107 T.C. No. 17
UNITED STATES TAX COURT
THE CHARLES SCHWAB CORPORATION AND INCLUDABLE SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 1271-92. Filed November 14, 1996.
P, an accrual basis taxpayer, provides discount securities brokerage services for which it earns a commission fee. As a discount broker, P does not engage in activities, such as research and portfolio management, that are normally conducted by a full- service broker. P executes a customer’s order to buy or sell securities on the trade date, but the securities are not actually transferred and payment is not due until the settlement date, which was generally 5 days after the trade date. Between those dates, P performs certain functions to record, confirm, and book the customer’s trade.
P commenced business in the State of California on Apr. 1, 1987. P deducted its California franchise taxes based on income for its first year ended Dec. 31, 1987, on its Federal income tax return for the taxable year ended Mar. 31, 1988. P then changed to a calendar year for Federal income tax purposes and is attempting to deduct its California franchise taxes based on - 2 -
income for its second year on its Federal income tax return for the taxable year ended Dec. 31, 1988.
Held: Under the "all events" test, P must accrue commission income for the purchase or sale of securities on the trade date as opposed to the settlement date.
Held, further: Under California law, P's liability for franchise taxes based on its income during its second year ended Dec. 31, 1988, was fixed on that date. Sec. 461(d), I.R.C., which would act to disallow the accrual of State taxes "to the extent that the time for accruing taxes is earlier than it would be but for any action of any taxing jurisdiction taken after December 31, 1960" does not apply because under California law as it existed prior to Dec. 31, 1960, all events fixing P's liability for franchise tax based on income earned during its second year would have accrued on Dec. 31 of its second year.
Philip C. Cook, Terence J. Greene, Timothy J. Peaden,
Karen S. Sukin, Ben E. Muraskin, Michelle M. Henkel,
Glenn A. Smith, Michael R. Faber, Teresa A. Maloney, for
petitioner.
Usha Ravi, Steven A. Wilson, and Emily Kingston, for
respondent.
RUWE, Judge: Respondent determined deficiencies in
petitioner’s Federal income taxes for the taxable years ending
March 31, 1988, and December 31, 1988, in the amounts of
$16,136,176 and $12,146,497, respectively.
After concessions, the issues remaining for decision are:
(1) Whether petitioner must accrue brokerage commission income on
the date a trade is executed or on the settlement date; and (2) - 3 -
whether petitioner is entitled to a deduction for its California
franchise tax liability in the amount of $932,979 on its Federal
income tax return for the 9-month period ending December 31,
1988.
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts and supplemental stipulation of facts
are incorporated herein by this reference. At the time its
petition was filed, petitioner’s principal place of business was
located in San Francisco, California.
Petitioner is a consolidated group consisting of The Charles
Schwab Corp.; its first-tier subsidiary, Schwab Holdings, Inc.;
and its second-tier operating subsidiary, Charles Schwab & Co.,
Inc. Petitioner provides discount securities brokerage and
related financial services, primarily to individuals, throughout
the United States. During the years in issue, petitioner was a
member of all major U.S. securities exchanges and had software
links with all registered U.S. securities exchanges, major
dealers, the National Securities Clearing Corp., and the
Depository Trust Co. During the relevant years, petitioner filed - 4 -
consolidated Federal income tax returns and computed its taxable
income under the accrual method of accounting.
Charles Schwab & Co., Inc., the operating subsidiary, was
incorporated in 1971 as the First Commander Corp. under the laws
of the State of California. First Commander Corp. changed its
name to Charles Schwab & Co., Inc. (Schwab & Co.), in 1973 after
Charles R. Schwab became its owner and chief executive officer.
Schwab & Co. initially conducted a retail securities
brokerage business from a single office in California and
published an investment advisory newsletter. In 1974, Schwab &
Co. took advantage of a trial period during which the Securities
& Exchange Commission (SEC) permitted discounts on securities
commissions. On May 1, 1975, the SEC abolished fixed commission
rates, and Schwab & Co. engaged exclusively in discount
securities brokerage transactions by focusing its marketing
efforts on investors who wished to conduct their own research,
make their own investment decisions, and avoid paying brokerage
commissions for research, advice, and portfolio management.
In November 1982, Schwab & Co.’s parent company, Schwab
Holdings, Inc. (which, at that time, was called The Charles
Schwab Corp.), agreed to merge into BankAmerica Brokerage Co.
(BBC), a wholly owned subsidiary of BankAmerica Corp.
(BankAmerica). As a result of the merger, Schwab & Co. became a
wholly owned subsidiary of BBC. In January 1983, BBC changed its
name to The Charles Schwab Corp. - 5 -
On March 31, 1987, Charles R. Schwab, through CL Acquisition
Corp. (currently known as The Charles Schwab Corp.), purchased
from BankAmerica the stock of The Charles Schwab Corp. (formerly
BBC and currently known as Schwab Holdings, Inc.), and its wholly
owned subsidiary, Schwab & Co., in a management-led leveraged
buyout.
Commission Income Issue
One of petitioner's primary sources of revenue is commission
income, which is earned by effecting sales and purchases of
stocks and other securities for its customers in a rapid,
efficient, and cost effective manner.
The primary service performed by petitioner in effecting
sales and purchases of stocks and securities on behalf of
customers is the execution of trade orders. Petitioner does not
engage in many of the other activities in which full-commission,
full-service brokerage firms engage, such as underwriting,
market-making, arbitrage, research, and portfolio management.
Petitioner also does not solicit transactions in any particular
security and does not offer investment advice to its customers
about the nature, potential value, or suitability of any
particular security. Nor does petitioner exercise any
discretionary authority over customer accounts or, with certain
limited exceptions, engage in principal transactions in any
security. - 6 -
Petitioner's strategy is to serve self-directed customers,
focusing on those who do not need or want to pay, through
commissions, for research, investment advice, or portfolio
management. As a result, a customer could save up to 76 percent
compared to rates charged by full-commission brokers. By
concentrating on unsolicited transactions on an agency basis,
petitioner substantially avoids the risk of losses and
liabilities faced by full-commission firms that engage in
investment banking, underwriting, market-making, arbitrage, and
other advisory and principal activities. Moreover, petitioner's
customers are not assigned to a particular representative but,
instead, may trade with any available representative. As a
result, the departure of a registered representative from
petitioner does not typically result in a loss of customers.
The "trade date" is the day a trade occurs. On this day, a
customer’s order is executed by locating a seller or purchaser
for securities on terms acceptable to the customer. The date on
which petitioner settles the accounts of a customer whose order
to buy or sell securities has been executed is termed the
"settlement date". Settlement is the process of transferring
payment from buyer to seller and certificates from seller to
buyer. When customers buy securities, petitioner must receive
the full confirmed amount due no later than the settlement date.
When customers sell securities, petitioner must receive the stock
certificates, properly endorsed, by the settlement date. - 7 -
In 1988, there was no Federal rule that mandated a specific
settlement cycle for securities transactions.1 Instead, the
settlement cycle in the United States varied among markets and
was largely a function of market custom, exchange rules, and
industry practice. The rules of the New York Stock Exchange,
however, required transactions to be settled no later than the
fifth business day after the trade date.
After a customer’s order is received, petitioner transmits
the order to the exchange floor for execution via the exchange’s
system or through floor brokers. A report of execution, which
lists the transactions in terms of shares purchased or sold, but
not by customer name or account number, is returned to the firm
as a trade record. After the trade is executed and while the
customer is still on the telephone, petitioner can verbally
confirm the execution for "market" orders2 placed via telephone
while the markets are open. The price paid or received by the
customer for the purchase or sale of securities is determined
according to the market price in effect on the trade date.
Petitioner must perform a series of functions after the
order is placed and the trade executed. These functions, which
1 See infra note 4. 2 A "market" order is an order from a customer to buy or sell securities as soon as practicable at the then-current market price. This is in contrast to a "limit" order, which is an order to buy or sell securities when the market reaches a price level specified by the customer. - 8 -
are performed up until settlement, consist of (i) recording, (ii)
figuration, (iii) confirmation, (iv) comparison, and (v) booking.
In the recording function, each transaction is coded, and
each trade is assigned a number that identifies the issuer and
the issue. The place of execution (i.e., a stock exchange) is
also coded along with any other details needed to process the
trade properly.
In the figuration function, petitioner computes the contract
money, commission to be earned, taxes, fees, and all other
related money amounts associated with the trade during nightly
batch processing on the day the trade is executed. The net is
the amount that the customer must pay in the case of a purchase
or is entitled to receive in the case of a sale. The results of
the figuration function are available, in written format, on the
morning following the trade date. In addition, petitioner can
apprise a customer of the commission cost of any trade at the
time of the execution of the trade by accessing a computer screen
designed to compute commissions on customer trades.
The confirmation function involves mailing a written
notification to the customer, usually on the first business day
after the trade is executed. The confirmation serves as an
invoice and written notification of the trade. The confirmation
contains the following information: (1) A description of the
trade, including the name of the security, quantity, execution
price, settlement money, commission, and other fees; (2) trade - 9 -
date; (3) settlement date; (4) place of execution; (5) capacity
in which the firm acted; (6) customer’s name and address; (7)
customer’s account number; (8) type of customer account; and (9)
the amount due. Petitioner also encloses a remittance stub and a
return envelope with the confirmation.
The comparison function, which is required by the National
Association of Securities Dealers, Inc., and which generally
begins on the first day following the trade date, is the process
by which customers’ trades are balanced or reconciled against the
opposing brokerage firm’s transactions. This is done through the
clearing facilities of the exchanges where petitioner holds
memberships. In addition to the broker-to-broker comparison,
petitioner also compares the report of execution to its trade
record, which represents the customer’s order.
Petitioner and the clearing facility attempt to resolve
"uncompared trades" (i.e., those trades whose terms do not match
or compare in some respect between petitioner and the opposing
firm) by the next business day following the execution of a
customer order. However, the resolution of open items continues
until all trades are balanced, which may not occur until the
settlement date, to ensure that petitioner is not undergoing any
undue risk. If petitioner has an uncompared trade that was
unreconciled, it will be required to enter the marketplace and
buy or sell to cover the trade. - 10 -
In the booking function, the customer’s transaction is
entered on petitioner’s records, including the recording of fees
and commissions due to petitioner.
Unlike many other discount brokers, who depend on third-
party vendors, petitioner performs all execution, clearing, and
account maintenance functions for its customers. This enables
petitioner to gain greater control over the quality of customer
service and to retain free credit balances and securities for use
in margin lending.
On the settlement date, petitioner physically effects the
delivery of the securities and receipt of the sale price, in the
case of a sale, or receipt of the securities and delivery of the
purchase price, in the case of a purchase. When a customer of
petitioner sells securities that are not held by petitioner in
street name,3 the certificates must be properly endorsed and
received by petitioner by settlement date. If a customer of
petitioner already has sufficient funds in his or her account,
petitioner automatically uses these funds on the settlement date
to pay for securities purchased, even though the confirmation
indicated an amount due. If petitioner does not receive payment
for securities purchased by the customer by the settlement date,
3 Securities are said to be carried in "street name" when they are held in the name of the broker instead of the customer's name. Holding securities in street name allows for ease of transfer by the broker and convenience to the customer, because it avoids the necessity of obtaining the customer's endorsement to transfer the security. - 11 -
petitioner reserves the right to cover the position, and the
customer is responsible for any loss resulting from the execution
of the trade order.
A security is not debited or credited to the customer’s
account until the actual settlement date. The settlement date is
also important for purposes of determining who is entitled to
receive dividends paid on stock and interest that has accrued on
bonds. Dividends are paid to the holders of record (i.e., those
persons in whose name the stock is registered). If a transaction
occurs, but does not settle prior to the dividend record date or
if the security is not re-registered in the new name by the
record date, the buyer is not entitled to the dividend. Bonds
trade at market price plus accrued interest. Interest continues
to accrue to the bond’s seller up to, but not including, the
settlement date.
As a general rule, petitioner does not permit cash and next-
day orders. In the event of customer hardship, such as a medical
emergency or an escrow closing, however, proceeds from a sale can
be paid to a customer prior to settlement. In such instances,
the customer is charged a special prepayment fee of the greater
of $10 or 0.2 percent of principal in addition to the standard
commission for the trade.
There was generally a 5-day delay between the trade and
settlement dates. The 5-day delay between the trade and
settlement dates allows sufficient time to reflect the trade in - 12 -
petitioner’s books and records and to deliver the securities.
The securities clearance and settlement system is exposed to
several sources of risk including market risk, participant or
credit risk, and external risk, such as a domestic or
international event. A reduction of the time between trade
execution and settlement can make the settlement cycle safer, but
such reduction is not without obstacles, which would require
changing established settlement practices and educating retail
and institutional investors.4
Mistakes can occur in placing the customer order, such as
trading the wrong security or quantity of securities, selling the
security when instructed to buy and vice versa, or performing
figuration incorrectly. Petitioner determines if the error is a
representative error or a customer error by reviewing a tape
recording of the telephone order, if available.
4 The SEC adopted a new rule under the Securities Exchange Act of 1934, ch. 404, 48 Stat. 881, which establishes a 3- business-day settlement period for broker-dealer trades, effective June 1, 1995. 17 C.F.R. sec. 240.15c6-1 (1996). The new rule is designed to: (i) Reduce settlement risk, the risk to clearing corporations, their members, and public investors inherent in settling securities transactions by reducing the number of unsettled trades in the clearance and settlement system at any given time; (ii) reduce the liquidity risk among the derivative and cash markets and reduce financing costs by allowing investors that participate in both markets to obtain the proceeds of securities transactions sooner; and (iii) facilitate risk reduction by achieving closer conformity between the corporate securities markets and Government securities and derivative securities markets that currently settle in fewer than 5 days. 58 Fed. Reg. 52891 (Oct. 13, 1993). - 13 -
No customer of petitioner can cancel an order that is
executed in accordance with the customer’s instructions. If
petitioner made an error, the customer is made whole by canceling
the transaction and rebilling it. When transactions are canceled
and rebilled, new trade confirmations are generated and sent to
the customer, showing both the canceled trade information and the
corrected trade information. When petitioner cancels and rebills
a customer for a trade that it incorrectly executed, the customer
is liable only for the amount determined according to
circumstances existing on the original trade date.
Individual trades may be canceled if an entire transaction
is canceled. For example, a customer’s trade would be canceled
if an initial public offering were canceled after trading was
initiated. In these instances, the trades never settle and
petitioner collects no commission.
For the taxable year ended December 31, 1988, petitioner
accrued commission income on the purchase or sale of securities
on the settlement date for tax and book purposes. Petitioner’s
trades that were executed in 1988, but settled in 1989, resulted
in $3,357,576 net commission income.
Franchise Tax Issue
Petitioner qualified to do business in California on
February 9, 1987. Petitioner commenced business in California on
April 1, 1987. - 14 -
Petitioner elected a calendar taxable year for California
income and franchise tax purposes. Petitioner’s first Federal
taxable year ended on March 31, 1988, but petitioner changed its
Federal taxable year to a calendar year for its second and
subsequent years.
Petitioner reported California franchise tax in the amount
of $879,500 on its first California Franchise or Income Tax
Return (Form 100) for the income year ending December 31, 1987,
and paid such amount with its return. Petitioner deducted this
amount on its Federal return filed for the taxable year ended
March 31, 1988.
For the income year ending December 31, 1988, petitioner
reported California franchise tax in the amount of $932,979 on
its second California Franchise or Income Tax Return (Form 100)
and paid such amount with its return. On its Federal return
filed for the taxable year ended December 31, 1988, petitioner
did not deduct the franchise tax that it paid for California
income year 1988. Petitioner now claims that this was an error
and that it should be entitled to deduct the 1988 franchise tax
for its taxable year ended December 31, 1988.
OPINION
The first issue we must decide is whether petitioner, an
accrual basis taxpayer, must accrue brokerage commission income - 15 -
on the trade date or on the settlement date. Neither party
cites, nor did we find, any cases directly on point.5 The
question of when an accrual basis securities broker must accrue
commissions earned on securities transactions appears to be one
of first impression.
Petitioner kept its books and records and filed its income
tax returns using the accrual method of accounting. Under the
accrual method, income is to be included for the taxable year
when (1) all the events have occurred that fix the right to
receive such income, and (2) the amount can be determined with
reasonable accuracy. Secs. 1.446-1(c)(1)(ii), 1.451-1(a), Income
Tax Regs. The parties do not dispute that the second prong of
the test--that the amount of the commissions can be determined
with reasonable accuracy--is met as of the trade date. Our
discussion is thus limited to whether petitioner had a fixed
right to receive the commission income as of that date.
Under the all events test, it is the fixed right to receive
the income that is controlling and not whether there has been
actual receipt thereof. Spring City Foundry Co. v. Commissioner,
292 U.S. 182, 184-185 (1934). The taxpayer’s right to receive
income is fixed upon the earliest of (1) the taxpayer’s receipt
5 We note that in Rev. Rul. 74-372, 1974-2 C.B. 147, the IRS ruled that a stock brokerage business using the accrual method of accounting must accrue commission income on the trade date, rather than on the settlement date. Respondent's position herein is consistent with this ruling. - 16 -
of payment, (2) the contractual due date, or (3) the taxpayer’s
performance. See Schlude v. Commissioner, 372 U.S. 128, 133, 137
(1963); Cox v. Commissioner, 43 T.C. 448, 456-457 (1965). An
accrual basis taxpayer must report income in the year the right
to such income accrues, despite the necessity for mathematical
computations or ministerial acts. Continental Tie & Lumber Co.
v. United States, 286 U.S. 290, 295-297 (1932); Dally v.
Commissioner, 227 F.2d 724 (9th Cir. 1955), affg. 20 T.C. 894
(1953); Resale Mobile Homes, Inc. v. Commissioner, 91 T.C. 1085,
1095 (1988), affd. 965 F.2d 818 (10th Cir. 1992). Moreover, the
fact that a taxpayer cannot presently compel payment of the money
is not controlling. Commissioner v. Hansen, 360 U.S. 446, 464
(1959).
Petitioner argues that its commission is earned when
delivery of the securities and payment of the purchase price
occur, which is not until the settlement date. According to
petitioner, the acts that it performs between the trade date and
the settlement date are not merely ministerial. Rather, they are
integral parts of the service for which it is paid a commission,
and they represent a substantial percentage of the total discount
brokerage services provided. Respondent, on the other hand,
argues that execution of an order on behalf of a customer is the
essential service that petitioner performs and is the time at
which petitioner’s right to receive, and the customer’s
obligation to pay, the commission arises. According to - 17 -
respondent, all the actions that remain to be performed by
petitioner after the trade date are of a ministerial nature to
effectuate the mechanics of the transfer and are merely in
confirmation of the trade executed. We agree with respondent.
Petitioner is a member of all major U.S. securities
exchanges. The essential service that petitioner provides to its
customers is the execution of trades through its access to the
securities exchanges. It is through this access that the
customer acquires the ability to make a trade. Indeed,
petitioner’s statement of Terms and Conditions, which states the
agreement between petitioner and the customer, provides that
petitioner "executes orders for securities only and does not give
investment advice." There is no mention of posttrade services,
such as recording, confirmation, or booking.
Moreover, the price of the securities that a customer
purchases or sells and the amount of commission due to petitioner
are determined as of the trade date. If petitioner does not
receive payment on a purchase or sale order executed for the
customer, it liquidates the customer’s account to collect the
amount, including the commission, determined on the trade date.
Upon execution of a customer order, a written confirmation is
generated automatically and is sent to the customer on the next
business day following the trade date. The written confirmation
serves as an invoice and as written notification to the customer
of the trade. The confirmation statement itemizes the total cost - 18 -
of the trade, including the amount of the commission, and lists
the total "amount due". Petitioner encloses a remittance stub
and a return envelope with the confirmation. The customer does
not have the right to cancel an order that petitioner executes in
accordance with the instructions of the customer.
In applying the all events test, this and other courts have
distinguished between conditions precedent, which must occur
before the right to income arises, and conditions subsequent, the
occurrence of which will terminate an existing right to income,
but the presence of which does not preclude accrual of income.
Central Cuba Sugar Co. v. Commissioner, 198 F.2d 214, 217-218 (2d
Cir. 1952), affg. in part and revg. in part 16 T.C. 882 (1951);
Wien Consol. Airlines, Inc. v. Commissioner, 60 T.C. 13, 15
(1973), affd. 528 F.2d 735 (9th Cir. 1976); Buckeye Intl., Inc.
v. Commissioner, T.C. Memo. 1984-668; see also Resale Mobile
Homes, Inc. v. Commissioner, 965 F.2d 818, 824 (10th Cir. 1992),
affg. 91 T.C. 1085 (1988).6
We think the above factors indicate that petitioner’s
execution of a trade for a customer is a condition precedent that
6 Although Central Cuba Sugar Co. v. Commissioner, 198 F.2d 214, 217-218 (2d Cir. 1952), affg. in part and revg. in part 16 T.C. 882 (1951), Wien Consol. Airlines, Inc. v. Commissioner, 60 T.C. 13, 15 (1973), affd. 528 F.2d 735 (9th Cir. 1976), and Buckeye Intl., Inc. v. Commissioner, T.C. Memo. 1984-668, involved the accrual of deductions rather than the proper reporting of income, this Court has recognized that similar considerations apply with respect to both issues. See Simplified Tax Records, Inc. v. Commissioner, 41 T.C. 75, 79 (1963); Buckeye Intl., Inc. v. Commissioner, supra. - 19 -
fixes petitioner’s right to receive the commission income. The
functions that remain to be performed by petitioner after the
trade date are of a ministerial nature to effectuate the
mechanics of the transfer and confirm the trade executed.
Although failure to perform these functions may ultimately divest
petitioner of its right to the commission income, we think that
these functions are conditions subsequent and, therefore, do not
preclude accrual of commission income on the trade date.
Nor does the possibility that an executed trade may not
settle due to cancellation of an entire public offering make
petitioner’s right to the commission income too indefinite or
contingent for accrual. See Brown v. Helvering, 291 U.S. 193,
199-200 (1934) (holding that overriding commissions received by a
general agent for policies written must be accrued even though
there was a contingent liability to return a portion of the
commission in the event the policy was canceled); Georgia School-
Book Depository, Inc. v. Commissioner, 1 T.C. 463, 468-470 (1943)
(holding that a book broker that represented publishers in sales
of school books to the State of Georgia must accrue commission
income, despite the fact that the State was obligated to pay for
the books only out of a particular fund, and, during the years in
issue, the fund was insufficient to pay for the books in full).
The possibility that a trade might not finally be settled is, if
anything, a condition subsequent to the execution of the trade,
which was the event that fixed petitioner's right to the - 20 -
commission. See Central Cuba Sugar Co. v. Commissioner, supra at
217-218 (holding that sales commission expenses were deductible
in the year the taxpayer entered the contract for sale even
though they were not payable until delivery, and even though the
commission expenses were subject to adjustment in accordance with
final weighing before shipment and forfeiture if the contract
were not carried out).
Petitioner argues that unlike full-commission securities
brokers who engage in a full range of activities, such as
research and portfolio management, the functions performed by
petitioner between the trade and settlement dates represent a
substantial percentage of the services provided by petitioner to
its brokerage customers. According to petitioner, the commission
income received by petitioner does not represent payment for
investment advice or other pretrade services, but rather is a fee
for the specific services of executing the transaction and
handling the mechanics of the transfer of title and delivery on
the settlement date. Therefore, petitioner argues, even if the
posttrade activities conducted by a full-commission broker are
considered ministerial, they cannot be considered ministerial
when performed by a discount broker such as petitioner.
While we appreciate the differences in the services provided
by full-commission and discount brokers, we cannot agree that
ministerial acts that constitute conditions subsequent to a
customer’s obligation to pay commissions are converted to - 21 -
conditions precedent merely because they may comprise a
significant percentage of the overall activities conducted by the
broker.
Petitioner argues that this case is governed by Hallmark
Cards, Inc. v. Commissioner, 90 T.C. 26 (1988). In Hallmark, a
manufacturer and seller of greeting cards shipped its Valentine
merchandise to customers in the year prior to that in which the
holiday occurred. The terms of the sale specified that title and
risk of loss did not pass to the customer until January 1 of the
year following the shipment. This Court held that the taxpayer’s
right to income from the sale became fixed only upon passage of
title and risk of loss to the purchasers, notwithstanding that
delivery of the goods had occurred earlier. Id. at 32-33.
Petitioner argues that because title to the securities does not
pass, and petitioner is not relieved of its risk of loss until
the settlement date, its right to the commission income is not
fixed until the settlement date.
Hallmark v. Commissioner, supra, is distinguishable from the
instant case. In Hallmark, the taxpayer was a manufacturer and
seller of goods. Thus, passage of title and risk of loss
constituted the essence of the transaction; without such passage,
no sale occurred. Conversely, the present case involves a
service provider that executes securities trades as an agent of
its customers. We think that the focus in this case must be on
the contractual relationship between petitioner and its customer, - 22 -
not on the relationship between the customer and the purchaser or
seller of the securities.7 The agreement between petitioner and
its customers was that any trade executed by petitioner in
accordance with the customer's instructions could not be
canceled. In contrast, the customer in Hallmark had the right to
return the merchandise without penalty until title passed. Id.
at 33. The essence of the transaction between petitioner and its
customer is the execution of a trade on behalf of the customer.
Accordingly, we uphold respondent’s determination that
petitioner must accrue commission income for the purchase or sale
of securities on the trade date as opposed to the settlement
date.
California Franchise Tax Issue
The next issue we must decide is whether petitioner is
entitled to a deduction for its California franchise tax
liability in the amount of $932,979 on its Federal income tax
return for the taxable year ended December 31, 1988.
Respondent does not dispute that petitioner properly deducted
$879,500 on its Federal return for the taxable year ended March
7 We note, however, that the legislative history of the Tax Reform Act of 1986 indicates that for Federal income tax purposes, both cash and accrual method taxpayers must recognize gain or loss on the sale of securities traded on an established market on the date the trade is executed. S. Rept. 99-313 (1986), 1986-3 C.B. (Vol. 3) 131. Such treatment, while not controlling as to brokerage commissions, is consistent with our holding herein. - 23 -
31, 1988, for the franchise tax it paid for the California income
year 1987. Regardless of whether the franchise tax properly
accrued on December 31, 1987, as petitioner contends, or on
January 1, 1988, as respondent contends, both parties agree that
the deduction was proper in petitioner’s first Federal taxable
year. Instead, the parties’ dispute centers on the deductibility
of the California franchise tax for petitioner’s second Federal
taxable year.
To understand the crux of the dispute, it is necessary to
understand some of the history with respect to the California
franchise tax. California imposes an annual franchise tax on
most corporations doing business within the State of California
for the privilege of exercising their corporate franchises. Cal.
Rev. & Tax. Code sec. 23151(a) (West 1992). In general, the tax
computed for the "taxable year"8 is based upon the net income of
the preceding year, which is designated the "income year". Id.
secs. 23041(a), 23042(a), 23151(a) (West 1992).
Prior to the 1972 amendments to the California franchise tax
statutes, the California franchise tax generally accrued on the
first day of the taxable year. In Central Inv. Corp. v.
Commissioner, 9 T.C. 128, 132-133 (1947), affd. per curiam 167
F.2d 1000 (9th Cir. 1948), we held that even though the
8 The "taxable year" is the year for which the California franchise tax is payable. Cal. Rev. & Tax. Code sec. 23041(a) (West 1992) - 24 -
California franchise tax was measured by the preceding year’s
income, accrual basis taxpayers could accrue the tax only during
the taxable year. Under pre-1972 law, withdrawal or dissolution
relieved the taxpayer from taxation for the period of the taxable
year during which the corporate franchise was not exercised. The
tax was essentially a tax on the privilege of doing business in
the taxable year. Id. at 133. All events fixing a corporation's
liability for the California franchise tax did not occur until
the taxable year in which it exercised its privilege. Epoch Food
Serv., Inc. v. Commissioner, 72 T.C. 1051, 1053 (1979).
In 1972, California amended its franchise tax law so that
withdrawal or dissolution would no longer relieve a taxpayer from
tax based on the preceding year's income. In Epoch Food Serv.,
Inc. v. Commissioner, supra at 1054, we found that the effect of
this amendment was to change the accrual date for the tax from
January 1 of the taxable year to December 31 of the income year.
Thus, after the 1972 amendment, the event fixing the liability
for the California franchise tax is the earning of net income in
the income year, rather than the exercising of the corporate
franchise in the taxable year. Id.
Section 164(a) permits a deduction for State taxes during
the taxable year in which paid or accrued. However, section
461(d) overrides the normal rules for accruing taxes in certain
situations. Section 461(d)(1) provides: - 25 -
In the case of a taxpayer whose taxable income is computed under an accrual method of accounting, to the extent that the time for accruing taxes is earlier than it would be but for any action of any taxing jurisdiction taken after December 31, 1960, then, under regulations prescribed by the Secretary, such taxes shall be treated as accruing at the time they would have accrued but for such action by such taxing jurisdiction.
Under the regulations, any action of a taxing jurisdiction that
would accelerate the time for accruing a tax is to be disregarded
in determining the time for accruing such tax for purposes of the
deduction allowed under section 164(a). Sec. 1.461-1(d)(1),
Income Tax Regs. This applies to a taxpayer upon which the tax
is imposed at the time of the taxing jurisdiction's action, as
well as a taxpayer upon which the tax is imposed at any time
subsequent to such action. Id.
Respondent argues that section 461(d)(1) governs and that
petitioner may not accrue any deduction for California franchise
taxes based on 1988 income until 1989. Petitioner, on the other
hand, argues that respondent’s position fails to take into
account the special California statutory rules that applied to a
commencing corporation’s first and second income and taxable
years under pre-1972 California franchise tax law. Petitioner
contends those rules would have applied to petitioner's first and
second taxable years so that under the pre-1972 State law,
petitioner's liability would have become fixed on December 31,
1988, for the $932,979 franchise tax based on its 1988 income. - 26 -
Thus, petitioner argues that the 1972 amendments did not
accelerate the accrual of its California franchise tax and that
section 461(d)(1) and the cases interpreting that section with
respect to California law are inapplicable. See Epoch Food
Serv., Inc. v. Commissioner, supra; Central Inv. Corp. v.
Commissioner, supra; see also Hitachi Sales Corp. of Am. v.
Commissioner, T.C. Memo. 1992-504.
The general rule for a taxpayer that commenced business in
California before 1972 was that the franchise tax for the
taxpayer’s first taxable year was based upon the income received
during that year and that the income for the first taxable year
also served as the measure of the franchise tax for the
taxpayer’s second taxable year. Cal. Rev. & Tax. Code sec.
23222(a) (West 1992). Thereafter, the tax due for each taxable
year was based on the income earned in the next preceding income
year. Id. sec. 23151(a). However, a special rule applied where
the commencing corporation’s first taxable year was less than 12
months:
In every case in which the first taxable year of a taxpayer constitutes a period of less than 12 months, or in which a taxpayer does business for a period of less than 12 months during its first taxable year, said taxpayer shall pay as a prepayment of the tax for its second taxable year a tax based on the income for the first taxable year computed under the law and at the rate applicable to the second taxable year, the same to be due and payable at the same times and in the same manner as if that amount were the entire amount of its tax for that year; and upon the filing of its tax return within 2 months and 15 days after the close of - 27 -
the second taxable year it shall pay a tax for said year, at the rate applicable to that year, based upon its net income received during that year, allowing a credit for the prepayment; but in no event, except as provided in Section 23332, shall the tax for the second taxable year be less than the amount of the prepayment for that year, and said return for its second taxable year shall also be the basis for the tax of said taxpayer for its third taxable year, if the second taxable year constitutes a period of 12 months. [Id. sec. 23222(a).]
Cal. Rev. & Tax Code sec. 23222(a) was in effect prior to
December 31, 1960.9 Thus, prior to December 31, 1960, where a
taxpayer’s first taxable year was a period less than 12 months,
the income from the short year was not used as the basis for
computing the franchise tax for the second taxable year; rather,
the income earned in the taxpayer’s second taxable year was used
as a measure of its franchise taxes for the second taxable year.
Petitioner argues that under the law as it existed prior to
December 31, 1960 (prior to the 1972 amendment), its first year
ending December 31, 1987, constituted both its first income year
and its first taxable year, and that its franchise tax liability
based on 1987 income would have become fixed on the last day of
1987, even if petitioner had dissolved on January 1, 1988.
Similarly, petitioner argues that since its first taxable year
was a period less than 12 months, its second taxable year (the
9 Pursuant to the 1972 amendment, sec. 23222(a) of the Cal. Code applies only to taxpayers who commenced doing business in California prior to Jan. 1, 1972. Cal. Rev. & Tax Code sec. 23222(b) (West 1992). - 28 -
taxable year in issue) and income year would also have been the
same, and, thus, the franchise tax based on its second year's
income would have accrued on December 31, 1988. We agree.
None of our prior opinions dealt with a situation where the
income year and the taxable year would have been the same for
purposes of the franchise tax as it applied prior to December 31,
1960. However, that is the result of applying section 23222(a)
of the California code, as it existed prior to the 1972
amendment, to the facts of this case. Pursuant to that section,
the franchise tax for petitioner's first taxable year ended
December 31, 1987, would have been computed on income earned
during that period and would have been payable to the State for
the privilege of exercising the corporate franchise for the same
period. This franchise tax based on income received during the
first year would have been due regardless of whether petitioner
exercised its privilege after the close of its first year.
Because petitioner's first taxable year for franchise tax
purposes was for a period of less than 12 months, prior to the
1972 amendment, Cal. Rev. & Tax Code sec. 23222(a) would have
required petitioner to pay a franchise tax based on its income
for the second year for the privilege of exercising the corporate
franchise during the second year. The franchise tax liability
based on income earned during the second year would not have
depended upon the occurrence of an event subsequent to the end of - 29 -
the second year.10 All events necessary to fix petitioner's
liability for franchise tax in the amount of $932,979 based on
income earned during its second year would have occurred at the
end of the second year under the law as it existed prior to
December 31, 1960. It follows that petitioner's liability to the
State of California for franchise tax based on income earned
during its second year, which ended December 31, 1988, would have
accrued at the end of its second taxable year, regardless of the
1972 amendment to the franchise tax. We hold that section 461(d)
does not prevent petitioner from accruing its liability for
franchise tax in the amount of $932,979.
Respondent argues that even if petitioner's liability for
the franchise tax in the amount of $932,979, is otherwise
accruable in 1988, petitioner should not be allowed the deduction
because it would constitute a change in petitioner's accounting
method to which respondent has not consented. We disagree.
Petitioner used the accrual method of accounting. It
apparently did not accrue the $932,979 on its Federal income tax
return because it relied on Rev. Rul. 79-410, 1979-2 C.B. 213.
That ruling relied on section 461(d) and the premise that prior
10 Under Cal. Rev. & Tax Code sec. 23222(a), as it applied prior to 1972, the second taxable year would also have been the income year for purposes of computing the franchise tax for petitioner's third taxable year. Prior to the 1972 amendment, the franchise tax for the third taxable year would not be accruable until Jan. 1, 1989, and the franchise tax for each succeeding year would have been accruable in similar fashion. - 30 -
to 1972, California corporations could not generally have accrued
franchise tax based on an "income year" until the first day of
the following "taxable year". While the revenue ruling is based
in part on our holdings in Central Inv. Corp. v. Commissioner, 9
T.C. 128 (1947), and Epoch Food Serv., Inc. v. Commissioner, 72
T.C. 1051 (1979), those cases did not address the effect of
section 23222(a) of the California code on the accruability of
California franchise tax in a corporation's second taxable year
where the first taxable year was less than 12 months.11 The
impact of section 23222(a) on the case before us is a "fact"
determining whether the all events test has been met.
Petitioner's initial misconstruction of the facts in reliance on
respondent's revenue ruling should not be viewed as a method of
accounting other than the accrual method. Applying petitioner's
method of accounting to the correct facts is not a change in
accounting method requiring respondent's approval. We hold that
petitioner is entitled to accrue and deduct franchise tax in the
amount of $932,979 for purposes of computing its Federal income
tax for the taxable year ended December 31, 1988.
Decision will be entered
under Rule 155.
11 We note that the facts described in Rev. Rul. 79-410, 1979-2 C.B. 213, 213-214, address the impact of California law prior to the 1972 amendment where a corporation's first year was "other than a short year". (Emphasis added.)