Rev. Rul. 72-28

Advice has been requested as to the application under the circumstances described below, of the provisions of section 1341 of the Internal Revenue Code of 1954 relating to the computation of tax where the taxpayer restores a substantial amount held under claim of right.

For 1969 and prior taxable years, the taxpayer, a regulated public utility as defined in section 7701(a)(33) of the Code, was subjected to a series of purchased gas rate increases allowed by the Federal Power Commission, subject to refund under certain circumstances. The taxpayer effected legally binding arrangements whereby it collected from its consumers the increases in its purchased gas expense, subject to refund to the consumer of amounts refunded to the taxpayer by its pipeline supplier. The taxpayer paid the contingent increases to its supplier and, for Federal income tax purposes, took such amounts into account as part of cost of goods sold. The taxpayer collected corresponding equivalent amounts from the consumers which amounts were properly included in gross income. During 1970, the taxpayer received refunds of 4,000x dollars from its suppliers which were included in gross income and corresponding equivalent refunds were made in that year to the consumers.

The basic question presented is whether the provisions of section 1341 of the Code apply, even though the facts show, for 1969 and prior taxable years, that the taxpayer had increased its cost of goods sold by an amount equivalent to the amount received from its consumers that was included in gross income for those years under a claim of right.

As far as here pertinent, section 1341(a) of the Code provides that if (1) an item was included in gross income for a prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such item, (2) a deduction is allowable for the taxable year because it was established after the close of such prior year (or years) that the taxpayer did not have an unrestricted right to such item or to a portion of such item, and (3) the amount of such deduction exceeds $3,000, then tax imposed by chapter 1 of the Code shall be the lesser of the tax for the taxable year computed with such deduction or an amount equal to the tax for the taxable year computed without such deduction, minus the decrease in tax under chapter 1 for the prior taxable year (or years) which would result solely from the exclusion of such item (or portion thereof) from gross income for such prior taxable year (or years).

Section 1341(b)(2) of the Code provides, in part, that section 1341(a) of the Code does not apply to any deduction allowable with respect to an item which was included in gross income by reason of sale or other disposition of stock in trade of the taxpayer or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business. Section 1341(b)(2) of the Code also provides in effect that section 1341(a) shall apply if the deduction arises out of refunds or repayments with respect to rates made by a regulated public utility if such refunds or repayments are required to be made by the Government, political subdivision, agency, or instrumentality referred to in such section, or by order of the court, or are made in settlement of litigation or under threat or imminence of litigation. See also section 1.1341-1(f) of the Income Tax Regulations.

Section 1.1341-1(a)(2) of the regulations provides that for the purpose of this section "income included under a claim of right" means an item included in gross income because it appeared from all the facts available in the year of inclusion that the taxpayer had an unrestricted right to such item, and "restoration to another" means a restoration resulting because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item (or portion thereof).

The facts, in the instant case, disclose that the arrangements with the consumers are binding obligations and, therefore, the customers could commence litigation to have the arrangements enforced. Thus, the amounts refunded to consumers in 1970 come within the exception contained in section 1341(b)(2) of the Code. Furthermore, in determining the application of section 1341 of the Code, the fact that the taxpayer had increased the cost of goods sold in prior taxable years by amounts equivalent to those which were included in gross income for such prior years under a claim of right has no relevancy in determining the application of section 1341 of the Code.

Accordingly, in the instant case, the provisions of section 1341 of the Code are applicable in determining the Federal income tax liability of the taxpayer for 1970.