims and was indemnified (i.e., reimbursed) by its occurrence-
based insurers. However, beginning prior to Year D, the amount of claims
associated with the consumer product increased significantly. Because of this
significant jump, Taxpayer altered its accounting treatment for the claims in Year E.
Also in Year E, Taxpayer encountered trouble with its occurrence-based insurers
over these           tort claims.

        As the number of claims against Taxpayer for the consumer product rose in
the years prior to and during the years at issue, Taxpayer encountered resistance
regarding coverage from its occurrence-based insurers. In Year E, some of
Taxpayer’s occurrence-based insurers filed suit against Taxpayer and all its other
occurrence-based insurers, as well as its claims-made insurers in state court in
State 1 seeking an adjudication of certain coverage issues and a determination
concerning allocation among insurers for coverage under the terms of the various
insurance policies. A few months later in Year E, Taxpayer filed its own suit in
state court in State 2 (which was later removed to a federal district court in State 2)
against all its occurrence-based insurers seeking a determination concerning
allocation among its occurrence-based insurers and adjudication of its overlapping
policies. This action was later stayed pending resolution of the State 1 litigation.
Due to arbitration provisions, the claims-made insurers were dismissed from the
first law suit in Year F.

       The lawsuit brought by some of Taxpayer’s occurrence-based insurers
alleged that the other insurers were either partly or completely liable for the
insurance reimbursements to Taxpayer. That is, those occurrence-based insurers
alleged that the consumer product’s coverage event did not occur during the policy
period. Furthermore, those occurrence-based insurers disputed whether some of
the costs, including certain defense costs, were covered under the policies. The
lawsuit has continued until the present time, although the Taxpayer has
substantially prevailed on most issues in the suit, including definition of the event
for coverage and the allocation of coverage. Because of these victories, the
Taxpayer has received in recent years substantial reimbursement payments by a
number of its occurrence-based insurers for the           tort claims.
                                           5


       Furthermore, apparently because of the litigation filed in Year E, the
insurers, both the other occurrence-based insurers but primarily the claims-made
insurers, refused to pay claims for non-           product liabilities pending outcome
of the              tort claims litigation, even though there was no formal denial of
such claims.

      In all years, Taxpayer’s captive insurance company was not part of the suits
and never denied coverage for its primary insurance layer.

         For at least Years E and F, Taxpayer estimated for book purposes significant
liabilities and expenses associated with the          tort claims. Simultaneously,
Taxpayer estimated receivables for expected insurance reimbursements of the
same amount (after a one-time charge and deductibles). Taxpayer’s annual reports
and other filings with the public for those years noted the litigation over the
tort claims and a belief by the Taxpayer that, except for the one time charge taken
in Year E, it fully expected complete reimbursement of the estimated liabilities and
associated expenses (after deductibles).

       Prior to Year E, Taxpayer accounted on its books for its product liability
claims (           and non-       ) on a net basis. That is, when a liability claim was
made, Taxpayer estimated both the cost of the existing and potential claims (includ-
ing estimated damages and defense-related costs) and the amount of the expected
reimbursement. In most cases, because of the extensive insurance carried by the
Taxpayer, the estimated cost, after deductibles, was totally offset by the estimated
insurance reimbursement.1 For Year E onward, Taxpayer accounted for the
         liability claims separate from other product liability claims.

        In Year E, for all non-      liability claims, Taxpayer for tax purposes
stopped including into income the estimated reimbursement income associated with
the expenses paid and taken into account during the year. From Year E forward,
Taxpayer took into account as a deduction non-            product liability claims
actually paid; however, it only included in income funds actually received as
reimbursement. Taxpayer essentially went to a cash-type treatment of non-
liability claims expenses and income.



      1
         For tax purposes, Taxpayer reversed any unpaid product liability costs (net of
actual recovery) that remained unpaid as a Schedule M-1 adjustment, because of the
economic performance rules under I.R.C. § 461(h). Thus, for tax purposes, Taxpayer
took into account expenses actually paid in the year; it also included in income
expected reimbursement proceeds associated with product liability claims.
                                          6


       When Taxpayer altered its treatment of the expected reimbursement income
in Year E for non-         liabilities and moved to a cash-type basis, Taxpayer had
substantial receivables accrued for reimbursement income (income recognized for
tax purposes but for which Taxpayer had not received the actual cash reimburse-
ments). The amounts had been previously recognized in income. When Taxpayer
altered its treatment in Year E, it took a Schedule M-1 tax deduction for the amount
of the receivable, thus offsetting the prior treatment of these amounts as income.

       Taxpayer did not change its treatment of           liabilities for Years E and
thereafter for tax purposes. For tax purposes, expenses actually paid and expected
reimbursement associated with             tort claims were taken into account as
expenses and income. Unpaid expenses were not taken into account and were
reflected on the Schedule M-1. However, during the course of the examination of
Taxpayer, Taxpayer has filed an informal claim for a refund for Year E, backing out
the accrual of reimbursement income, and moving to the cash-type treatment it
adopted for its non-        liabilities, where only actual expenses and actual
income received are recognized for tax purposes.

       Taxpayer was also insured by various insurance companies under compre-
hensive general liability (CGL) insurance policies throughout its corporate history.
During certain years when Taxpayer was covered by occurrence-based CGL
policies, it engaged in manufacturing operations which produced hazardous
          wastes. Taxpayer was ordered to clean up these hazardous sites. At
least prior to Year C, Taxpayer did not accrue expected reimbursement income
associated with these environment claims, as there remained the issue whether
such clean-up costs were covered damages under the CGL policies (Taxpayer had
deducted actual costs of clean-up). Around Year C, State 1’s Supreme Court ruled
that such costs were in fact covered damages. Many of the costs were then
reimbursed.

       In Year D, Taxpayer requested reimbursement for a specific site clean-up
from the primary CGL insurance carrier. The reimbursement request was based on
a sum for past clean-up and a sum for expected future clean-up. By letter sent in
early Year E, Taxpayer’s primary CGL insurance carrier offered to reimburse
Taxpayer, but using different sums for past and future clean-up costs. Taxpayer
countered that offer with yet different figures, which the primary CGL carrier re-
countered with a fourth set of sums (all this occurred in Year E). No further
settlement negotiations have been held. For book purposes in Year E Taxpayer
included accrued reimbursement income reflecting sums approximately equal to
the primary CGL carrier’s final offer. Taxpayer included no amounts in income for
tax purposes.
                                          7


DISCUSSION

     Section 446(a) provides that taxable income shall be computed under the
method of accounting on the basis of which the taxpayer regularly computes his
income in keeping his books.

      Section 451(a) provides that any item of gross income is included in the
taxable year when received, unless, under the method of accounting used to
compute income, such amount is to be properly accounted for in a different period.
Since Taxpayer used the overall accrual method of accounting, the principles of
that method rather than actual receipt govern the year when insurance
reimbursements are included in gross income.

        Under general principles of accrual accounting, two conditions must be met
for income to be accrued in a given taxable year: the taxpayer must have a clear
right to the income and the amount of the income must be ascertainable. United
States v. Anderson, 269 U.S. 422, 441 (1926); Continental Tie & Lumber Co. v.
United States, 286 U.S. 290, 297 (1932); Dixie Pine Co. v. Commissioner, 320 U.S.
516, 519 (1944). These requirements have been formalized in Treas. Reg. § 1.451-
1(a).

      Treas. Reg. § 1.451-1(a) provides, in part, that under the accrual method of
accounting, income is includible in gross income when all events have occurred
which fix the right to receive such income and the amount thereof can be
determined with reasonable accuracy.

        Section 446(b), which is an exception to the general rule of section 446(a),
provides that if no method of accounting has been regularly used by the taxpayer,
or if the method used does not clearly reflect income, the computation of taxable
income shall be made under such method as, in the opinion of the Secretary, does
clearly reflect income.

        The Commissioner’s determination with respect to clear reflection of income
is entitled to more than the usual presumption of correctness, and the taxpayer
bears a heavy burden of overcoming a determination that a method of accounting
does not clearly reflect income. Hamilton Industries v. Commissioner, 97 T.C. 120
(1991). Whether a particular method of accounting clearly reflects income is a
question of fact which must be decided on a case-by-case basis. Peninsula Steel
Products & Equipment Co. v. Commissioner, 78 T.C. 1029, 1045 (1982).
                                           8


       Treas. Reg. § 1.446-1(a)(1) provides, in part, that the term "method of
accounting" includes not only the over-all method of accounting of the taxpayer but
also the accounting treatment of any item.

       Treas. Reg. § 1.446-1(e)(2)(ii)(a) provides, in part, that a change in the
method of accounting includes a change in the overall plan of accounting for gross
income or deductions or a change in the treatment of any material item used in
such overall plan. A material item is any item which involves the proper time for the
inclusion of the item in income or the taking of a deduction.

      Treas. Reg. § 1.446-1(e)(2)(ii)(b) provides that a change in method of
accounting does not include a change in treatment resulting from a change in
underlying fact.

       Section 446(e) and Treas. Reg. § 1.446-1(e)(2)(i) state that a taxpayer which
changes its method of accounting on the basis of which it keeps its books must,
prior to changing to a different method, secure the consent of the Commissioner.
Consent must be secured regardless of whether the method a taxpayer is changing
is proper or permitted. Treas. Reg. § 1.446-1(e)(2)(2)(i); Commissioner v. O
Liquidating Corp., 229 F.2d 225 (3d Cir. 1961), cert. denied, 368 U.S. 898 (1961).

       The governing principles for determining the year of accrual of insurance
reimbursement remains whether a taxpayer has a fixed right to receive the income
and reasonable estimation of the amount to be received.2 The Service has adhered
to a position that an accrual basis taxpayer would be required to recognize gain in
the year when the damages were sustained, even though the insurance payment
was not received until the following year. See G.C.M. 34163, Cental Tablet Mfg.
Co., I-3498 (July 14, 1969). Thus, if the insurer does not contest liability, income
accrues in the year of the loss. Max Kurtz v. Commissioner, 8 B.T.A. 679, 684
(1927) (accrual required where insurance company had admitted liability and
conceded the bulk of the loss claimed by the taxpayer in the year of loss); Rite Way
Products, Inc. V. Commissioner, 12 T.C. 475 (1949) (extent and amount of liability
of insurance company known in year of loss); Cappel House Furnishing Co. v.
United States, 244 F.2d 525 (6th Cir. 1957) (liability and approximate amount
determined in year of fire; liability was both clear and could be approximated).
"[T]he general rule [is] ... that when there is no contest over liability and its measure
does not depend on future events or contingencies, income accrues after liability
becomes fixed, although the exact amount may not be determined until later."


      2
        The sole issue in this Field Service Advice is whether the right to receive the
insurance reimbursement income was fixed; there is no issue regarding the reasonable
estimation of those amounts.
                                            9


Cappel House Furnishing Co., 244 F.2d at 529. Even though there was no
unequivocal admission of liability by the insurer, the record showed that the
concern of the insurer was not so much with the question of liability but with its
measure. Id. at 530.

       On the other hand, “where an insurance company does not admit liability in
the year of the loss, or takes a position in negotiations which makes it quite
uncertain whether the bulk of the claim will be recoverable, accrual is improper.”
Central Tablet Manufacturing Co. v. United States, 417 U.S. 673, 698-99 (1974)
(dissenting opinion), citing in footnote 2 of the dissent, Georgia Carolina Chem. Co.
v. Commissioner, No. 14,242 (T.C. Memo. 1944) (extent of liability not fixed in year
of loss because of uncertainty as to whether co-insurance clause, which would
reduce coverage, would be invoked by insurance company); Luckenback Steamship
Co. v. Commissioner, 9 T.C. 622 (1947) (amount of recovery on war risk insurance
uncertain in years of loss because of controversy between War Shipping
Administration and Comptroller General); Thalimer Brothers v. Commissioner, 27
T.C. 733 (1957) (where fire occurred six days prior to completion of tax year,
insurance proceeds did not accrue because extent of damage still uncertain); Curtis
Electro Lighting v. Commissioner, 60 T.C. 633 (1973) (accrual not required because
insurance company had never admitted to liability in any amount in taxable year);
Maryland Shipbldg & Drydock Co. v. United States, 409 F.2d 1363 (Ct. of Claims
1969) (accrual not required because extent of liability contested by insurance
company in negotiations not completed in taxable year). "With an accrual basis
taxpayer ..., it is crystallization of the right to receive income, not prior expectation,
nor subsequent receipt, that determines the year in which the income must be
declared for federal tax purposes." Id. at 1366. The “crystallization” only occurs if
there is an admission of liability by the insurer. “An insurer’s tacit recognition of the
fact and general extent of damage suffered by its insured, ..., does not meet or
displace this central requirement of admission of liability.” Id. at 1369.

Issues 1, 2, and 3

      Whether Taxpayer has a right to receive insurance reimbursements depends
upon an analysis of all the facts and circumstances. Based on the case law, we
believe admission of liability is the linchpin for determining whether the right to
receive insurance reimbursement is fixed. And we believe that Taxpayer’s right to
receive insurance reimbursements from the occurrence-based insurers for certain
        tort claims was not fixed in Years E and F due to the litigation instituted in
       3
Year E. In Year D, some of Taxpayer’s occurrence-based insurers filed suit


      3
       We are talking about insurance reimbursements above the primary layer held
by Taxpayer’s captive insurer.
                                             10


against Taxpayer and all its other occurrence-based insurers, as well as its claims-
made insurers, in state court in State 1 seeking an adjudication of certain coverage
issues and a determination concerning allocation among insurers for coverage
under the terms of the various insurance policies. A few months later in Year E,
Taxpayer filed its own suit in state court in State 2 (which was later removed to a
federal district court in State 2) against all its occurrence-based insurers seeking a
determination concerning allocation among its occurrence-based insurers and
adjudication of its overlapping policies. This action was later stayed pending
resolution of the State 1 litigation. Due to arbitration provisions, the claims-made
insurers were dismissed from the first lawsuit in Year F.

      The lawsuit brought by some of Taxpayer’s occurrence-based insurers
alleged that the other insurers were either partly or completely liable for the
insurance reimbursements to Taxpayer. Furthermore, those occurrence-based
insurers disputed whether some of the costs, including certain defense costs, were
covered under the policies (scope of coverage).

        Clearly, the litigation expressly disavows the liability of those occurrence-
based insurers who brought the suit in Year E. Arguably, the remaining insurers
liability for the certain         tort claims is also disavowed, at least indirectly. That
is, by inclusion of the other occurrence-based insurers and the claims-based
insurers in the first suit, along with the counter-suit brought by the Taxpayer, there
was no ability for the remaining insurers to admit liability. We believe this applies
for all the occurrence-based insurers, as all were involved in the litigation in the
years at issue.4 Because of the contested liabilities as expressed in the litigation,
there was no fixed right to receive the income in Years E and F.5 See Curtis
Electro, 60 T.C. at 636 (“The record does not show that the insurance companies,


       4
         As to the claims-made insurers, their inclusion in the initial litigation appears to
have been improper, as their coverage did not include years already covered by the
occurrence-based insurers. This is borne out by their dismissal from the State 1
litigation in Year F. Additionally, prior to Year E, when Taxpayer paid a claim,
apparently it was the occurrence-based insurers who provided indemnification.
Regardless, for these           claims, it is clear the claims-made insurers clearly
disavowed liability, as they did not provide coverage for such claims.
       5
         According to attachments to your request for field service advice, by Year F the
district court in State 1 had determined that the occurrence-based insurers were in fact
liable, although the scope of coverage was not yet determined. At that point, for at
least some of the liability, it was a question of when and not whether Taxpayer would
received insurance reimbursements. Based on the district court’s holding, Taxpayer’s
right to receive some reimbursement would be fixed in Year F.
                                            11


..., acknowledged liability for petitioner’s business losses, ...”); Maryland Shipbldg.
& Drydock, 409 F.2d at 1369 (“An unqualified recognition of liability by the obligor
is the essence of accrual by the prospective recipient.”)

        With respect to non-           claims filed against Taxpayer in Years E and F
(presumably involving almost exclusively the claims-made insurers), Taxpayer’s
various insurers refused to make any payments until the              tort claims litigation
was completed, even though there was no formal denial of the claims. The
rationale of the insurers was that if they should be found liable to indemnify
Taxpayer for the            tort claims, coverage limits might be exceeded and thus
liability for non-        claims might be beyond coverage limits. However, while
that rationale might be applicable to insurers (and only on an insurer by insurer
basis), it is not applicable to Taxpayer. Taxpayer’s product liability coverage was
so extensive that it ultimately could expect reimbursement in full for all non-
tort liabilities.

        While there was no express admission of liability, neither was there any
formal denial of the claims for the non-         tort claims. Prior to Year E,
Taxpayer accrued for tax purposes the right to receive insurance reimbursement.
Because of the litigation generated over the            tort claims, the insurers simply
stopped making payments, and Taxpayer decided to stop accruing the reimburse-
ment amounts for tax purposes. We believe this situation is closer to Cappel
House Furnishing Co., where the Sixth Circuit laid down the general rule "that when
there is no contest over liability and its measure does not depend on future events
or contingencies, income accrues after liability becomes fixed, although the exact
amount may not be determined until later." Id. at 529. The situation here is similar
in that even though there was no unequivocal admission of liability by the insurer
(as in Cappel House Furnishing Co.), the record showed that the concern of the
insurer was not so much with the question of liability but with its measure. Id. at

530. Here, too, the concern of the various insurers, none of whom denied liability,
was the measure of the liability for non-         tort claims. We believe that the
right to receive the insurance reimbursements for non-             tort claims remained
fixed in Years E and F, as there was no direct contest over liability, only an indirect
contest over the measure of such liability.

        As for the issue of whether Taxpayer had a right to receive insurance
reimbursements from its captive insurer for the years at issue, for both              and
non-          tort claims, we believe the right to receive reimbursements was fixed for
all the years in issue. At no time did the captive insurer contest or in any way
expressly deny its liability to Taxpayer. While payment was not made in the years
at issue, presumably in part due to the lawsuits over the           tort liabilities, there
remained a complete absence of a contest or dispute over the reimbursement.
                                           12


Because the captive insurer did not contest its liability, income accrues to Taxpayer
in the year of the loss. See Max Kurtz v. Commissioner, 8 B.T.A. 679, 684 (1927)
(accrual required where insurance company had admitted liability and conceded the
bulk of the loss claimed by the taxpayer in the year of loss); Rite Way Products, Inc.
V. Commissioner, 12 T.C. 475 (1949) (extent and amount of liability of insurance
company known in year of loss); Cappel House Furnishing Co. v. United States,
244 F.2d 525 (6th Cir. 1957) (liability and approximate amount determined in year of
fire; liability was both clear and could be approximated).

Issues 4, 5, and 6

       Taxpayer initially did not change its treatment of          liabilities for Years E
and thereafter for tax purposes. For tax purposes, expenses actually paid and
expected reimbursement associated with             tort claims were taken into account
as expenses and income. Unpaid expenses were not taken into account and were
reflected on the Schedule M-1 due to section 461(h). However, during the course
of the examination of Taxpayer, Taxpayer has filed an informal claim for a refund
for Year E, backing out the accrual of reimbursement income, and moving to the
cash-type treatment it adopted for its non-         liabilities, where only actual
expenses and actual income received are recognized for tax purposes.

         We believe Taxpayer’s informal claim for refund is proper, but only for
amounts above the captive insurer’s primary layer, based on our conclusion that
Taxpayer’s right to receive reimbursement income for its           tort liabilities was
not fixed in Years E and F.6 Taxpayer’s method of accounting for its              tort
liabilities was the accrual method of accounting. Under that method, accrual of
reimbursement income is governed by the all-events test under section 451, as the
deduction of claims paid is governed by the all-events test and economic
performance rules of section 461(h).

       Treas. Reg. § 1.446-1(a)(1) provides, in part, that the term "method of
accounting" includes not only the over-all method of accounting of the taxpayer but
also the accounting treatment of any item. A material item is any item which
involves the proper time for the inclusion of the item in income or the taking of a
deduction. Treas. Reg. § 1.446-1(e)(2)(ii)(a). The material item in this case is the
accrual of insurance reimbursement.


      6
          As noted in Footnote 5, it appears that by Year G the courts had resolved the
issue of who among the occurrence-based insurers was liable to reimburse Taxpayer.
Thus, in that year, the only question was the scope of coverage and when the
reimbursement monies were to be actually received. Accordingly, in Year G Taxpayer’s
right to receive a significant amount of the reimbursement was fixed.
                                           13


       In Years E and F, Taxpayer right to receive the reimbursement income for the
consumer product tort claims (above the captive insurer’s primary layer) was not
fixed due to the lawsuits filed in Year E. The contest of the liability by some of the
occurrence-based insurers, including by counter-suit all of Taxpayer’s occurrence-
based insurers (with the claims-made insurers denying liability due to their lack of
coverage during the years giving rise to the claims), prevented the right to receive
the income from becoming fixed. While the inclusion in income in Year E or not
affects timing, in this case the change in treatment of the income is due to a change
in facts. Treas. Reg. § 1.446-1(e)(2)(ii)(b) provides that a change in method of
accounting does not include a change in treatment resulting from a change in
underlying fact. The litigation calling into question any and all liability of the
insurers for reimbursement of the consumer product tort claims was a change in
facts affecting Taxpayer’s right to the income. Accordingly, this is not a retroactive
change in method of accounting, for which Taxpayer needs the consent of the
Commissioner. See Section 446(e).

      In Year E, for all non-       liability claims, Taxpayer for tax purposes
stopped including into income the estimated reimbursement income associated with
the expenses paid. When Taxpayer altered its treatment of the expected reimburse-
ment income for all non-        liabilities in Year E and moved to a cash-type basis,
Taxpayer had substantial receivables accrued for reimbursement income. It took a
Schedule M-1 deduction for the amount of the receivables, thus offsetting the prior
treatment of these amounts as income.

        We believe that Taxpayer’s change in its treatment of non-            liabilities
in Year E was an improper change in method of accounting. Taxpayer’s method of
accounting for reimbursement income was the accrual method of accounting under
section 451. Under that method, for years up to Year E, Taxpayer properly
included into income expected reimbursement income on certain product liability
claims. We have concluded that there was no contest preventing the fixing of the
right to receive insurance reimbursement income for Years E and F, except for the
         tort liabilities. Accordingly, it was improper for Taxpayer to unilaterally stop
accruing into income amounts expected to be reimbursed.

       Section 446(e) and Treas. Reg. § 1.446-1(e)(2)(i) state that a taxpayer which
changes its method of accounting on the basis of which it keeps its books must,
prior to changing to a different method, secure the consent of the Commissioner.
Consent must be secured regardless of whether the method a taxpayer is changing
is proper or permitted. Treas. Reg. § 1.446-1(e)(2)(2)(i); Commissioner v. O
Liquidating Corp., 229 F.2d 225 (3d Cir. 1961), cert. denied, 368 U.S. 898 (1961).
                                           14


        A change in method of accounting includes a change in treatment of a
material item. A material item is an item which affects the timing of income. The
year of accrual of insurance reimbursement income affects timing. Thus, the
change in treatment of the non-            insurance reimbursement is a change in
method of accounting, unless it is shown that there is a change in facts instead.
However, the facts in Year E had not changed; Taxpayer’s insurers did not contest
liability for non-      tort liabilities. Accordingly, Taxpayer changed its method of
accounting for insurance reimbursement from accrual to a cash-type method
without the Commissioner’s approval. Furthermore, Taxpayer’s reversal of its prior
reimbursement accounts receivable in Year E was likewise improper, as taxpayer
improperly changed its method of accounting without the Commissioner’s approval.

Issue 7

       Taxpayer engaged in manufacturing operations which produced hazardous
         wastes. Taxpayer was ordered to clean up these hazardous sites. In Year
D, Taxpayer requested reimbursement for a specific site clean-up from the primary
CGL insurance carrier. The reimbursement request was based on a sum for past
clean-up and a sum for expected future clean-up. By letter sent in early Year E,
Taxpayer’s primary CGL insurance carrier offered to reimburse Taxpayer, but using
different sums for past and future clean-up costs. Taxpayer countered that offer
with yet different figures, which the primary CGL carrier re-countered with a fourth
set of sums (all this occurred in Year E). No further settlement negotiations have
been held. For book purposes in Year E Taxpayer included accrued reimbursement
income reflecting sums approximately equal to the primary CGL carrier’s final offer.
Taxpayer included no amounts in income for tax purposes.

     We believe that Taxpayer’s right to receive the amount offered in the primary
CGL carrier’s final offer in Year E was fixed and should have been accrued into
income for tax purposes.

             An example of insurance proceeds meeting the criteria for
      accrual in a taxable period prior to that of receipt is found in Max
      Kurtz, et al., 8 B.T.A. 679, 684 (1927), where the Board found a
      prompt admission of liability by the insurer coupled with an unqualified
      concession as to the bulk of the loss claimed by the insured to be
      sufficient to sustain an accrual in the earlier period.

Maryland Shipbldg. & Drydock, 409 F.2d at 1369. We believe the final counter-
offer by the insurer admitted liability to the extent of the counter-offer, as thus the
right to that amount of reimbursement income was fixed in Year E. "[T]he general
rule [is] ... that when there is no contest over liability and its measure does not
                                          15


depend on future events or contingencies, income accrues after liability becomes
fixed, although the exact amount may not be determined until later." Cappel House
Furnishing Co., 244 F.2d at 529. Taxpayer’s CGL carrier had essentially admitted
liability, but disputed the exact amount. In these situations, the right to receive the
reimbursement income is fixed to the extent of the amount of the final offer from the
insurance carrier.

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS:

       As stated in the discussion, we believe that the litigation started by some of
the occurrence-based insurers in Year E expressly disavows their liability. (We
concluded that the claims-based insurers disavowed liability on the basis that their
policies were not in effect when the Taxpayer made the consumer product.) We
also stated that the remaining occurrence-based insurers liability for the certain
medical tort claims is also disavowed, at least indirectly. However, we believe
further facts should be developed to determine



       Our conclusion in the discussion is that the litigation among and between
Taxpayer and the occurrence-based insurers essentially prevents all those insurers
from admitting liability. Perhaps our net is cast too wide. Perhaps other occurrence-
base insurers did not disavow liability, but simply waited for clearer determination of
the liability allocation. If further factual development suggests this is the case, then
Taxpayer’s right to receive reimbursement income from those occurrence-based
insurers might in fact be fixed in the years at issue. If so, then with respect to those
insurers there would be a unauthorized change in method of accounting which we
should deny.

       Another issue for clarification regards the primary layer and the captive
insurer. We agree with you that the right to receive reimbursement income from the
captive insurer is fixed in all years at issue. However, we suggest reviewing the
facts regarding



                                                         . If any of the captive
insurer’s primary layer are included in the change in treatment of the medical
liabilities (where we concluded that no change in method has occurred), those
amounts should not be refunded, as the right to receive those amounts were not
affected by the litigation.
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      If you have any further questions, please call (202) 622-7870.


                                      Deborah A. Butler
                                      Assistant Chief Counsel


                               By:    _____________________
                                      JOEL E. HELKE
                                      Special Counsel
                                      Financial Institutions and Products Branch

CC:   William F. Hammack
      CC:MSR