In Sunoco, Inc., v. United States, No. 15-587T, (November 22, 2016) the United States Court of Federal Claims rejected Sunoco's claim for a federal income tax refund of over $300 million. The Court concluded that excise tax credits allowed under Section 6426(a) must be treated as a reduction in the claimant's excise tax liability under Section 4081. Thus, the claimant's income tax deduction for federal excise taxes (including the deduction taken into account in computing cost of goods sold) is limited to the claimant's excise tax liability after reduction by the credits allowable under Section 6426(a).¹

Background

On its returns for tax years 2005-2008, Sunoco reduced the amount of excise tax taken into account in determining cost of goods sold by the amount of the excise tax credits allowed under Section 6426(a). Sunoco subsequently concluded that the full amount of excise tax before reduction by the credits should have been taken into account in computing cost of goods sold. Consistent with this conclusion, Sunoco claimed that the taxable income and income tax liability reported on its returns were overstated and that it was entitled to a refund. The IRS reached the opposite conclusion regarding the effect of the credit. In Notice 2015-56, 2015-35 I.R.B. 235, the Service stated that excise tax credits allowed to a taxpayer under Section 6426(a) reduce federal excise taxes allowable as a federal income tax deduction (or, if applicable, cost of goods sold). The Service first stated this position and set forth its reasoning in Chief Counsel Advice 201406001. See Tax Alerts 2015-1625 and 2014-281.

Court's analysis

The Court concluded that the statutory language was unclear and could be interpreted to support either Sunoco's or the IRS's position. Accordingly, the Court looked to legislative history to resolve the issue. The Court noted that the excise tax credit under Section 6426(a) and the related cash payment under Section 6427(e)² were enacted as a replacement for the reduced excise tax rate previously available under Section 4081 for alcohol fuel mixtures. The Court concluded that the principal purpose of this change was to increase funding for the Highway Trust Fund by creating the accounting fiction that fuel taxes received by the government were not reduced by credits allowed under Section 6426(a).³

The Court noted that, under prior law the reduced excise tax rate resulted in a lower income tax deduction and an increased income tax liability. In contrast, under Sunoco's interpretation, there would be no increase in income tax liability, resulting in an increase, relative to prior law, in the subsidy provided by the credit of about 35%.⁴ The Court noted that the Joint Committee's revenue estimators scored the change as having "No Revenue Effect." From this, the Court concluded that "it seems clear that Congress did not believe … that it was giving a drastically increased subsidy to alcohol fuel blenders," and "the legislative history favors the Government's position."

The Court also cited the analogous treatment of manufacturer's rebates and state income tax credits as support for the Government's position. The Court suggested that the treatment of manufacturer's rebates stands for the proposition that any reduction in the amount of money the taxpayer must pay out of its own pocket for inventory should reduce the taxpayer's cost of goods sold and increase the taxpayer's gross income. For state tax credits, the Court cited cases in which the portion of a state credit that reduced tax liability was not included in income, but the excess that was paid in cash was included in income. Although the Court noted that this is the opposite of the result for which the IRS is arguing in the current case, it is nevertheless authority for the proposition that credits can be bifurcated, with part of the credit included in income and part excluded.

The Court dismissed Sunoco's argument based on Section 87, which specifically includes the income tax credit for alcohol and biodiesel fuels in gross income. The Court noted that there was no need for a specific inclusion of the excise tax credit if, as the Court assumed, the credit reduced excise tax liability and the cost of goods sold.

Finally, the Court stated that "courts expect Congress to speak unequivocally when it intends to confer tax benefits on the scale Sunoco suggests." Specifically: "[O]ne would expect Congress to expressly state, either in the legislative history or by statute, that it intended to convey this benefit. Congress has not done so here."

Implications

The Claims Court decision upholds the Service's position that excise tax credits used under Section 6426(a) to offset excise tax liability also offset the excise tax liability taken into account in determining income tax deductions and cost of goods sold. The decision, if upheld on appeal, substantially reduces the benefit of renewable fuel subsidies for claimants with fuel excise tax liabilities. In contrast, it is the Service's position that excise tax credits paid to claimants under Section 6427(e), because they exceed the claimant's excise tax liability, are excluded from gross income. This bifurcation of the excise tax credit places a premium on tax planning. For example, compare the situation of a biodiesel producer that creates a 99.9/0.1 mixture of biodiesel/taxable fuel before delivering the biodiesel to a terminal with a position holder that creates a 90/10 mixture at the terminal. Because the producer has no excise tax liability, it will receive, tax-free, $1.00 per gallon for the biodiesel used in the mixture. The position holder will likely have excise tax liability that exceeds the biodiesel credit. Accordingly, although the position holder's excise tax liability decreases by $1.00 per gallon, its income tax liability increases by 35 cents per gallon (assuming a 35% marginal rate). Thus, the net benefit to the position holder is only 65 cents per gallon. Before 2014, when the Service first announced the bifurcation rule, most taxpayers did not anticipate the adoption of such a rule and did not structure their transactions so as to take full advantage of the credit.

Because of the large amount at stake, the Claims Court decision is likely to be appealed to the US Court of Appeals for the Federal Circuit. In addition, the issue is still being litigated in the Northern District of Texas and the Tax Court. Accordingly, taxpayers affected by the decision should continue to preserve their refund claims until the issue is finally resolved.

Although the treatment of payments under Section 6427(e) were not at issue in the Sunoco's claim, the Claim's Court opinion raises concerns about the treatment of those payments under Section 6427(e). The Court's reasoning based on the Joint Committee estimate that the change from prior law to the current system had no revenue effect and the Court's conclusion that Congress needs to speak unequivocally when it intends to confer tax benefits on the scale involved in these cases would seem equally applicable to Section 6427(e) payments.

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ENDNOTES

¹ Two other cases involving this issue are currently before the courts. In the US District Court for the Northern District of Texas, Exxon Mobil Corporation filed a complaint on October 6, 2016, claiming that this rule resulted in an overstatement of its gross income for tax years 2008 and 2009 of over $963 million. Thus, the tax liability involved is likely on the same order of magnitude as that in the Sunoco case. In a Tax Court case, Growmark, Inc. and Subsidiaries v. Commissioner, Docket No. 23797-14, filed on October 9, 2014, Growmark claims the rule resulted in an overstatement of its gross income for tax years 2009 and 2010 of over $14 million.

² If the credit exceeds excise tax liability, the claimant is entitled to a cash payment of the excess.

³ Section 9503(b)(1), relating to transfers of fuel taxes to the Highway Trust Fund, provides for transfers to the Trust Fund of "amounts equivalent to the taxes received in the Treasury" under [Sections 4041 and 4081, relating to taxes on motor fuels] and that "taxes received under [S]ections 4041 and 4081 shall be determined without reduction for credits under [S]ection 6426."

⁴ Assuming a 35% tax rate, the increase in the subsidy would actually be approximately 54%. A $100 rate reduction under prior law would result in a net benefit of $65 after taking into account the income tax increase. The $35 increase in the subsidy that would result if it were completely excluded from income is 53.85% of $65.