Appeal from the United States District Court for the Northern District of California. D.C. No. CV-84-0877-TEH. Thelton E. Henderson, District Judge, Presiding.
Before: Procter Hug, Jr., Cynthia Holcomb Hall, and Diarmuid F. O'Scannlain, Circuit Judges. Opinion by Judge Hug; Dissent by Judge Hall.
This is an appeal by Transamerica from a judgment disallowing a refund of income taxes attributable to its former subsidiary, United Artists Corporation ("UA"), for the production of films that it acquired and distributed for exhibition. The Internal Revenue Service ("IRS") assessed income tax deficiencies for depreciation disallowed for the years 1971, 1972, and 1973. Transamerica paid the additional tax and sued for a refund. The sole issue on appeal is the interpretation of a formula established in Rev. Rul. 60-358 for the depreciation of the cost of production of television and motion picture films. The question of interpretation focuses on the proper treatment of production costs that are paid as a percentage of the income earned from the exhibition of the films. The district court entered summary judgment for the Government, disallowing the refunds. We reverse.
Jurisdiction in the district court was based on 28 U.S.C. § 1346(a)(1) and our appellate jurisdiction is based on 28 U.S.C. § 1291.
For the years in issue, Transamerica owned UA, which contracted for the production of motion picture films and distributed them for exhibition. The income tax due on the profit from the distribution of the films is the matter in contention.
Transamerica paid deficiency assessments and filed two actions for refund of taxes and interest paid for the years 1971, 1972, and 1973. These actions originally involved numerous issues, which have since been resolved. The dispute involves the depreciation expense attributable to films which were distributed and for which income was received in those tax years. The actions were consolidated and submitted to the court for decision on cross-motions for summary judgment based on stipulated facts. The issue on appeal, being strictly a legal issue, is subject to de novo review.
UA contracted with third parties for the production of the films it distributed. It contracted to pay certain producers, writers, directors, actors, and others a flat amount plus a percentage of the film's future gross receipts or net profits. The percentage portions of these payments are known as "participations." During this period, UA also operated under collective bargaining agreements with guilds representing writers, actors, directors, and others who contributed to the production of the films, which required payment to those guilds of a percentage of all revenues it received from the television exhibition of each film it distributed. These payments are known as "residuals."
The profit that UA makes on the distribution of a film is the revenue it earns from exhibition, less the costs incurred under these contracts for production and its distribution expenses. The film that is produced is considered to be a capital asset. The Internal Revenue Code ("IRC") provides that taxpayers may not deduct the cost of purchasing or producing a capital asset in the year in which the costs are incurred. Instead, the costs must be allocated by means of depreciation expense over the period during which the capital asset will produce income. The objective is to allocate as evenly as possible the cost of the asset with the flow of the income it produces.
In recognition of the special circumstances involved with television films, the IRS issued Rev. Rul. 60-358, 1960-2 C.B. 68, allowing depreciation expense to be calculated on a formula based upon the forecast of future income. In Rev. Rul. 64-273, 1964-2 C.B. 62, the IRS acknowledged that this method of calculating depreciation also is applicable to motion picture films.
Under this method, the taxpayer must forecast the total amount of income that the motion picture will produce over its entire lifetime. The taxpayer is then allowed to take a depreciation deduction each year in proportion to the amount of income received in that year relative to the total amount of income forecasted.
The interpretation of Rev. Rul. 60-358 is the crux of this dispute. The revenue ruling provides in pertinent part as follows:
It has come to the attention of the Internal Revenue Service that the methods of computing depreciation described in section 167(b) of the Code are in most cases inadequate when applied to television films, resulting in a distortion of income on the returns filed by taxpayers deriving income from such films. This distortion is caused by a strikingly uneven flow of income, earned by groups of programs within the series, resulting from contract restrictions, methods of distribution and audience appeal of the programs. . . . The usefulness of such assets in the taxpayer's trade or business is measurable over the income it produces and cannot be adequately measured by the passage of time alone. Therefore, in order to avoid distortion, depreciation must follow the "flow of income."
Some producers of television films have used the so-called "cost recovery" method in reporting their income. By use of this method, no taxable income is reported until the income from the films exceeds the cost thereof. However, such "cost recovery" method is not acceptable for Federal income tax purposes.
After an extensive study and consideration of the matter, the Service has concluded that the so-called "income forecast" method is readily adaptable in computing depreciation of the cost of television films without producing any serious distortion of income. This method requires the application of a fraction, the numerator of which is the income from the films for the taxable year, and the denominator of which is the forecasted or estimated total income to be derived from the films during their useful life, including estimated income from foreign exhibition or other exploitation of such films. The term "income" for purposes of computing this fraction means income from the films less the expense of distributing the films, not including depreciation. This fraction is multiplied by the cost of films which produced income during the taxable year, after appropriate adjustment for estimated salvage value. The "income forecast" method may be illustrated as follows:
Example: Certain television films which produced income within the first taxable year cost 800x dollars, after appropriate adjustment for estimated salvage value. The income therefrom for the first taxable year was 600x dollars; second year 150x dollars; and third year, 300x dollars. Total estimated income to be derived from the films 1200x dollars.
600x dollars x 800x dollars=400x dollars (first year's depreciation)
150x dollars x 800x dollars=100x dollars (second year's depreciation)
300x dollars x 800x dollars=200x dollars (third year's depreciation)
The ruling goes on to explain how income forecasts can be adjusted in subsequent years if it is found that the income forecast was substantially overestimated or underestimated. The issue before us is the application of the basic formula above-quoted. The essential question is whether the "cost of the films" is to include the cost of the percentage "participations" and "residuals." The taxpayer contends it is; the IRS contends it is not. The practical effect of including participations and residuals in the cost factor is to permit the depreciation of all costs of production in order to match expenses evenly with income.
The costs of the participations and residuals, in actuality, are clearly costs of producing the film and not expenses incurred in distribution. Transamerica followed generally accepted accounting principles in utilizing the "income forecast method" to spread these participation and residual costs proportionately over the flow of the net income derived from the film.*fn1 Furthermore, this seems to be in accord with the imperative of the revenue ruling that "in order to avoid distortion, depreciation must follow the 'flow of income.'" Rev. Rul.60-358.
Rev. Rul. 60-358, in explaining the formula, deducts the anticipated expenses of distribution in calculating the net revenue forecast to be used, but allocates the cost of production as depreciation. There are recognized uncertainties in the formula. The gross revenue is an estimate and the distribution expenses are estimates. Thus, the net revenue factor in the formula is an estimate, but is accepted for use in calculating depreciation. The fact that the element of the cost of production attributed to participations and residuals is dependent upon the net revenue estimate should not preclude the inclusion of that cost element in the formula. The Government and Transamerica agree that the amount of participations and residuals can be accurately calculated from the net income projection. Thus, with the net income projection being a given factor in the formula, the participations and residuals are also a given factor in that formula. In order for the formula to operate as designed, so as to spread the costs of production evenly over the flow of income derived from the film, all costs of production, including participations and residuals, must be included.
The Government contends that because the amounts of the participations and residuals are uncertain, they should not be included in the cost to be depreciated, but rather should be deducted as expenses when they become due and payable under the various contracts.*fn2 The Government approach does not result in spreading the costs of production evenly over the flow of income as does the American Institute of Certified Public Accountants approach, which was utilized by Transamerica. This is demonstrated by the following examples using the Rev. Rul. 60-358 formula.
Assume that the projected net revenue is $1,200,000, and that the pre-release cost is $600,000. The projected profit would be $600,000. Further assume that the participations and residuals require payments of 33 1/3% of the profits, being $200,000. Thus, pre-release costs of $600,000 plus $200,000 in participations and residuals would equal $800,000. Finally, assume that $300,000 a year for four years is realized in income net of distribution expenses. Transamerica's and the Government's application of the Rev. Rul. 60-358 formula would be as follows:
Net Income Cost Depreciation
$300,000 X $800,000 = $200,000
$300,000 X $800,000 = $200,000
$300,000 X $800,000 = $200,000