                          T.C. Memo. 2001-175



                        UNITED STATES TAX COURT



                     WESTPAC PACIFIC FOODS,
         SAVE MART, TAX MATTERS PARTNER, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 12400-99.                         Filed July 16, 2001.


     Andrew A. Bassak and Alvin T. Levitt, for petitioner.

     Andrew R. Moore and Lloyd T. Silberzweig, for respondent.



                MEMORANDUM FINDINGS OF FACT AND OPINION

     VASQUEZ, Judge:     By way of separate notices of final

partnership administrative adjustment, respondent determined that

Westpac Pacific Foods (Westpac) failed to report $5,572,538 and

$4,922,945 of gross income for taxable years 1990 and 1991,

respectively.    The sole matter for decision is whether certain

upfront payments that Westpac received in consideration of
                               - 2 -

entering various purchasing contracts constitute income in the

year of receipt.   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

     Westpac is a general partnership whose principal offices

were located in Stockton, California, at the time the petition in

this case was filed.1   Westpac was formed for the purpose of

acquiring land, constructing a warehouse facility, and operating

such facility for the storage of food and other products sold to

the following three grocery store chains:   Raley's Inc.

(Raley's), Save Mart Supermarkets, Inc. (Save Mart), and Bel Air

Mart, Inc. (Bel Air).   Raley's and Save Mart each owned 45

percent of Westpac, and Bel Air owned the remaining 10 percent.

During the years in issue, Westpac used the accrual method of

accounting for tax reporting purposes.

GTE Sylvania Contract

     On or about July 12, 1990, Westpac entered into an agreement

with Sylvania Lighting division of GTE Products Corp. (GTE

Sylvania) by which Westpac agreed to (1) make GTE Sylvania its

exclusive branded lamp supplier for Westpac and its member stores

for a 4-year term; (2) “aggressively and regularly” advertise and


     1
        Westpac changed its name from Westpac Pacific Foods to
Super Store Industries (SSI) at some point in 1991. For the sake
of convenience, references to Westpac include references to SSI.
                              - 3 -

promote GTE Sylvania's products; (3) dedicate on average at least

12 lineal feet of shelf space to GTE Sylvania's products in its

member stores; and (4) purchase $17 million in lamp products

during the term of the agreement.   In consideration of Westpac's

volume purchase commitment, GTE Sylvania agreed to pay Westpac

$1,100,000 as an “unearned advance allowance”.   This allowance

was paid to Westpac by check dated July 31, 1990.   GTE Sylvania

further agreed to pay Westpac $200,000 on the first, second, and

third anniversaries of the agreement, provided that Westpac

established to the satisfaction of GTE Sylvania an adequate

warehouse distribution arrangement.   During Westpac's 1991 tax

year, GTE Sylvania paid to Westpac the first $200,000 annual

installment.

     The contract refers to the total $1,700,000 in payments as

the “Westpac Allowance” and contains the following passage

regarding Westpac's obligation to repay such allowance:

     Upon termination of this Agreement, WestPac will
     reimburse GTE Sylvania on a pro-rated basis for any
     portion of the WestPac Allowance advanced to WestPac
     but not earned due to the failure by WestPac to
     purchase at least $17.0 million in lamps.

GTE Sylvania further reserved the right to decrease the Westpac

Allowance if, in its judgment, Westpac did not (1) use its best

efforts to promote and purchase for resale GTE Sylvania branded

lamps or (2) dedicate on average at least 12 linear feet of shelf

space to GTE Sylvania products through its member stores.
                               - 4 -

     By letter dated August 18, 1994, Westpac terminated its

contract with GTE Sylvania effective October 3, 1994, due to lack

of sales volume.   The termination letter recognized Westpac's

obligation to repay a prorated portion of the Westpac Allowance.

In December 1994, Westpac repaid GTE Sylvania a prorated amount

totaling $861,857.

Ambassador Contract

     On or about August 24, 1990, Westpac entered into an

agreement dated August 14, 1990, with Ambassador Cards

(Ambassador), a division of Hallmark Cards, Inc.   Westpac agreed

to maintain Ambassador as its primary supplier of social

expression merchandise and committed its member grocery store

chains (excepting those Save Mart stores which were under an

existing contract with American Greetings Corp.) to purchase

$61,047,000 worth of goods from Ambassador.   In exchange,

Ambassador agreed to (1) pay Westpac $4,572,000 upon execution of

the contract; (2) provide each member store a credit equal to the

wholesale value of the opening order of everyday Ambassador

merchandise; (3) issue a quarterly credit to each member grocery

store chain equal to 5 percent of the total net wholesale

purchases of Ambassador products made by Westpac's member stores

as a group; and (4) issue a credit equal to 5 percent of net

wholesale purchases to any store that later became subject to
                                - 5 -



the agreement for a period of 12 months after Ambassador's

merchandise was installed.2

     The agreement required Westpac to repay a pro rata portion

of the $4,572,000 upfront cash payment and the initial inventory

purchase credit if one of Westpac's member stores ceased

operations.   The contract defined the pro rata repayment

obligation in terms of the percentage of the volume purchase

commitment that remained unsatisfied at the time.

     On March 14, 1994, Westpac and Ambassador executed an

addendum to their contract.    The addendum increased Westpac's

volume purchase obligation to $76,047,000.    The addendum also

called for Ambassador to pay Westpac (1) $1,225,000 to cover the

cost of opening inventory in additional stores that became

covered under the agreement and (2) $1,225,000 as an additional

placement allowance.    Ambassador, through its affiliate Hallmark

Marketing Corp., made the combined $2,450,000 payment by check

dated April 29, 1994.

     In March 1997, Westpac and Ambassador discussed the

possibility of terminating their contract.    In the course of

these discussions, Ambassador prepared a letter setting forth the



     2
        This last credit provision was aimed primarily at the
Save Mart stores which Ambassador anticipated would join the
agreement at the conclusion of the preexisting contract between
Save Mart and American Greetings Corp.
                               - 6 -

amounts that Westpac would be required to repay to Ambassador

upon termination.   This letter included a table entitled “Super

Stores Industries Payback Calculation for Early Contract

Termination” that listed the amount of payments Westpac received

under the contract and the volume of purchases Westpac had

achieved through December 1996.   The table calculated the

repayment amount on a pro rata basis in proportion to Westpac's

percentage completion of the volume purchase requirement.    After

discussing the possibility of terminating the contract, the

parties decided against it.

American Greetings Contract

     On or about January 10, 1991, Save Mart entered into an

agreement with American Greetings Corp. (American Greetings) in

which Save Mart agreed to make American Greetings its “exclusive

supplier” of everyday and seasonal counter cards, tray packs,

wraps, bows, and other auxiliary products.   Save Mart further

agreed to maintain in its stores the then-existing lineal footage

dedicated to American Greetings products.

     The term of the American Greetings contract ran from

January 1, 1991, to December 31, 1995.   If, however, Save Mart

had not purchased $17,970,000 in products from American Greetings

by December 31, 1995, the contract term would be automatically

extended until such time as Westpac met this volume purchase

target.
                              - 7 -

     In exchange for Save Mart's commitments, American Greetings

agreed to provide Westpac with the following:   (1) A credit of

$100 per lineal foot dedicated to American Greetings products in

newly constructed stores or newly acquired stores not carrying

American Greetings products; (2) an annual discount equal to 5

percent of the increase in purchases made in the prior year over

that made in the year before the prior year; (3) a 1.5-percent

discount on total net receipts to American Greetings from Save

Mart purchases, creditable each quarter; (4) additional discounts

totaling $1,250,000 “in lieu of periodic volume discounts”,

creditable upon execution of the agreement; and (5) a 5-percent

advertising allowance based on the sale of everyday and seasonal

counter cards.

     Whereas the contract called for the $1,250,000 discount to

be made in the form of a credit, the parties subsequently agreed

that payment would be made in cash.   The parties also agreed that

the cash payment would be made to Westpac instead of directly to

Save Mart.3

     Save Mart and American Greetings terminated their contract

before Save Mart satisfied its volume purchase commitment.

Although the contract contained no express provision requiring



     3
        Evidently, the payment was assigned from Save Mart to
Westpac because Westpac's owners had agreed to pool the advance
payments which they received under this and other long-term
purchase contracts.
                                - 8 -

the repayment of any portion of the upfront payments received by

Save Mart or Westpac, American Greetings calculated Westpac's

repayment obligation at $406,243 on a prorated calendar basis.

Westpac's internal correspondence reflected a repayment

obligation of $512,500 based on the percentage of the volume

purchase commitment it had satisfied.   Accordingly, Westpac

accepted American Greetings’ lower demand and paid American

Greetings $406,243 by check dated September 28, 1995.   The check

stub contains a notation that the payment constitutes a

“repayment of contract adv[ance]”.

McCormick Contract

     On or about March 4, 1991, Westpac entered into an agreement

with McCormick & Co., Inc. (McCormick), dated February 27, 1991,

by which Westpac agreed to use McCormick as its “primary

supplier” of spices, extracts, foil seasonings, mixes, gourmet

spices, and cake decorations.   In addition, Westpac agreed to

purchase $50 million in McCormick products over an indefinite

period.

     In consideration of Westpac's commitments, McCormick agreed

to make a series of cash payments to Westpac and to supply

Westpac with certain amounts of free products.   In particular,

McCormick agreed to pay Westpac $5 million4 and to provide



     4
        McCormick actually paid Westpac $4,801,000 during the
1991 taxable year.
                                - 9 -

Westpac with $1 million worth of free products upon execution of

the agreement.    McCormick further agreed to make the following

“incentive payments” as Westpac achieved various volume purchase

targets:

           Volume Level   Cash Payment     Free Product

           $10,000,000    $3,000,000         $750,000
            20,000,000     2,000,000          750,000
            30,000,000     2,000,000          750,000
            40,000,000     1,000,000          750,000

The contract obligated Westpac “to repay any unearned prepaid

allowances on a pro rata basis” in the event Westpac failed to

satisfy the entire $50 million volume purchase commitment.

Westpac's Financial and Tax Reporting

     Westpac recorded the upfront cash payments which it received

from GTE Sylvania, Ambassador, American Greetings, and McCormick

as liabilities in favor of the manufacturers.    For financial and

tax accounting purposes, Westpac would treat a portion of the

payment which it considered earned (that is, the amount of the

total payment received multiplied by the percentage of the volume

purchase commitment satisfied during the year in issue) as either

an item of “other income” or as a reduction to its cost of goods

sold.   Specifically, on its 1990 tax return, Westpac reported

what it considered to be the earned portions of the upfront cash

payments received on the Ambassador and GTE Sylvania contracts as

other income because Westpac had no cost of goods sold during
                                   - 10 -

that year which to offset.5        In 1991, Westpac reported what it

considered to be the earned portions of the upfront cash payments

received on the McCormick and American Greetings contracts as a

reduction to its cost of goods sold.         Westpac intended to treat

similarly the deemed earned portions of the upfront cash payments

received on the Ambassador and GTE Sylvania contracts as

reductions to its cost of goods sold, but its income tax preparer

mistakenly continued the “other income” treatment for these

amounts from the prior year's tax return.

        The chart below summarizes the upfront cash payments that

Westpac received in the years in issue as well as the portion of

such payments Westpac recognized as income for tax purposes

during those years:

                           Cash Payments            Income Recognized
Contract                 1990         1991          1990         1991

McCormick                  -0-       $4,801,000      -0-     $571,628
Ambassador            $4,572,000          -0-     $119,878    329,705
American Greetings         -0-        1,250,000      -0-      293,102
GTE Sylvania           1,100,000        200,000     87,947     87,862

Total                  5,672,000      6,251,000    207,825   1,282,297

Respondent determined Westpac was required to include in income

the full amount of the upfront cash payments in the taxable year

in which such payments were received.6


        5
        During 1990, Westpac's warehouse operation had not been
completed, and therefore all purchases under the Ambassador and
GTE Sylvania contracts were made directly by Westpac's partners.
        6
        Westpac received certain payments under a contract which
it entered into with Phillip Morris, Inc., and the parties have
                                                   (continued...)
                                - 11 -

                                OPINION

A.   Characterization of Payments

     The parties devoted a significant portion of the trial

toward determining the proper characterization of the upfront

cash payments which Westpac received under the purchase contracts

at issue.   Petitioner contends that such payments constitute

advance trade discounts; that is, the payments were made in sole

consideration of Westpac's obligation to purchase the volume of

goods stated in the contract.    Petitioner points to Westpac's

obligation under each of the purchase contracts to repay a

prorated portion of the upfront cash payments if it failed to

satisfy its volume purchase commitment.7


     6
      (...continued)
stipulated the amounts that Westpac is required to include in
income as a result of these payments. Therefore, the figures
determined by respondent in the deficiency notice do not coincide
exactly with those contained in the table above.
     7
        The McCormick and GTE Sylvania contracts contained an
express repayment obligation. While the Ambassador and American
Greetings contracts did not contain such an express provision,
petitioner's expert witness testified that such an obligation
existed implicitly pursuant to industry custom. The existence of
an implicit repayment obligation is confirmed by Westpac's
dealings with the greeting card manufacturers. Westpac
terminated its contract with American Greetings prior to
satisfying its volume purchase commitment. Upon termination,
Westpac issued a $406,243 check to American Greetings as a
repayment of its contract advance. Similarly, Westpac
contemplated terminating its contract with Ambassador prior to
satisfying its volume purchase commitment. In the course of
negotiations, Ambassador supplied Westpac with a calculation of
the amount of the upfront cash payment that Westpac would be
obligated to return. Westpac never questioned its repayment
                                                   (continued...)
                               - 12 -

     Respondent takes exception to petitioner's characterization

of the upfront payments as constituting advance trade discounts

exclusively.    Respondent notes that, under each purchase

contract, Westpac agreed to maintain the manufacturer as the

primary or exclusive supplier of the relevant product line.     In

addition, under the American Greetings and GTE Sylvania

contracts, Westpac agreed to maintain a specified amount of shelf

space for the manufacturer's product.    Respondent therefore

argues that some portion of the upfront cash payments should be

characterized as made in consideration of these non-volume-

related commitments.

     We hold that Westpac is not entitled to defer recognition of

the payments as income beyond the year of receipt.    We explain

our decision below.

B.   Tax Treatment of Payments

     Section 61 broadly defines gross income as “all income from

whatever source derived”.    See also sec. 1.61-1(a), Income Tax

Regs.    In interpreting a predecessor to section 61, the Supreme

Court determined that the broad statutory language evidenced

congressional intent to tax all gains except those specifically

exempted.    See Commissioner v. Glenshaw Glass Co., 348 U.S. 426,



     7
      (...continued)
obligation. We therefore agree with petitioner that an implicit
repayment obligation existed in Westpac's contracts with
Ambassador and American Greetings.
                              - 13 -

430 (1955).   The Court concluded that the payments in dispute in

Glenshaw Glass Co. constituted gross income, describing them as

“undeniable accessions to wealth, clearly realized, and over

which the taxpayers have complete dominion.”   Id. at 431.

     Section 451 sets forth the general rule that an item of

income shall be included in the taxpayer's gross income for the

taxable year in which received by the taxpayer unless, under the

method of accounting used by the taxpayer in computing taxable

income, such amount is to be properly accounted for in a

different period.   Westpac was an accrual method taxpayer.    Under

the accrual method of accounting, income is included 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.   See sec. 1.451-1(a), Income Tax Regs.   The

right to receive income becomes fixed at the earliest of (1)

required performance, (2) the date payment becomes due, or (3)

the date payment is made.   See Schlude v. Commissioner, 372 U.S.

128, 133, 137 (1963); Charles Schwab Corp. v. Commissioner, 107

T.C. 282, 292 (1996), affd. 116 F.3d 1231 (9th Cir. 1998); Cox v.

Commissioner, 43 T.C. 448, 456-457 (1965).

     Pursuant to the above-described principles, Westpac was

required to include the advance trade discounts in income for the

taxable year in which such discounts were received.   Westpac had

unfettered use of the cash payments in the years in which
                               - 14 -

respondent seeks to include them in income.     Accordingly, Westpac

had “actual command over the property taxed-–the actual benefit

for which the tax is paid.”    Corliss v. Bowers, 281 U.S. 376, 378

(1930).   Petitioner makes a number of arguments in favor of a

contrary result which we address below.

     1.     Whether an Advance Trade Discount Can Constitute Gross
            Income

     Petitioner contends that an advance trade discount cannot

constitute an item of gross income.     Petitioner looks to the

regulations promulgated under section 471 to support its

argument.   Section 471 provides generally that a taxpayer is

required to take inventories whenever, in the opinion of the

Secretary, the use of inventories is necessary to clearly

determine the taxpayer's income.    In such cases, inventory costs

must be calculated at the beginning and end of each year.     See

sec. 1.471-1, Income Tax Regs.   With respect to merchandise

purchased over the course of the taxable year, inventory cost is

defined as the invoice price less trade or other discounts.       See

sec. 1.471-3(b), Income Tax Regs.   Petitioner contends that,

pursuant to this last definition, trade discounts serve only as a

reduction to cost of goods sold and that any discounts paid in

advance of purchases cannot constitute gross income.
                              - 15 -

     Petitioner reads section 1.471-3(b), Income Tax Regs.,

beyond its proper scope.8   As confirmed by a later portion of the

regulation, the import of section 1.471-3(b), Income Tax Regs.,

is that a taxpayer's inventory cost includes only the net amount

paid by the taxpayer for goods that the taxpayer has acquired:

“To this net invoice price should be added transportation or

other necessary charges incurred in acquiring possession of the

goods.”   Sec. 1.471-3(b), Income Tax Regs. (emphasis added).

Accordingly, the “discount” to which section 1.471-3(b), Income

Tax Regs., refers arises contemporaneously with the purchase of

specific goods as inventory and is subtracted from their invoice

price to determine their cost.   The term does not include cash

payments that the seller or manufacturer of goods paid to Westpac

in exchange for Westpac's   agreement to purchase goods from the

same vendor in the indefinite future and to not purchase

competing brands from other suppliers.    Cf. Harkins v.

Commissioner, T.C. Memo. 2001-100.     Based on the evidence,

petitioner has failed to show that Westpac received the payments

concurrently with its purchase of specific goods in inventory and

that they are properly allocable as trade discounts off the




     8
        Petitioner's argument under this regulation is further
undermined by the fact that Westpac failed to account for what it
considered to be the earned portions of the advance trade
discounts as reductions to its cost of goods sold on its 1990
income tax return.
                               - 16 -

invoice prices of those goods.    Accordingly, section 1.471-3(b),

Income Tax Regs., has no application to this case.

     2.     Whether Westpac's Method of Accounting Clearly Reflects
            Income

     Petitioner further contends that its proposed method of

accounting for the advance trade discounts is called for by

section 1.471-2(a), Income Tax Regs.    That regulation provides as

follows:

          § 1.471-2. Valuation of inventories.--(a) Section
     471 provides two tests to which each inventory must
     conform:

          (1) It must conform as nearly as may be to the
     best accounting practice in the trade or business, and

            (2) It must clearly reflect income.

     Section 1.471-2(a), Income Tax Regs., contains two elements

stated in the conjunctive.    Petitioner has established that

Westpac's method of accounting for the advance trade discounts is

consistent with Generally Accepted Accounting Principles as well

as with the best accounting practice in the grocery store

industry.    Accordingly, petitioner has met the first requirement

of the regulation.    Petitioner, however, cannot satisfy the

regulation's second element.    Deferring the recognition of

payments actually received does not clearly reflect income,

regardless of whether the payments have been earned.    See Schlude

v. Commissioner, 372 U.S. 128 (1963); American Auto. Association

v. United States, 367 U.S. 687 (1961); Automobile Club of Mich.
                              - 17 -

v. Commissioner, 353 U.S. 180 (1957); S. Garber, Inc. v.

Commissioner, 51 T.C. 733 (1969); Farrara v. Commissioner, 44

T.C. 189 (1965).

     Petitioner contends that John Graf Co. v. Commissioner, 39

B.T.A. 379 (1939), requires that trade discounts not be

recognized as income prior to the elimination of all

contingencies to which their recognition is subject.   The

taxpayer in John Graf Co., a beverage retailer, instituted a

lawsuit against a beer producer regarding the quality of beer

that the taxpayer had previously purchased.   As part of the

agreement by which the parties settled the matter, the beer

producer agreed to deliver to the taxpayer, free of charge, 500

cases of beer having a posted price of $1.10 per case.    In

addition, the manufacturer agreed to provide the taxpayer with

incremental discounts totaling $2,450 on additional purchases.

If the taxpayer refused to order any beer after delivery of the

first 500 free cases, such failure to order would constitute a

waiver of the balance of the credit allowance.    Id. at 380.

     During the taxable years at issue, the taxpayer's purchases

entitled it to a discount of $177.50 over the $550 of free

product it received.   In ruling on the tax consequences of the

taxpayer's settlement, the Board held that the taxpayer

recognized income only to the extent of the discount which it

actually received in the taxable year in issue.    Id. at 385.
                              - 18 -

Noting that the taxpayer was not obligated to make additional

purchases under the settlement agreement and that receipt of the

total discount was not certain, the Board held that the

taxpayer's income would not be accurately reflected were it

required to accrue the full amount of the potential discount

prior to receipt.   Id. at 384.

     We find the decision in John Graf Co. v. Commissioner,

supra, of little relevance to the present dispute.   The John Graf

Co. case addressed the issue of whether discounts not yet

received should be accrued in income;9 it did not address the

issue of whether recognition of discounts actually received

subject to a contingent repayment obligation could be deferred.

As to this latter issue, it is well settled that contingent

repayment obligations do not operate to defer the recognition of

income:

     If a taxpayer receives earnings under a claim of right
     and without restriction as to its disposition, he has
     received income which he is required to return, even
     though it may still be claimed that he is not entitled
     to retain the money, and even though he may still be
     adjudged liable to restore its equivalent. * * * [N. Am.
     Oil Consol. v. Burnett, 286 U.S. 417, 424 (1932).]




     9
        A number of the purchase contracts at issue in the
present case contained provisions for additional discounts to be
paid if Westpac met certain volume purchase targets. Unlike the
Commissioner's position in John Graf Co. v. Commissioner, 39
B.T.A. 379 (1939), respondent does not contend that those future
discounts should be accrued in income prior to their receipt.
                              - 19 -

C.   Disparity Between Financial and Tax Accounting

     In this case, the proper method of accounting for the

advance trade discounts for financial accounting purposes does

not coincide with the proper tax accounting treatment of such

items.   Such divergence, however, is not unprecedented.   See

Frank Lyon Co. v. United States, 435 U.S. 561, 577 (1978) (“we

are mindful that the characterization of a transaction for

financial accounting purposes, on the one hand, and for tax

purposes, on the other, need not necessarily be the same”).      As

explained in Thor Power Tool Co. v. Commissioner, 439 U.S. 522,

542-543 (1979), financial accounting and tax accounting serve

distinct objectives:

     The primary goal of financial accounting is to provide
     useful information to management, shareholders,
     creditors, and others properly interested; the major
     responsibility of the accountant is to protect these
     parties from being misled. The primary goal of the
     income tax system, in contrast, is the equitable
     collection of revenue; the major responsibility of the
     Internal Revenue Service is to protect the public fisc.
     Consistent with its goals and responsibilities,
     financial accounting has as its foundation the
     principle of conservatism, with its corollary that
     “possible errors in measurement [should] be in the
     direction of understatement rather than overstatement
     of net income and net assets.” * * * In view of the
     Treasury's markedly different goals and
     responsibilities, understatement of income is not
     destined to be its guiding light. Given this
     diversity, even contrariety, of objectives, any
     presumptive equivalency between tax and financial
     accounting would be unacceptable. [Fn. refs. omitted.]

Thus, sound justification exists for the disparate treatment of

Westpac's contingent obligation to return the advance trade
                             - 20 -

discounts between the financial accounting and tax accounting

regimes.

D.   Conclusion

     We sustain respondent's determination that the advance trade

discounts that Westpac actually received under the purchase

contracts at issue constitute income in the year of receipt.

     To reflect the foregoing,

                                     Decision will be entered under

                                 Rule 155.
