In Re: Harvard Ind ( 2009 )

Opinions of the United
2009 Decisions States Court of Appeals
for the Third Circuit
6-17-2009
In Re: Harvard Ind
Precedential or Non-Precedential: Precedential
Docket No. 07-3006
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PRECEDENTIAL
UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT
_____________
No. 07-3006
_____________
IN RE: HARVARD INDUSTRIES, INC., et al.,
Debtor
HARVARD SECURED CREDITORS LIQUIDATION
TRUST,
Appellant
v.
INTERNAL REVENUE SERVICE,
Appellee
______________
On Appeal from the United States District Court
for the District of New Jersey
(D.C. No. 07-cv-00305)
District Judge: Honorable Garrett E. Brown, Jr.
1
_______________
Argued September 11, 2008
Before: McKEE, SMITH, and WEIS, Circuit Judges.
(Filed June 17, 2009)
JAMES N. LAWLOR, Esq. (Argued)
Wollmuth Maher & Deutsch LLP
One Gateway Center, Ninth Floor
Newark, New Jersey 07102
Attorney for Appellant
KENNETH L. GREENE, Esq.
ARTHUR T. CATTERALL, Esq.
RACHEL I. WOLLITZER, Esq. (Argued)
Tax Division
Department of Justice
950 Pennsylvania Avenue, N.W.
Post Office Box 502
Washington, D.C. 20044-0000
Attorney for Appellee
_______________
OPINION OF THE COURT
_______________
2
McKee, Circuit Judge
This tax dispute arose in the course of bankruptcy
proceedings for Harvard Industries, Inc. and related entities
(collectively “Harvard”). Its resolution requires us to determine
the meaning of “specified liability losses” as that phrase is used
in 26 U.S.C. § 172(f). 1 In the bankruptcy court, Harvard
attempted to collect a federal tax refund for the 1986 tax year
based upon three categories of “specified liability losses”
incurred in the 1996 tax year that purportedly qualified for a
special ten-year net operating loss carry-back pursuant to 26
U.S.C. § 172(b)(1)(C).2 The bankruptcy court allowed the
1
For purposes of this appeal we are concerned only
with the version of this statute that existed in 1996. The
section has since been amended several times.
2
“Carry-backs” and “carry-forwards” allow the
taxpayer to spread out its good and bad years for tax purposes,
thus smoothing out revenue and tax liabilities and creating
something akin to an average taxable income. Usually,
3
carry-back for each of the claimed expenses over the
government’s objection.
On appeal from the bankruptcy court, the district court
ruled that (i) payments to a qualified pension plan that were
made pursuant to a settlement agreement with the Pension
Benefit Guaranty Corporation (“PBGC”)3 did not “arise under
Federal . . . law” and were therefore not “specified liability
taxpayers may only carry net operating losses back two years.
In the case of certain large and unusual expenses, called
“specified liability losses,” Congress has determined that
taxpayers should have the ability to spread such losses over a
greater period of time. See United Dominion Indus. v. United
States, 532 U.S. 822, 825 (2001). This cushions the fiscal
impact that certain extraordinary expenses would otherwise
have on the taxpayer.
3
The PBGC is a wholly-owned United States
government corporation that administers the federal insurance
program for private pension plans under Title IV of ERISA.
See generally Pension Benefit Guar. Corp. v. LTV Corp., 496
U.S. 633, 636-37 (1990); 29 U.S.C. § 1302(a).
4
losses” under § 172; (ii) losses incurred in relation to the
manufacture of defective lock nuts were not “product liability”
damages within the meaning of § 172, and hence were not
“specified liability losses”; but (iii) payments made pursuant to
a retrospective workers’ compensation insurance policy were
properly deductible as “specified liability losses” in the 1996 tax
year. For the reasons that follow, we will affirm in part and
reverse in part.
I. FACTUAL BACKGROUND
In 1986, Harvard earned profits of approximately $6.5
million and hence paid a total of $2,442,175 in federal income
taxes. For the 1996 tax year, Harvard sustained a net operating
loss of $41,399,563. On April 23, 1998, Harvard filed an
Amended Corporation Income Tax Return in which it claimed
a refund in the amount of $2,435,872 for the 1986 tax year
based on a specified liability loss generated during the 1996 tax
5
year that was purportedly eligible to be carried back ten years
pursuant to § 172 of the Internal Revenue Code (“I.R.C.”).4 In
a Notice of Partial Claim Allowance dated February 23, 1999,
the Internal Revenue Service (“IRS”) allowed the carry-back for
such losses as were attributable to Workers’ Compensation
payments, but denied the remainder of the claimed refund.
On March 5, 1999, Harvard filed a protest to the First
Partial Disallowance and challenged the Service’s basis for
denying portions of its refund claim. Harvard also expanded the
refund claim to include, among other things: (i) “product
liability” payments in the amount of $3,829,807 which included
forgiven accounts receivable and a settlement payment to one
distributor in connection with defective lock-nuts manufactured
4
Section 172(f) of the IRC, as written in 1996, allowed
corporations to carry certain types of losses back ten years
rather than the usual two or three.
6
by a Harvard operating division; and (ii) prior year pension
payments in the amount of $6,000,000 (the “PBGC Payments”).
The IRS issued a Second Notice of Partial Disallowance
on October 1, 1999, denying Harvard’s refund application for
the lock-nuts and the PBGC payments. The IRS denied the
claim related to the lock-nuts because: (i) Harvard’s liability was
based on breach of contract and breach of implied warranty of
merchantability, as opposed to product liability; (ii) Harvard’s
customers suffered no physical or emotional harm due to the
defective lock-nuts; (iii) costs incurred by Harvard were for
repair and replacement of the lock-nuts. The IRS also
determined that the pension payments were not eligible for a
ten-year carry-back because the Code requires that the event
giving rise to an eligible liability “under state or federal law”
must occur at least three years before the tax year in question,
1996 in this case. The IRS’s position was that because the
7
payments were made pursuant to a settlement agreement with
the PBGC in 1994, they did not meet the Code’s requirements
for eligible “special liability loss” carry-backs. The IRS also
took the position that the formation of pension plans and the
decision to enter a Settlement Agreement with the PBGC
regarding additional funding requirements for the pension plans
were voluntary decisions of Harvard, not “arising under federal
law” as required by the Code. Rather, they “related to” an
obligation under federal law, which is not enough to satisfy the
“arising under” element required for the special carry-back
provision of the Code. As we explain below, this ongoing
dispute was ultimately brought before the bankruptcy court.
A. Losses Related to Defective Lock-Nuts
Elastic Stop Nut of America (“ESNA”), an operating
division of Harvard, manufactured lock-nuts for use in
commercial and military aircraft engines and airframes.
8
Harvard sold the lock-nuts to various distributors, who resold
them to aircraft manufacturers. Military and commercial
specifications required that the lock-nuts be baked for 23 hours
in order to withstand extreme temperatures during use. Failure
to comply with this requirement could result in a condition
called “hydrogen embrittlement” which could cause the lock-
nuts to crack and fail.
In 1993, it was discovered in the course of an internal
investigation that certain of Harvard’s lock-nuts were defective
because they had not been baked for 23 hours as required.
When the defect was discovered, Harvard informed its
customers and stopped shipping the lock-nuts pending further
investigation. Prior to the time Harvard stopped shipping the
lock-nuts, there were no reported instances in which the failure
of an ESNA lock-nut caused an accident or resulted in personal
injury or property damage. In some cases, efforts were made to
9
recall and rework some of the lock-nuts. However, several
distributors who had received the defective lock-nuts refused to
pay for them because they could not be resold and/or had to be
recalled.
Harvard’s largest customer - Harco - filed suit against
Harvard based on the sale of defective lock-nuts, alleging: (1)
breach of contract; (2) breach of implied warranty of
merchantability; (3) breach of the implied covenant of good
faith and fair dealing; (4) fraud; (5) negligent misrepresentation;
and (6) civil RICO violations. The suit was ultimately settled in
an agreement dated April 22, 1996. Pursuant to that agreement,
Harvard paid Harco $820,000 and Harco agreed to “release and
discharge” Harvard from “any and all claims asserted” in
Harco’s complaint. Harvard then entered into settlement
agreements with other distributors, whereby ESNA forgave a
total of $3,009,807 in receivables for the lock-nuts. Harvard
10
subsequently claimed that it should be allowed to treat all these
expenses as “product liability” losses eligible for a ten-year
carry-back.
B. PBGC Settlement Pension Payments
Harvard filed for Chapter 11 bankruptcy in May of 1991.5
Thereafter, the bankruptcy court confirmed a plan of
reorganization which required Harvard to pay all holders of
allowed unsecured claims 100 cents on the dollar by 1994. In
order to meet its obligations under the plan, Harvard sought to
obtain $100 million in financing by offering senior unsecured
notes.
However, the PBGC was concerned about the issuance
of the notes. Harvard’s pension plans had a “substantial amount
5
This 1991 bankruptcy and reorganization is distinct
from the 2002 bankruptcy which gave rise to the present
dispute.
11
of unfunded benefit liabilities” due to erroneous actuarial
assumptions underlying pension plan contributions for 1992 and
1993. The PBGC therefore took the position that the note
offering might provide “sufficient basis for the PBGC to seek
termination of one or more of [Harvard’s] pension plans
pursuant to section 4042(a)(4) of ERISA, [29 U.S.C. §
1342(a)(4)].” Negotiations followed in which the PBGC and
Harvard reached a settlement agreement. Pursuant to that
agreement, Harvard made a $ 6 million additional contribution
to its pension plans in 1996 and agreed to pay an additional $1.5
million for each of twelve consecutive quarters thereafter.6
The PBGC Settlement Agreement contains restrictions on
the amount and use of the proposed Senior Notes. Harvard
warranted in the agreement that: “as of the date of execution of
6
Only the $ 6 million payment in 1996 is at issue in
this appeal.
12
this Settlement Agreement there are no past due minimum
funding contributions owed to any of” its pension plans, and the
PBGC agreed that it would not institute proceedings to terminate
any of taxpayer’s pension plans “as a result of the Senior Notes
offering.”
C. Workers’ Compensation Payments
From April 1988 to April 1992, Harvard annually
purchased insurance policies from the Wausau Insurance
Company (“Wausau”). The policies included insurance for
general liability, workers’ compensation and automobile
insurance. Harvard describes the Wausau workers’
compensation polices as “retrospective insurance plans.”
Pursuant to these policies, Harvard paid an initial premium at
the beginning of each policy year based on actuarial assumptions
about the amount of claims that would be paid. Once Harvard
13
paid its premium to Wausau, Wausau had access to these funds
and used them to pay claims covered by the policy.
At the end of each policy year, adjustments were made to
the premium based on the difference between the actual amount
paid out on claims and the expected claim amounts that had
been estimated based on actuarial assumptions. Even after the
policy years expired, as claims arising in those years were paid,
Harvard could be required to submit additional payments.
Wausau periodically sent reports to Harvard concerning claim
activity. By comparing year to year reports, Wausau could
determine if Harvard had to make additional payments to cover
any shortfall for each plan year. Harvard also paid taxes and
premium expenses for plan administration, calculated as a
percentage of claims expenses.
According to testimony given by a Harvard
representative, Harvard’s records indicated that the retrospective
14
adjustments pertaining to the refund request at issue here were
sent to Harvard around October 1995. Wausau and Harvard
then commenced negotiations and ultimately came to an
agreement as to the appropriate adjustments in early 1996. The
Trust also seeks to carry-back those payments to Wausau as
“specified liability losses” arising under state law because they
constitute Harvard’s obligation to provide workers’
compensation benefits for its employees.
II. PROCEDURAL BACKGROUND.
On January 15, 2002, Harvard, along with several
subsidiaries, filed a voluntary petition for bankruptcy under
Chapter 11 of the Bankruptcy Code. Thereafter, Harvard filed
a “Motion Requesting a Determination as to Debtor’s Rights to
a Tax Refund.” The substance of the motion dealt with the three
categories of supposed “specified liability losses” described
above. Harvard argued that each expense qualified for a refund
15
of federal taxes paid for the 1986 tax year. The motion was
heard as a contested matter pursuant to Fed. R. Bank. P. 9014.
While the motion was pending, Harvard’s Reorganization Plan
was confirmed and the Harvard Secured Creditors Liquidation
Trust (the “Trust”) became the party in interest with respect to
any potential refund. Eventually, the Trust and the government
filed cross-motions for summary judgment in the bankruptcy
court.
On March 24, 2005, the bankruptcy court granted the
Trust’s summary judgment motion with respect to two of the
three categories of specified liability loss expenses at issue. In
re Harvard Indus., Inc., 324 B.R. 238 (Bankr. D.N.J. 2005).
The court ruled that the lock-nut related payments were product
liability losses as they were a “liability of the taxpayer for
damages on account of . . . loss of the use of property” in
accordance with I.R.C. § 171(f)(4). The court reasoned that
16
“[s]ince the term ‘property’ is not defined in the statute,” it must
be accorded “its ordinary meaning . . . [which] would include
the Lock-Nuts at issue here.” Id. at 241. The bankruptcy court
also ruled that the pension payments “arose under ERISA,” and
were therefore also specified liability losses under the Tax Code.
Id. at 242. Thus, Harvard was entitled to a refund as a result of
the allowance of these expenses. The bankruptcy court denied
Harvard’s motion with respect to the third category of claimed
expenses (workmen compensation premiums) pending
additional discovery, and denied the government’s cross-motion
for summary judgment. The amount of the overpayment ordered
by the bankruptcy court exceeded the 1986 tax paid when added
to the refund amounts already received by Harvard. Therefore,
no further refunds could be ordered and the bankruptcy court’s
summary judgment order was final. Thereafter, the government
17
appealed to the United States District Court for the District of
New Jersey, which had jurisdiction under 28 U.S.C. § 158(a).
For reasons we explain below, the district court reversed
the bankruptcy court’s order with regard to the lock-nut
expenses and the PBGC payments, and remanded the matter for
resolution of the third disputed category of losses. After a
hearing, the bankruptcy court ordered that Harvard was entitled
to a refund with respect to the retrospective adjustments to its
workers compensation plan, but held that administrative fees
associated with the plan could not be included in the carry-back.
On November 22, 2006, the Trust appealed to the district court
and the district court subsequently affirmed in part, reversed
with respect to administrative costs associated with the policy,
and remanded to the bankruptcy court for entry of judgment.
The district court’s order is a final order because it disposes of
all claims with respect to all parties. Thereafter, the Trust
18
appealed to this court. We have jurisdiction pursuant to 28
U.S.C. § 158(d).
III. STANDARD OF REVIEW
Our standard of review is the same as the district court’s
review of the bankruptcy court’s ruling. In re Schick, 418 F.3d
321, 323 (3d Cir. 2005). We review an order granting summary
judgment de novo. American Flint Glass Workers Union v.
Anchor Resolution Corp., 197 F.3d 76, 80 (3d Cir. 1999). The
bankruptcy court’s application of the “all events” test is also
reviewed de novo.7 ABCKO Indus., Inc. v. Commissioner, 482
7
The “all events” test is used to determine when a
business expense has been incurred for tax purposes. It
originated in United States v. Anderson, 269 U.S. 422, 441
(1926) and had been codified at 26 U.S.C. § 461(h)(4), which
provides:
[T]he all events test is met with respect to any
item if all events have occurred which
determine the fact of liability and the amount of
such liability can be determined with reasonable
19
F.2d 150, 154 (3d Cir. 1973). Factual findings are reviewed for
clear error. Nantucket Investors. II v. California Fed. Bank, 61
F.3d 197, 203 (3d Cir. 1995).
IV. ANALYSIS.
All of the issues before us turn on the interpretation of §
172 of the I.R.C. In 1996, that section allowed for certain
portions of net operating losses, called “specified liability
losses,” to be carried back ten years to offset tax liabilities
incurred in more profitable years.
During the period in question, I.R.C. § 172 (f) defined
“specified liability loss” as follows:
(1) In General. - The term “specified liability
loss” means the sum of the following amounts to
the extent taken into account in computing the net
operating loss for the taxable year:
accuracy.
20
(A) Any amount allowable as a deduction
under section 162 or 165 which is attributable to -
(i) product liability, or
(ii) expenses incurred in the
investigation or settlement of, or opposition to,
claims against the taxpayer on account of product
liability.
(B) Any amount (not described in subparagraph (A))
allowable as a deduction under this chapter with respect to a
liability which arises under Federal or State law, or out of any
tort of the taxpayer if -
(i) in the case of a liability arising
out of a Federal or State law, the act (or failure to
act) giving rise to such liability occurs at least 3
years before the beginning of the taxable year . .
. .8
8
Section 172(f)(1)(B) was amended in 1998. “This
provision now includes only certain enumerated ‘federal or
state’ liabilities attributable to the reclamation of land, the
decommissioning of a nuclear power plant, the dismantling of
a drilling platform, the remediation of environmental
contamination, or a payment under any workmen’s
compensation act.” Standard Brands Liquidating Creditor
Trust v. United States, 53 Fed Cl. 25, 27 n.3 (Fed. Cl. 2002).
The Conference Notes that accompanied the amendment state
that there was no intention of altering the interpretation of the
previous wording of the section - and that the amendment
only applies to tax years after 1998. H.R. Conf. Rep. No.
21
The Trust contends that all three categories of 1996
expenses at issue here qualify as “specified liability losses”
under this section of the Code and can thus be carried back to
1986 - making Harvard eligible for a refund from that year. As
noted earlier, Harvard claims that expenses related to the lock-
nuts qualify as “product liability losses,” while the pension
payments and the workers’ compensation insurance payments
purportedly “arise out of a Federal or State law,” and therefore
satisfy the requirements of § 172(f).
As there is no binding authority interpreting this statute,
we rely on basic tenets of statutory interpretation. When
interpreting a statute, “the literal meaning of the statute is most
important, and we are always to read the statute in its ordinary
and natural sense. Galloway v. United States, 492 F.3d 219, 223
105-825, at1590 (1998).
22
(3d Cir. 2007) (internal quotation marks and citations omitted).
In construing the Tax Code, we “strictly construe deductions and
allow such deductions only as there is a clear provision
therefor.” Id. Moreover, we rely on the legislative history only
where the text itself is ambiguous. Id. We have recently ruled
that where a provision of the I.R.C. is ambiguous, we apply a
Chevron analysis to any applicable treasury regulations.
Swallows Holding, Ltd. v. Comm’r, 515 F.3d 162 (3d Cir. 2008).
A. “Product Liability” Losses.
The I.R.C. defines “product liability” for purposes of
section 172(f)(1)(A)(I) as:
(A) liability of the taxpayer for damages on
account of physical injury or emotional harm to
individuals or damage to or loss of the use of
property, on account of any defect in any product
which is manufactured, leased, or sold by the
taxpayer, but only if
(B) such injury, harm or damage arises after the
taxpayer has completed or terminated operations
23
with respect to, and has relinquished possession
of, such product.
26 U.S.C. § 172 (f)(4). Neither the Supreme Court, nor any
circuit court of appeals has interpreted this provision.
The bankruptcy court analyzed the language of the statute
and concluded that Harvard’s settlement with Harco and other
customers qualified as “liability . . . for damages on account of
. . . loss of the use of property.” 324 B.R. at 241 (quoting I.R.C.
§ 172(f)(4). It reasoned that the word “property,” which is not
defined in the statute, should be read to include the lock-nuts
themselves. Therefore, the court concluded:
Loss of the use of the defective property is
precisely what occurred here. Harvard’s
customers were distributors who were unable to
use the Lock-Nuts manufactured by [Harvard]
because of a defect known as hydrogen
embrittlement. Here again, the court gives the
term “use” its plain meaning which would include
intended use as an item to resell.
Id.
24
The district court rejected the interpretation of the
bankruptcy court. It reasoned that:
Loss contemplates possession followed by the
failure to maintain possession. Harvard’s
customers did not have possession of lock-nuts fit
for resale at any point; they merely had possession
of defective lock-nuts that were unfit for resale.
Consequently, Harvard’s customers could not
have lost the use of the property for its intended
purpose where they did not possess usable lock-
nuts in the first place.
Additionally, Section 172(f)(4)(B) requires
that “such injury, harm, or damage arises after the
taxpayer has completed or terminated operations
with respect to, and has relinquished possession
of, such product.” In the instant case, the defect
that gave rise to Harvard’s liability arose during
the manufacturing of the lock-nuts, as Harvard’s
own brief admits. [] Since the damage to the
property clearly occurred before Harvard
relinquished possession of the product, the
damage to the lock-nuts is excepted from the
statutory definition of product liability as stated in
26 U.S.C. § 172(f)(4).
App. 38.
25
As we have just noted, product liability is “liability of the
taxpayer for damages on account of physical injury or emotional
harm to individuals or damage to or loss of the use of property,
on account of any defect in any product which is manufactured,
leased, or sold by the taxpayer . . . .” I.R.C. § 172(f)(4)(A)
(emphasis added). It is uncontested that the lock-nuts were
defective. It is also uncontested that none of Harvard’s
customers suffered physical injury or emotional harm because
of the defective lock-nuts.9 There is also no allegation that any
of the lock-nuts caused any damage to other property of any
customer or “down-stream” user. (For instance, had a defective
lock-nut caused a plane to crash, Harvard might well have been
9
Harvard notes in its opening brief that a defective
lock-nut may have been related to the crash of a Navy plane
and the death of a pilot. However, that incident occurred after
the 1996 tax year and is not relevant to this appeal.
Moreover, it appears from the record that no suit was ever
filed against Harvard in relation to that crash.
26
liable for the cost of replacing the plane as well as other
damages.) The question then is whether the distributor’s
inability to resell the defective product itself qualifies as
“damage to or loss of the use of property.”
Both the district court and the bankruptcy court examined
the statute closely, referencing dictionary meanings for each
significant term. Yet, those two courts arrived at opposite
conclusions. This clearly suggests an ambiguity in the language
of the statute. Much of the textual ambiguity arises from the
fact that it is not clear whether Congress intended “property” in
the phrase, “loss of the use of property,” to include the
defective product itself as opposed to the property of
downstream purchasers or users to which the defective product
has caused loss or damage..
In arguing that “property” refers to something other than
the actual lock-nuts, the government focuses on the fact that
27
Congress used “property” and “product” differently in the
statute. Relying on this distinction, the government reminds us
that:
Where the statutory language refers to the
defective product, it uses the term “product,”
which term appears once in subparagraph (A)
and once in subparagraph (B). I.R.C. § 172
(f)(4). Subparagraph (A) refers to “damages . .
. on account of any defect in any product,” while
subparagraph (B) refers to the requirement that
the “damage arises after the taxpayer has
completed or terminated operations with respect
to, and has relinquished possession of, such
product.” I.R.C. § 172(f)(4). Not only is the
defective product referred to in both instances by
the term “product,” but the second instance in
effect refers back to the first instance by using
the term “such product.” Id.
On the other hand, the term “product”
does not appear in the phrase “loss of the use of
property,” i.e., the statutory language does not
refer to a “loss of use of the product or other
property.” Id. Rather, the statute refers to a
“loss of use of property.” Id. In this context, the
term “product,” and not the term “property,”
refers to the lock-nuts. Thus, when viewed in the
context of the definition as a whole, the
28
distributor’s inability to resell the lock-nuts did
not constitute a loss of use of property.
Reply Br. 35-36. Although this approach has some surface
appeal, we believe it actually does more to demonstrate the
difficulty of textual analysis than to establish the congressional
intent underlying the language we must interpret.
We therefore turn to legislative history for guidance. In
re Unisys Sav. Plan Litigation, 74 F.3d 420, 444 (3d Cir. 1996)
(“If the statutory language is unclear, we then look to [a
statute’s] legislative history.”). The House Conference Report
stated that “[t]he definition of product liability under the senate
amendment is intended to include the kinds of damages that are
recoverable under prevalent theories of product liability.” H.R.
Rep. No. 95-1800, at 286 (1978). It went on to state that “[t]he
definition of product liability in the amendment does not include
liabilities arising under warranty, which essentially are contract
29
liabilities.” Id. at 287.10 Unfortunately, there was more than one
prevalent theory about the kinds of damages recoverable under
product liability law when the statute was enacted. Fortunately,
the Supreme Court has discussed the divergent views of product
liability that were viable around that time.
In East River Steamship Corp. v. Transamerica Delaval,
Inc., 476 U.S. 858, 867-70 (1986), a defectively designed ship
10
In 1986, the I.R.S. promulgated a regulation which
paraphrases the conference report’s statement: “product
liability does not include liabilities arising under warranty
theories relating to repair or replacement of the property that
are essentially contract liabilities.” Treas. Reg. §1.172-
13(b)(2)(ii). It goes on to explain, by way of example, that
“The costs incurred by a taxpayer in repairing or replacing
defective products under the terms of a warranty, express or
implied, are not product liability losses.” Id. Neither party
has devoted much time to arguing the Chevron implications
of this regulation. Were we to conduct a Chevron analysis,
the result would likely accord with that which we have
reached. That is, in the face of ambiguous language, it is
reasonable to construe the statute so as to exclude damage to,
or loss of, the use only of a defective product itself from the
scope of specified liability losses.
30
turbine component malfunctioned and damaged the turbine itself
without harming any other part of the ship. The Supreme Court
was called upon to determine whether, in the context of
admiralty law, injury to a product itself was the kind of harm
that should be addressed by contract law or product liability law.
This was then a question of first impression in admiralty. The
Court began its analysis by noting that “general maritime law is
an amalgam of traditional common-law rules, modifications of
those rules, and newly created rules,” which are “[d]rawn from
state and federal sources.” Id. at 864-65. It is this analysis of
prevailing common law rules that makes the Court’s opinion
useful to our analysis here.
The Court viewed the “paradigmatic products-liability
action [as] one where a product ‘reasonably certain to place life
and limb in peril,’ distributed without reinspection, causes
bodily injury.” Id. at 866 (citing MacPherson v. Buick Motor
31
Co., 111 N.E. 1050 (N.Y. 1916)). It then discussed the
expansion of products liability to include protection against
property damage based on similar concerns of safety. Id. at 867.
However, the expansion traditionally only involved cases where
“the defective product damages other property.” Id. (emphasis
added).
The Court described the “majority approach” as one
which held that there should be no action in tort for “purely
monetary harm” in order to “preserv[e] a proper role for the law
of warranty . . . .” Id. at 868 (citation omitted). The minority
approach “held that a manufacturer’s duty to make nondefective
products encompassed injury to the product itself, whether or
not the defect created an unreasonable risk of harm.” Id. at 868-
69. After evaluating the merits of these different approaches,
the Court concluded that where the only injury was to the
product itself, “the resulting loss due to repair costs, decreased
32
value, and lost profits is essentially the failure of the purchaser
to receive the benefit of its bargain - traditionally the core
concern of contract law.” Id. at 869 (citing E. Farnsworth,
Contracts § 12.8, pp. 839-40 (1982)). The Court concluded that
“a manufacturer in a commercial relationship has no duty under
either a negligence or strict products-liability theory to prevent
a product from injuring itself.” Id. The Court also reasoned that
the policy concerns for public safety were not as compelling in
these circumstances as in those where bodily injury or harm to
other property occurred.
Thereafter, we had to decide what rule Pennsylvania
would adopt when a defective product “damaged itself.” In
Aloe Coal Co. v. Clark Equipment Co., 816 F.2d 110 (3d Cir.
1987), we predicted that “Pennsylvania courts, although not
bound to do so, would nevertheless adopt the Supreme Court’s
reasoning in East River.” Id. at 112. In so doing, we reversed
33
a conclusion we had reached in a previous case, because we
were persuaded by the “cogent reasoning” of East River. Id. at
119.
Neither of these cases controls our present inquiry under
the Tax Code. However, we continue to find the reasoning of
East River persuasive, and the distinction it draws between
warranty and contract damages on the one hand, and product
liability and tort damages on the other, is similar to that drawn
by the Congress that drafted and enacted 26 U.S.C. § 172(f).
Moreover, this approach is reinforced here because Harco sued
Harvard on various theories of contract and warranty liability
based on the defective lock-nuts. Harco did not assert a product
liability cause of action. Thus, the damages here are “liabilities
arising under warranty,” which Congress did not intend to
include in the statute.
34
As noted earlier, the taxpayer has the burden of proving
its eligibility for a deduction, and statutes authorizing deductions
are a matter of legislative grace and are to be construed narrowly
unless the text of the statute authorizing the deduction reflects
a different congressional intent. See B.A. Properties Inc., v.
Government of the Virgin Islands, 299 F.3d 207 (3d Cir. 2002).
Viewed in that context, we are not persuaded by the Trust’s
argument that the IRS’s interpretation of the statute will leave
manufacturers with no incentive to make safe products. In fact,
the argument is specious. Even if corporations are not allowed
to carry-back this deduction 10 years - they may still take a
deduction for such expenses in the applicable tax year.
Furthermore, regardless of how such liabilities are treated for
tax purposes, the threat of products liability and other claims
hangs over a company that makes unsafe products. Here, for
example, the potential products liability and tort recovery from
35
death and injury that could have resulted from a plane crash
caused by the defective lock-nuts would dwarf the claimed tax
benefit of allowing a ten year carry-back.
We therefore conclude that the district court did not err
in reversing the bankruptcy court’s conclusion that the loss fell
within the scope of § 172(f). The district court was correct in
accepting the government’s position and disallowing the Trust’s
claim that the payments for defective lock-nuts qualified for the
ten year carry-back.
B. PBGC Payments
A taxpayer may also claim a specified liability loss if the
deduction “arises under a Federal or State law” if “the act (or
failure to act) giving rise to such liability occurs at least 3 years
before the beginning of the taxable year” and “the taxpayer used
an accrual method of accounting throughout the period or
36
periods during which the acts or failures to act giving rise to
such liability occurred.” 11 I.R.C. § 172(f)(1)(B).
As explained above, Harvard made $6 million in
payments to its various pension plans in the 1996 tax year
pursuant to the settlement agreement with the PBGC. The Trust
argues that these payments “arose under” the Employee
Retirement Income Security Act, 29 U.S.C. § 1001 et. seq.
(“ERISA”). ERISA sets minimum standards for most
voluntarily established pension and health plans in private
industry. The Trust maintains that the underfunding of
Harvard’s pension plans in 1992 and 1993 created ERISA
liability and that the liability therefore arose under ERISA and
was partially discharged through the 1996 PBGC payments.
11
The government does not dispute that Harvard used
an accrual method of accounting throughout the relevant
period.
37
Thus, according to the Trust, those payments meet the statute’s
requirements because they constitute a liability that arose under
federal law and accrued at least three years before the loss.
The government argues that these payments are not a
specialized liability loss for two reasons. First, the PBGC
payments are not rooted in federal law; rather, they resulted
from choices made by Harvard. Second, the relevant act was the
choice to enter into a settlement agreement with the PBGC in
1994 - an act which occurred less than three years before the
payments.
However, we are persuaded by the bankruptcy court’s
insightful analysis of this issue. We therefore adopt the
bankruptcy court’s cogent and persuasive discussion of this
issue:
In arguing that the payments did not arise under
federal law, the IRS focuses on the fact that
Harvard had satisfied its minimum funding
38
requirements under section 412 of the IRC. That
argument ignores the fact that those are not the
only payment obligations under ERISA.
Additional funding requirements may be triggered
by a plan's unfunded current liability. []. That
was the case here because the PBGC had
determined that Harvard had unfunded current
liabilities in the tax years 1992 and 1993. It is
certainly true that Harvard’s settlement with the
PBGC on that issue was motivated by its desire to
issue senior notes to fund its plan of
reorganization without objection from the PBGC,
but that does not change the ultimate fact that the
plans had unfunded liabilities in 1992 and 1993.
Thus, to maintain its qualified status Harvard was
required by law to make those payments.
That, of course, leads to the IRS's other argument: that the need
for additional contributions to the pension plans arose out of a
choice made by Harvard to maintain qualified pension plans for
its employees. In a recent decision on this issue the Federal
Circuit Court of Appeals stated that “the nature and amount of
the liability must be traceable to a specific law and cannot be the
result of choices made by the taxpayer or others.” Major Paint
Co. v. United States, 334 F.3d 1042 (Fed. Cir.2003). While that
decision is interesting, it does not instruct a court on where it
must draw the line regarding what constitutes a choice made by
a taxpayer. At some level everything involves a choice. It is
frequently recognized that liability for workers’ compensation
claims may qualify for specified liability loss status, Host
Marriott v. United States, 113 F. Supp. 2d 790 (D. Md. 2000),
39
aff’d 267 F.3d 363 (4th Cir.2001), yet that liability only arises
because an employer makes the decision to hire workers who are
covered by that law. A similarly slippery slope is apparent here.
While it is certainly true that offering an ERISA qualified
pension plan to its employees was a voluntary business decision
by Harvard, the court finds that the more prudent interpretation
would be to find that once a decision like that is made then
Harvard was bound by all of ERISA’s regulations. Thus,
complying with ERISA’s funding requirements was not a
voluntary decision on the part of Harvard, it was required by
federal law.
The next issue is whether the liability arose within three years
prior to the beginning of the taxable year at issue. The IRS
takes the position that the final act fixing Harvard's liability
occurred on July 26, 1994, the date Harvard entered into its
agreement with the PBGC. The court finds that argument to be
misplaced. The agreement with the PBGC did nothing to create
Harvard’s liability, it was merely the settlement of how that
liability would be paid. The liability itself was created in tax
years 1992 and 1993 due to Harvard’s reliance on inaccurate
actuarial assumptions. []. Therefore, the court finds that the
liability arose more than three years prior to the relevant tax
year. Accordingly, the court will grant summary judgment in
favor of Harvard on the issue of its pension plan payments
qualifying as specified liability losses.
324 B.R. at 242-43.
40
As is evident from the portion of the bankruptcy court’s
opinion set forth above, that court’s analysis was guided by the
decision in Major Paint Co. v. United States, 334 F.3d 1042
(Fed. Cir. 2003). There, the court held that in order for a
liability to “arise under” a federal law, “the nature and the
amount of the liability must be traceable to a specific law and
cannot be the result of choices made by the taxpayer and
others.” Id., at 1046. Major Paint is the latest of only four cases
that have addressed the meaning of “arising under” in § 172.
In Sealy Corporation v. Commissioner, a taxpayer argued
that professional fees the company paid to have filings required
by the SEC and ERISA prepared, as well as costs incurred
during an IRS audit, “arose under federal law” and should
therefore qualify for the ten-year carry-back. 171 F.3d 655, 656
(9th Cir. 1999). The Court of Appeals rejected this argument,
holding that “[t]he act giving rise to each of the liabilities in
41
question was the contractual act by which Sealy engaged
lawyers or accountants” and that these acts “did not occur at
least three years before [the tax year in question].” Id. at 657.
In Host Marriott Corp v. United States, the Court of
Appeals for the Fourth Circuit adopted the reasoning of the
district court in holding that interest on a federal income tax
deficiency was a specified liability loss. 267 F.3d 363, 365 (4th
Cir. 2001). The district court had noted that “[t]he liability for
federal income tax deficiency interest arises out of 26 U.S.C. §
6601(a) under a rate established by § 6621.” Host Marriott
Corporation v. United States, 113 F. Supp. 2d 790, 793 (D. Md.
2000). The district court also distinguished Sealy, by noting that
the taxpayer’s liability for tax deficiency interest is “set by
federal . . . law, not by [taxpayer’s] choice.” Id. at 794.
Finally, in Intermet Corporation v. Commissioner, the tax
court held that state tax deficiencies and interest on federal and
42
state tax deficiencies are specified liability losses because
federal law “expressly imposes” those liabilities.” 117 T.C. 133,
140 2001 WL 1164198 (2001).
As the bankruptcy court mentioned, in Major Paint, the
Court of Appeals for the Federal Circuit had to decide whether
fees paid to various professionals employed to assist the
taxpayer during bankruptcy proceedings “arose under federal
law.” The taxpayer argued that the costs arose under the
Bankruptcy Code and emphasized that a bankruptcy judge,
rather than a contract, determines when and how outside
professionals will be paid. Id. at 1046. The court conceded that
“[t]he Bankruptcy Code does require the appointment of a
committee of creditors holding unsecured claims” and the Code
further provides that the committee “may select and authorize
the employment . . . of one or more attorneys, accountants, or
other agents, to represent or perform services for such
43
committee.” However, the court in Major Paint reasoned that
“to say that simply because an entity files for bankruptcy any
costs for outside professionals “arise under” the bankruptcy
code in the context of I.R.C. § 172(f) stretches the limits of the
Tax Code.” Id. The court in Major Paint agreed with the Sealy
court that it is the act that immediately gives rise to the liability
that must arise out of federal law, and not a “chain of causes”
that can be traced to a federal law no matter how attenuated or
nuanced the link. Id. at 1047.
Although specified liability losses must obviously “arise
under” federal law rather than merely be “related to” it, we
believe that formulation is, by itself, too simplistic to be
determinative here because it merely states a conclusion based
on reiterating the statutory text. That, without more, does not
create a useful framework for analyzing a particular expense or
the specific expenditure at issue here. We think the link
44
between payments made pursuant to a settlement agreement
with a federal agency threatening enforcement action and the
underlying federal obligation to comply with ERISA is
sufficiently direct that it may be said to “arise under federal law”
and therefore qualify for the ten-year carry-back.
We also agree that the liability itself arose in 1992 and
1993, and the 1994 agreement was merely the mechanism for
discharging that liability. Moreover, just as the payments under
the settlement agreement are so directly related to the ERISA
liability as to have arisen under ERISA, we also conclude that
the payments must be treated as arising in 1992 and 1993 when
the underlying liability arose, and not when the agreement
enforcing that liability was executed. The date of the latter has
nothing to do with the fact that the liabilities would have existed
in 1992 and 1993 whether or not the 1994 agreement was ever
45
entered into. Accordingly, payments made pursuant to that 1994
agreement were entitled to the ten year carry-back under § 172.
C. Workers’ Compensation Payments
The bankruptcy court concluded that the Trust had
proven that Harvard incurred $2,076,066 in workers’
compensation and product liability expenses in the years in
question. The government argues that was error because all
premiums for insurance were paid from April 1988 to April
1991, and there was no evidence of payments in the 1996 tax
year.
The bankruptcy court found that Harvard owned
retrospective insurance workers’ compensation and general
liability policies from Wausau for four years, April 15, 1988 to
April 30, 1992. Yearly premiums were based on Harvard’s
actual loss experience during the applicable term. The policies
required prepayment of an initial premium in the policy year.
46
That payment was intended as both a premium for traditional
insurance and a prepayment designed to cover anticipated claims
under the policies. Even after the policy years expired, Harvard
was required to make further premium payments to Wausau as
claims arising in those years were paid. Until the retrospective
premium was finally agreed upon, Harvard could not determine
what amount to pay Wausau.
Based on the language of I.R.C. § 172, the bankruptcy
court and the district court both concluded that retrospective
premium adjustments were properly considered specified
liability losses, as they arose under state workers’ compensation
requirements. As we find no clear error in the bankruptcy
court’s factual findings, we will therefore affirm its findings
regarding when the payments were made, and for what purpose.
The district court concluded that the bankruptcy court
erred in excluding the “administrative expense component” of
47
the policies from the ten-year carry-back. The district court
noted that Harvard was required by state laws to have insurance
for workers’ compensation claims. To satisfy this express
requirement, Harvard purchased insurance and paid premiums
in the 1996 tax year. The fact that Harvard bought retrospective
policies instead of traditional policies did not alter the nature of
the payments.12
Harvard was charged additional premium expenses even
after the policy expired. Those additional premiums were
calculated using actual losses multiplied by a loss conversion
factor. The loss conversion factor was designed in part to cover
Wausau’s administrative costs, such as the cost of investigating
and settling claims. The district court concluded that such
12
For a succinct explanation of the complexities of
retrospective insurance policies, see Mark G. Ledwin, The
Treatment of Retrospectively Rated Insurance Policies in
Bankruptcy, 16 Bankr. Dev. J. 11, 12-13 (1999).
48
features were always part of the price a taxpayer pays for
insurance of any kind and thus should not be disqualified from
the total qualifying specified liability loss because of the way it
is calculated in this particular type of plan. We agree.
No insurance company would survive for long without
covering its administrative costs. Those costs allow it to process
and pay the claims that are the very purpose of purchasing an
insurance policy. We see no justification in law or policy to
allow these deductions for the actuarially derived cost of
premiums and disallow the administrative costs attendant to
every insurance policy merely because those costs are assessed
and billed as they were here. We will therefore affirm the ruling
of the district court in full on this issue.
V. CONCLUSION
For the reasons explained above, we reverse the district
court’s ruling with respect to Harvard’s 1996 payments to its
49
pension plans. On all other points, we affirm. We will
remand this matter to the district court to recalculate the
amount of refund due to the Trust in accordance with this
opinion.
50