Bargained customer incentives reduce gross sales

Plain-English summary

Chief Counsel considered a media company's program that provided customers with redacted merchandise or points as part of negotiated advertising purchases. The company and each customer bargained for the advertising and incentives together for one price, and the incentives were not contingent on later customer performance. The advice concluded that the incentive costs were purchase-price adjustments that reduced gross receipts in computing gross income under IRC § 61. They were not business-expense deductions under IRC § 162. Because the amounts were adjustments to cost of goods sold rather than deductions, the IRC § 274 deduction limitations did not apply.

Ruling snapshot

• Question: Could the taxpayer treat merchandise and points provided in a bargained exchange with customers as an adjustment to cost of goods sold?
• Outcome: Advice given, the costs reduced gross sales and were not subject to IRC § 274
• Key authorities: IRC §§ 61, 162, and 274; Treas. Reg. § 1.61-3(a); Rev. Rul. 2005-28

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       memorandum
       Number: 201501010
       Release Date: 1/2/2015
       CC:ITA:B04 : KAAqui                                   Third Party Communication: None
       CC:ITA:B07:MANixon                                    Date of Communication: Not Applicable
       POSTF-103576-14

UILC: 61.00-00; 274.00-00

date: August 22, 2014

 to:    Associate Area Counsel, Large Business & International (Area 1 ) CC:LB&I
        Attn: Joshua Nachman, CC:LB&I:F:LI

from: Branch 7, Office of Associate Chief Counsel, Income Tax and Accounting
(CC:ITA:B07)

subject: ----------------------------------------------

       This Chief Counsel Advice responds to your request for assistance. This advice may
       not be used or cited as precedent.


       LEGEND

       Taxpayer                   =        ----------------------------------------------

       b                          =        ------------------------------------------

       c                          =        ---------------------------------------------------------------

       d                          =        ---------

       e                          =        -----------------------

       f                          =        ---------------------------------------------------------------------------------
       --------------------------------------------------------------------------------------------------------------

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ISSUES

(1) Whether Taxpayer may treat as an adjustment to cost of goods sold the costs of
b it provides to customers in a bargained-for exchange.

(2) If Taxpayer may not treat the costs of b as an adjustment to cost of goods sold,
are deductions for the costs of b subject to the disallowance provisions of § 274
of the Internal Revenue Code (Code)

CONCLUSION

(1) Yes. Taxpayer may treat the costs of b as an adjustment to cost of goods sold.

(2) Because Taxpayer may treat the costs of b as an adjustment to cost of goods
sold, issue (2) is moot.

FACTS

Taxpayer, a c company, is engaged in the d publication and distribution of e media for f.
Taxpayer’s customers are generally advertisers that pay to include their products in the
print media and other advertising. Taxpayer established an added value merchandising
program under which it purchased b and paid related companies to provide suite
accommodations and catering services to the ultimate b holders. Taxpayer also
provided customers with merchandising allowances or points to acquire b at a later
date. The cost of these items generally constituted no more than twenty-five percent of
the order placed. Taxpayer treated these expenditures as an adjustment to its cost of
goods sold. The revenue agent determined that Taxpayer should have deducted the
expenditures from its gross income under § 162, subject to the limitations of § 274.

LAW AND ANALYSIS

Generally, except as otherwise provided in the Code, gross income means all income
from whatever source derived. I.R.C. § 61(a). The Supreme Court has long recognized
that the definition of gross income sweeps broadly and reflects Congress’ intent to exert
the full measure of its taxing power and to bring within the definition of gross income all
accessions to wealth. Commissioner v. Schleier, 515 U.S. 323, 327 (1995).

Purchase price adjustments and rebates are not within the definition of income.
Generally, when a seller refunds or rebates part of the purchase price of goods or
services to a customer as an inducement to purchase, the payment does not constitute
an expense to the seller or income to the purchaser. It is an adjustment to the price of
the service or property sold.
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There is a fundamental difference between expenditures that constitute refunds and
rebates (also known as “returns and allowances”) and expenditures that are treated as
business deductions under § 162. Max Sobel Wholesale Liquors v. Commissioner, 630
F.2d 670, 671-672 (9th Cir. 1980), affg 69 T.C. 477 (1977). The cost of goods
purchased for resale in a taxpayer’s trade or business is subtracted from gross receipts
to compute gross income. Treas. Reg. § 1.61-3(a) of the Income Tax Regulations.
These offsets do not constitute deductions and are not subject to the various limitations
on deductions pertaining to § 162. Metra Chem Corp. v. Commissioner, 88 T.C. 654,
661 (1987). Since we conclude that the expenditures at issue constitute purchase price
adjustments, the provisions of §162 are inapplicable and need not be addressed. See
Metra Chem Corp.

The seminal case in this area is Pittsburgh Milk Co. v. Commissioner, 26 T.C. 707
(1956), nonacq. 1959-2 C.B. 8-9, nonacq. withdrawn and acq. 1962-2 C.B. 5-7, acq.
withdrawn and nonacq. 1976-2 C.B. 3-4, and nonacq. withdrawn in part and acq. in part
1982-2 C.B. 2, where a dairy wholesaler paid cash rebates to customers under an
informal arrangement to avoid state minimum milk pricing regulations. The court
concluded that allowances the milk producer paid to buyers lowered the selling price of
the milk for income tax purposes and held that only the net price was includable in the
seller’s gross income. The court stated:

  It does not follow, of course, that all allowances, discounts, and rebates made by
  a seller of property constitute adjustments to the selling prices. Terminology,
  alone, is not controlling, and each type of transaction must be analyzed with
  respect to its own facts and surrounding circumstances. Such examination may
  reveal that a particular allowance has been given for a separate consideration –
  as in the case of rebates made in consideration of additional purchases of
  specified quantity over a specified subsequent period; or as in the case of
  allowances made in consideration of prepayment of an account receivable, so as
  to be in effect a payment of interest. The test to be applied, as in the
  interpretation of most business transactions, is: What did the parties really intend,
  and for what purpose or consideration was the allowance actually made?
  Where, as here, the intention and purpose of the allowance was to provide a
  formula for adjusting a specified gross price to an agreed net price, and where
  the making of such adjustment was not contingent upon any subsequent
  performance or consideration from the purchaser, then, regardless of the time or
  manner of the adjustment, the net selling price agreed upon must be given
  recognition for income tax purposes. Pittsburgh Milk, at 717.

In Rev. Rul. 2005-28, 2005-1 C.B. 997, the Service held that Medicaid rebates incurred
by a pharmaceutical company are purchase price adjustments that are subtracted from
gross receipts in determining gross income. In so holding, the Service relied on
Pittsburgh Milk, noting the following:
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The court focused on the facts and circumstances of the transaction, what the
parties intended, and the purpose or consideration for which the allowance was
made. The court found that the allowances were part of the sales transaction
and concluded that gross income must be computed with respect to the agreed
net prices for which the milk was actually sold. Thus, under Pittsburgh Milk,
where a payment is made from a seller to a purchaser, and the purpose and
intent of the parties is to reach an agreed upon net selling price, the payment is
properly viewed as an adjustment to the purchase price that reduces gross sales.

The facts in this case fall squarely within the parameters of Rev. Rul. 2005-281. It is
undisputed that Taxpayer agreed to provide and the purchasers agreed to accept both
printed advertisements and b or points for a single price. The fact that Taxpayer may
incur the expense to acquire the b after it executes the contract with the purchaser is
not legally significant under Pittsburgh Milk. Similarly, whether a rebate is payable in
merchandise or in cash doesn’t matter. The result is the same. Max Sobel Wholesale
Liquors, 69 T.C. at 481. The determinant facts are that the purchaser and Taxpayer
negotiated over the amount of b or merchandising allowances or points that would be
an integral part of the sale and the adjustment was not contingent on any subsequent
performance or consideration from the purchaser.

Since the costs of b which Taxpayer provides to customers are to be treated as cost of
goods rather than business expenses deductible under § 162, the costs also are not
subject to the limitations of § 274. Metra Chem Corp., 88 T.C. at 661.

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

Please call (202) 317-4718 if you have any further questions.

                                        /s/ Willie Armstrong
                                  By: _____________________________
                                      WILLIE E. ARMSTRONG, JR.
                                      Senior Technician Reviewer, Branch 7
                                      (Office of Associate Chief Counsel, Income Tax
                                      & Accounting)

1
The Commissioner must follow his own relevant revenue rulings in Tax Court proceedings. Rauenhorst
v. Commissioner, 119 T.C. 151, 170-173 (2002).
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