APPEAL FROM THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF KANSAS (D.C. NO. 6:06-CV-01049-JTM-KMH).
The opinion of the court was delivered by: Murphy, Circuit Judge.
Before LUCERO, SEYMOUR, and MURPHY, Circuit Judges.
The government appeals the district court's decision that taxpayer-appellee Koch Industries, Inc. was entitled to use the percentage-of-completion method of accounting under 26 U.S.C. § 460 to report $62 million in income received from the State of New Mexico for warranting a State highway would meet certain performance standards over a specified period of time. Exercising jurisdiction under 28 U.S.C. § 1291, this court REVERSES, and REMANDS for entry of judgment in favor of the government because the percentage-of-completion method of accounting applies only if "manufacture, building, installation, or construction is necessary for the taxpayer's contractual obligations to be fulfilled," 26 C.F.R. § 1.460-1(b)(2)(i), and because the percentage-of-completion method cannot be used to defer tax on income received under a guaranty, warranty, or maintenance agreement, id. § 1.460-1(d)(2).
Taxpayer-Appellee Koch Industries, Inc. ("Koch") is a corporation organized under the laws of the state of Kansas. During the period at issue, Koch was the common parent of an affiliated group of corporations and filed consolidated federal income tax returns on behalf of itself and its affiliated group of corporations. In 1995, Koch created Koch Performance Roads, Inc., to market higher cost, longer lasting roads made of a new polymer-modified asphalt. To offset the higher initial construction costs, Koch offered extended warranties to customers. In its vision statement, Koch explained its willingness to extend fifteen to twenty year warranties on its roads as follows,
The Performance Road objective is to provide a road with lower life cycle costs. Agencies currently spend less on initial construction and then incur greater maintenance and reconstruction expense. A Performance Road would spend more on initial construction but would incur far less maintenance and reconstruction expense leading to lower life cycle costs. It is typical to find that the break-even point between these alternatives will occur around year 12. Therefore, in order to provide value to the customer, the warranty period typically needs to exceed 14 years.
In July 1998, Koch, through its indirect subsidiary Mesa, PDC, LLC, and the State of New Mexico Highway and Transportation Department ("New Mexico") entered into a contract entitled "Agreement for Corridor 44 Professional Services and Warranty" (Corridor Agreement) regarding the expansion of State Highway 44 ("SH44") using Koch's Performance Roads concept. Due to a lack of state funding, the parties developed a financing solution under which the state would issue financing mechanisms known as Grant Anticipation Revenue Vehicle Bonds which permitted the state to pledge future federal-aid highway funds to the repayment of the bonds. Because this plan contemplated leveraging future federal funds available to maintain the road, it was necessary to include in the contract all of the maintenance measures that would be necessary during the repayment of the bonds.
The SH44 project was divided into two phases, a construction phase and a rehabilitation phase. Koch's obligations during the rehabilitation phase were governed by two contracts: (1) a "Pavement Warranty," that required Koch to perform all work necessary to assure performance of the pavement*fn1 ; and (2) a "Structures Warranty," that required Koch to perform all work necessary to assure performance of the structures (bridges, drainage, and erosion structures).*fn2 Neither warranty agreement required New Mexico to show any design defects to give rise to Koch's obligation to repair or replace pavement or structures. Instead, both warranties included detailed performance criteria which SH44's pavement and structures were required to meet. Although it was virtually certain that some work would have to be done at some point in time under the warranty agreements, Koch had no obligation to perform any work on the highway unless and until the highway and/or structures thereon failed to meet the performance standards included in the warranty agreements.
The Pavement Warranty divided the term of the warranty into four periods and listed the minimum acceptable criteria corresponding to each particular period of time. The Pavement Warranty provided up to a 21.5-year warranty term for the segments of the highway.*fn3 A number of the performance criteria, such as those pertaining to rut depth, delamination, and pot holes, remained constant over the entire warranty term. The performance criteria pertaining to smoothness, cracking, and depressions, however, became less stringent with the passage of time, indicating the parties did not intend the road to remain in the same condition over the warranty period.*fn4 The Structures Warranty provided up to a 11.5-year warranty term.*fn5 The minimum specifications listed in the Structures Warranty similarly permitted some decline in the condition of the structures over the warranty period.
Koch received $46,753,000 for its construction phase services and $62,000,000 under the warranties covering the rehabilitation phase.*fn6 Section 11.11 of the Corridor Agreement required $39,000,000 of the warranty price to be allocated to pavement reconstruction costs. However, that section also explicitly stated this allocation "in itself shall create no legal liability upon [Koch] to spend any sums under the Agreement or Warranty" and emphasized that the terms and conditions of the Corridor Agreement, Pavement Warranty, and Structure Warranty were to govern the parties' obligations during the rehabilitation phase.
Koch used the percentage-of-completion method of accounting provided for in 26 U.S.C. § 460 to report the $62 million it received as consideration for the two warranties. By using this method to report its income, rather than reporting the income in the year received, Koch deferred payment of tax on the income for a substantial number of years. On audit, the Commissioner of Internal Revenue determined Koch was not entitled to use the percentage-of-completion method of accounting to report its income from its agreements with the State and, accordingly, determined deficiencies in its tax. Koch paid the resulting deficiency, filed administrative refund claims and, when those claims were denied, filed this refund suit.
The district court granted summary judgment for Koch and concluded Koch was entitled to refunds of $339,520 for 1998, $1,972,187 for 1999, $1,294,515 for 2000, and $16,596,092 for 2001, plus interest. The court concluded the warranties were long-term construction contracts to which the percentage-of-completion method could apply. The court then concluded neither of the agreements were true warranties, and the regulation did not preclude Koch's use of the ...