Koch Industries, Inc. v. United States

FILED
United States Court of Appeals
Tenth Circuit

April 27, 2010
PUBLISH Elisabeth A. Shumaker
Clerk of Court
UNITED STATES COURT OF APPEALS

TENTH CIRCUIT

KOCH INDUSTRIES, INC. AND
SUBSIDIARIES,

Plaintiff - Appellee,
v. No. 08-3347
UNITED STATES OF AMERICA,

Defendant - Appellant.

APPEAL FROM THE UNITED STATES DISTRICT COURT
FOR THE DISTRICT OF KANSAS
(D.C. NO. 6:06-CV-01049-JTM-KMH)

Ellen Page DelSole, Attorney, Tax Division, Department of Justice (Lanny
Welch, of Counsel, United States Attorney; Marietta Parker, of Counsel, Acting
United States Attorney; John A. DiCicco, Acting Assistant Attorney General;
Richard Farber, Attorney, Tax Division, Department of Justice; with her on the
briefs), Washington, D.C., for Defendant-Appellant.

Matthew D. Lerner, Steptoe & Johnson LLP, Washington D.C. (Lisa M. Zarlenga,
Steptoe & Johnson LLP, Washington, D.C., and James M. Armstrong, Foulston
Siefkin LLP-Wichita, Wichita, Kansas, with him on the brief), for Plaintiff-
Appellee.

Before LUCERO, SEYMOUR, and MURPHY, Circuit Judges.

MURPHY, Circuit Judge.
I. Introduction

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).

II. Background

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

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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 breakeven 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

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governed by two contracts: (1) a “Pavement Warranty,” that required Koch to

perform all work necessary to assure performance of the pavement 1; and (2) a

“Structures Warranty,” that required Koch to perform all work necessary to assure

performance of the structures (bridges, drainage, and erosion structures). 2 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

1
The Pavement Warranty states:

PDC warrants that during the term of this Warranty the Pavement
shall meet the Pavement Performance Criteria. If at any time during
the term of this Warranty any portion of the Pavement described in
the Pavement Performance Criteria shall fail to meet the applicable
Pavement Performance Criteria, PDC, shall Repair or Replace the
Pavement to the extent necessary to cause such portion of the
Pavement to meet the Pavement Performance Criteria.
2
The Structures Warranty states:

PDC warrants that during the term of this Warranty the Structures
shall meet the Structures Performance Criteria. If at any time during
the term of this Warranty any of the Structures shall fail to meet the
Structures Performance Criteria, PDC shall Repair or Replace the
Structure to the extent necessary to cause it to meet the Structure
Performance Criteria.

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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. 3 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. 4 The Structures Warranty provided up to a 11.5-year

warranty term. 5 The minimum specifications listed in the Structures Warranty

3
The exact term of pavement warranty was dependant on SH44’s rate of
completion and use. The warranty remained in effect until the earlier of: (1) 20
years after substantial completion of the last segment, (2) 21.5 years after
substantial completion of a particular segment, or (3) the end of the calendar year
in which the equivalent standard axle loads (ESALs) for a particular segment
reached or exceeded 4,000,000.
4
For example, Koch warranted that SH44’s smoothness, as measured
through the International Roughness Index (“IRI”) in meters per kilometer, would
be no worse than 1.25 m/km during the first period, 1.70 m/km during the second
period, 2.10 m/km during the third period, and 2.50 m/km during the final period.
IRI measures a standard vehicle’s accumulated suspension motion over a
particular section of road.
5
The structures warranty remained in effect until the earlier of: (1) 11.5
years after substantial completion of the first segment, or (2) the end of the
(continued...)

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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. 6 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

5
(...continued)
calendar year in which the ESALs for a particular segment reached or exceeded
2,000,000.
6
A total of $420,000,000 of federal funding was allotted to the project.

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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 percentage-of-completion method to report the $62 million payment it

received in consideration for extending the two warranties.

III. Analysis

Both parties moved for summary judgment on the issue of whether it was

appropriate for Koch to use the percentage-of-completion method set out in § 460

of the Internal Revenue Code (the “Code”) to report the $62 million received

under the warranty agreements. Summary judgment is appropriate “if the

pleadings, the discovery and disclosure materials on file, and any affidavits show

that there is no genuine issue as to any material fact and that the movant is

entitled to judgment as a matter of law.” Fed. R. Civ. P. 56(c). “When applying

this standard, we view the evidence and draw reasonable inferences therefrom in

the light most favorable to the nonmoving party.” Simms v. Oklahoma ex rel.

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Dep’t of Mental Health & Substance Abuse Servs., 165 F.3d 1321, 1326 (10th Cir.

1999).

The interpretation of a federal statute, such as § 460, is a question of law

which this court reviews de novo. True Oil Co. v. Comm’r, 170 F.3d 1294, 1298

(10th Cir. 1999). Furthermore, “[b]ecause Congress has delegated to the

Commissioner the power to promulgate ‘all needful rules and regulations for the

enforcement of [the Internal Revenue Code],’ 26 U.S.C. § 7805(a), we must defer

to his regulatory interpretations of the Code so long as they are reasonable.”

Cottage Sav. Ass’n v. Comm’r, 499 U.S. 554, 560-61 (1991). As with all

regulations, the Code’s implementing regulations “must be interpreted so as to

harmonize with and further and not to conflict with the objective of the statute

[they] implement[].” Joy Techs., Inc. v Sec’y of Labor, 99 F.3d 991, 996 (10th

Cir. 1996) (quotations omitted); see also Emery Mining Corp. v. Sec’y of Labor,

744 F.2d 1411, 1414 (10th Cir. 1984) (“[W]here there is an interpretation of an

ambiguous regulation which is reasonable and consistent with the statute, that

interpretation is to be preferred.” (quotation omitted)). Furthermore, absent a

statutory definition, words are to be given “their ordinary, contemporary, common

meaning at the time Congress enacted the statute.” Hackwell v. United States,

491 F.3d 1229, 1236 (10th Cir. 2007) (quotation omitted); see also Robinson v.

Shell Oil Co., 519 U.S. 337, 341 (1997) (“The plainness or ambiguity of statutory

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language is determined by reference to the language itself, the specific context in

which that language is used, and the broader context of the statute as a whole.”).

Section 451 of the Code generally requires that “any item of gross income

shall be included in the gross income of a taxpayer for the tax year in which the

item is received by the taxpayer, unless, under the accounting method used by the

taxpayer in computing taxable income, the item is properly accounted for as of a

different period.” 26 U.S.C. § 451; see also INDOPCO, Inc. v. Comm’r, 503 U.S.

79, 84 (1992) (stating generally that “the Code endeavors to match expenses with

the revenues of the taxable period to which they are properly attributable, thereby

resulting in a more accurate calculation of net income for tax purposes”). Thus,

unless there is an applicable statutory exception, an accrual method taxpayer who

receives an advance payment must include that payment in gross income at the

time of receipt. See, e.g., Auto. Club of Michigan v. Comm’r, 353 U.S. 180, 188-

90 (1975); Schulde v. Comm’r, 372 U.S. 128, 130-37 (1963); Am. Auto. Ass’n v.

United States, 367 U.S. 687, 691-92 (1961).

Section 460 of the Code provides such an exception, allowing the taxable

income from a long-term contract to be determined under the percentage-of-

completion method. 26 U.S.C. § 460(a). Use of the percentage-of-completion

method to account for income from long-term construction projects is “in large

part justified by the difficulty in determining the net profitability of a

construction project because of fluctuating and unforeseen costs.” United States

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v. Howard, 855 F.2d 832, 836 (11th Cir. 1988) (referring to the “completed

contract method” of long-term contract income deferral); see also Rev. Rul. 70-

67, 1970-1 C.B. 117 (stating price fluctuations, strikes, and unexpected

construction difficulties often “make[] it impossible for any construction

contractor, no matter how carefully he may estimate, to tell with any certainty

whether he has derived a gain or sustained a loss until a particular contract is

completed”). Nevertheless, it is well established that deferral provisions, such as

§ 460, are to be construed strictly. See, e.g., Estate of Bell v. Comm’r, 928 F.2d

901, 903 (9th Cir. 1991) (holding the deferral benefits of 26 U.S.C. § 6166 are “a

matter of legislative grace” and to be strictly and narrowly construed); Elam v.

Comm’r, 477 F.2d 1333, 1335 (6th Cir. 1973) (relying on the “well settled

principle that statutes granting tax exemptions or deferments must be strictly

construed”); see also Comm’r v. Jacobson, 336 U.S. 28, 49 (1949) (stating that

tax exemptions “are specifically stated and should be construed with restraint”);

Helvering v. Nw. Steel Rolling Mills, Inc., 311 U.S. 46, 49 (1940) (“[P]rovisions

granting special tax exemptions are to be strictly construed.”).

Under § 460, the term “long-term contract” is defined as “any contract for

the manufacture, building, installation, or construction of property if such

contract is not completed within the taxable year in which such contract is entered

into.” 26 U.S.C. § 460(f)(1). The Treasury Regulations emphasize that “[l]ong-

term contract methods of accounting apply only to the gross receipts and costs

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attributable to long-term contract activities.” 26 C.F.R. § 1.460-1(d)(1). 7 The

Regulations also clarify that “[a] contract is for the manufacture, building,

installation, or construction of property if the manufacture, building, installation,

or construction of property is necessary for the taxpayer’s contractual obligations

to be fulfilled and if the manufacture, building, installation, or construction of

that property has not been completed when the parties enter into the contract.”

Id. § 1.460-1(b)(2)(i) (emphasis added). In addition, the Regulations state a

party’s retention of title to and risk of loss with respect to the subject matter, as

well as the parties’ characterization of their agreement, is not relevant to the

classification of a contract under § 460. Id.

Income not attributable to long-term contract activities “generally must be

taken into account using a permissible method of accounting other than a long-

term contract method.” Id. § 1.460-1(d)(1). An exception, however, exists for

non-long-term contract activities “incident to or necessary for” the completion of

a long-term contract. Id. Examples of such non-long-term activities provided by

the Regulations include “the provision of architectural, design, engineering, and

construction management services, and the development or implementation of

7
26 C.F.R. § 1.451-3 (as amended in 1992) governs this case because 26
C.F.R. § 1.460-1 (2001), the current regulation, became effective after the
agreements at issue here were executed. The parties and court below cited the
current version of the regulations, and the difference is immaterial because the
current and former regulations contain essentially the same language limiting use
of the percentage-of-completion method.

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computer software.” Id. § 1.460-1(d)(2). The Regulations, however, have long

made clear that “performance under a guaranty, warranty, or maintenance

agreement is a non-long-term contract activity that is never incident to or

necessary for the manufacture or construction of property under a long-term

contract. Id.; see also 26 C.F.R. § 1.451-3(a)(3) (1986) (providing that “costs

incurred with respect to any guarantee, warranty, maintenance, or other service

agreement relating to the subject matter of such contracts, shall be accounted for

under a proper method of accounting” other than long-term contract methods); id.

§ 1.451-3(d)(7) (1986) (providing that costs properly allocable to a long-term

contract “do not include costs incurred with respect to any guarantee, warranty,

maintenance or other service agreement relating to the subject matter of the long-

term contract.”).

Under the undisputed facts of this case, neither the Pavement Warranty nor

the Structures Warranty are long-term contracts under § 460. To be classified as

a long-term contract, “manufacture, building, installation, or construction of

property [must be] necessary for the taxpayer’s contractual obligations to be

fulfilled.” Id. § 1.460-1(b)(2)(i). Thus, a long-term construction contract

necessarily entails a fixed and definite obligation on the part of the contractor to

provide specified construction services. To be sure, § 460 is directed toward

mitigating uncertainties inherent in long-term construction work. See, e.g.,

Howard, 855 F.2d at 836 (referring to the fluctuating and unforeseen costs of

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performing construction work); Rev. Rul. 70-67, 1970-1 C.B. 117 (highlighting

price fluctuations, strikes, and unexpected construction difficulties as relevant

uncertainties). Section 460, however, is not directed toward mitigating all

construction-related uncertainties, such as the lack of certainty arising as the

result of a party’s decision to enter into a contract creating a contingent obligation

to perform long-term construction work.

Neither warranty agreement required Koch to perform “manufacture,

building, installation, or construction” to fulfill its contractual obligations.

Rather, both warranties included detailed performance standards which SH44’s

pavement and structures were required to meet, many of which were lowered with

the passage of time. Although it was virtually certain that some work would be

performed at some point during the warranty period, 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. 8 Indeed, the contracts explicitly stated that Koch is not obligated “to

spend any sums under the Agreement or Warranty” and emphasized that the terms

8
Koch touted the low maintenance costs of it’s Performance Road concept,
claiming “[a] Performance Road would spend more on initial construction but
would incur far less maintenance and reconstruction expense leading to lower life
cycle costs.” Koch recognized that the “breakeven point” between a conventional
road and a Performance Road “occur[red] around year 12” of the road’s life cycle,
and that it was therefore necessary for “the warranty period typically . . . to
exceed 14 years.”

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and conditions of the Corridor Agreement, Pavement Warranty, and Structure

Warranty were to govern the parties’ obligations during the rehabilitation phase.

Prior to entering into the warranties, Koch created preliminary financial

models in an effort to assess their profitability. According to one of its managers,

Koch’s liabilities under the warranties depended on “the ultimate pavement

design, the ultimate quality of construction, the ultimate quality of the materials

used, the traffic and loading of that traffic and the weather conditions.” Koch

forecasted it would spend between $17,493,180 and $94,010,183 to fulfill its

obligations under the warranties. However, Koch’s manager testified these

projections were based on “future events that cannot be predicted.” The

undisputed facts demonstrate there was a lack of certainty regarding what specific

long-term construction work, if any, would be necessary to fulfill Koch’s

obligations under the warranties. As a result, the warranties are not “long-term

contracts” for the purpose of § 460 of the Code.

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 While not directly at issue, 9 26 C.F.R. § 1.460-1(d) is nevertheless helpful

to the analysis of whether the Pavement and Structures Warranties are eligible for

income deferral under § 460. Indeed, § 1.460-1(d)(2) is the only portion of the

Regulations which defines “non long-term contract activity” and expressly

addresses whether warranties are within the scope of § 460. Section 1.460-

1(d)(2) provides:

Non-long-term contract activity means the performance of an activity
other than manufacturing, building, installation, or construction, such
as the provision of architectural, design, engineering, and
construction management services, and the development or
implementation of computer software. In addition, performance
under a guaranty, warranty, or maintenance agreement is a non-long-
term contract activity that is never incident to or necessary for the
manufacture or construction of property under a long-term contract.

Id. The regulation’s statement that “performance under a guaranty, warranty, or

maintenance agreement is a non-long-term contract activity” applies beyond the

context of activities incident to or necessary for the completion of a long-term

contract and forecloses warranty income from long-term contract treatment under

9
Section § 1.460-1(d) provides an exception allowing long-term contract
methods to be used to account for non-long-term activities which are “incident to
or necessary for” the completion of a long-term contract. In briefing the question
of whether the warranties at issue are stand-alone long-term contracts, Koch
emphasized it was not claiming the warranties were “incident to or necessary for”
the completion of the underlying contract for the construction of SH44.
Nevertheless, discussion of § 1.460-1(d)(2) is relevant because the section
indicates not only that a warranty can never be incident to or necessary for the
completion of a long-term contract, but also that “performance under a guaranty,
warranty, or maintenance agreement is a non-long-term contract activity.” 26
C.F.R. § 1.460-1(d)(2).

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§ 460. Under the undisputed facts in this case, the two contracts at issue fall

within the scope of the term warranty as used in § 1.460-1(d)(2) and are therefore

not eligible for income deferral under § 460.

Although the Regulations do not define the terms “guaranty, warranty, or

maintenance agreement,” this phrase must be interpreted to harmonize with the

objectives of § 460. Joy Techs., 99 F.3d at 996. In addition, any ambiguity in the

terms “guaranty, warranty, or maintenance agreement” should not be construed to

expand the scope of the deferral provision. See Estate of Bell, 928 F.2d at 903;

Elam, 477 F.2d at 1335. In light of these rules of construction, the contracts at

issue fall within the scope of the terms “guaranty, warranty, or maintenance

agreement,” regardless of whether they are classified as performance warranties,

service contracts, or maintenance agreements.

That the warranties may have been separately negotiated and executed,

involved a lengthy warranty period, were expensive, could require Koch to

perform work regardless of whether the road was defective, and involved a virtual

certainty that some warranty work would be performed does not foreclose them

from being within the scope of the terms “guaranty, warranty, or maintenance

agreement.” In its modern usage, the term warranty is not limited to warranties

against manufacturing defects. Rather, it extends to warranties for future

performance that guarantee a product will perform at a certain level for a stated

period of time. See, e.g., Liberty Lincoln-Mercury, Inc. v. Ford Motor Co., 171

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F.3d 818, 823 (3d Cir. 1999) (noting an agreement “to perform maintenance or

repair (or both) service on a consumer product for a specified duration” are a

“subspecies of warranty”). Cf. 18 R ICHARD A. L ORD , W ILLISTON ON C ONTRACTS

§§ 52:45, 52:46 (4th ed. 2004 & Supp. 2009) (discussing generally express

warranties and warranties “as to future performance” under the Uniform

Commercial Code). Koch has cited no authority indicating that the

Commissioner, in promulgating Treasury Regulation § 1.460-1(d)(2) and its

predecessor § 1.451-3(a)(3), intended the scope of the term “warranty” to not

include such performance warranties. Reading such warranties as eligible for

long-term contract treatment under § 460 would improperly expand the scope of

the income deferral provision. See Estate of Bell, 928 F.2d at 903; Elam, 477

F.2d at 1335.

In its agreements, Koch unmistakably warranted SH44’s pavement and

structures would meet certain criteria, and that it would repair or replace them to

the extent necessary to bring them into compliance with the agreed upon criteria.

Koch did not unconditionally obligate itself to perform any specific construction

services. Instead, it offered New Mexico a performance warranty covering its

work on SH44. Under the Regulations, this type of contingent activity is “a non-

long term contract activity that is never incident to or necessary for the

manufacture or construction of property under a long-term contract.” 26 C.F.R.

§ 1.460-1(d)(2). Accordingly, as a matter of law, the income Koch received in

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consideration of these agreements is ineligible for reporting under the percentage-

of-completion method of accounting.

Based on a review of the record, there are no disputes of material fact

relevant to either the question of whether the warranties are long term contracts

under § 460 or whether they fall within the scope of the terms “guaranty,

warranty, or maintenance agreement.” The district court erred in granting

summary judgment in favor of the taxpayer. Instead, summary judgment in favor

of the government is appropriate.

IV. Conclusion

For the foregoing reasons, the court holds that the undisputed facts

demonstrate Koch was not entitled to use the percentage-of-completion method of

accounting under 26 U.S.C. § 460 to report $62,000,000 in income it received

from the State of New Mexico for warranting that SH44 would meet certain

performance standards over a specified period of time. Accordingly, this court

REVERSES the district court’s decision to grant summary judgment in favor of

Koch, and REMANDS for entry of summary judgment in favor of the

government.

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