Percentage-of-completion method does not apply to long-term warranty of state highway, appeals court holds

The U.S. Court of Appeals for the Tenth Circuit on April 27 held that a company was not entitled to use the percentage-of-completion method (PCM) under section 460 to report $62 million in income received from a state for warranting that a state highway would meet certain performance standards over a specified period of time (Koch Industries Inc. v. United States, No. 08-3347 (10th Cir. Apr. 27, 2010)).

A Koch subsidiary entered into an agreement in 1998 with the state of New Mexico to expand (construct) a particular stretch of roadway and to undertake continuing rehabilitation work (maintenance) for approximately 20 years to keep the roadway in high performance. This life-cycle approach to road construction and maintenance was new, and the subsidiary planned to use a new polymer-modified asphalt that was more expensive than regular asphalt but was anticipated to last longer. The agreement contained language regarding "warranties" for the pavement and structures (e.g., bridges), and provided for payment of $46.7 million for the construction phase and $62 million for the rehabilitation "warranty" obligations.

In this case, the parties disputed whether Koch was entitled to use the PCM for the $62 million received under the "warranty" portions of the agreement. The central argument was over whether Koch's obligations were warranties, making PCM treatment unavailable. The district court ruled in favor of Koch, distinguishing these "rehabilitation warranties" from the traditional warranties that are excluded from PCM treatment by Treasury reg. section 1.460-1(d)(2).

In reversing the lower court, the Tenth Circuit reasoned that the method applies only if "manufacture, building, installation, or construction is necessary for the taxpayer's contractual obligations to be fulfilled" and that the method "cannot be used to defer tax on income received under a guaranty, warranty, or maintenance agreement." The appeals court noted that the regulation permits some non-long-term contract activity to be accounted for under the PCM if "incident to or necessary for" the completion of a long-term project, but concluded that the regulation forecloses any application of that exception to warranties.

The appeals court noted that "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." Because of the uncertainty regarding what specific long-term construction work would be required, the court concluded that the warranties were not long-term contracts within the meaning of section 460.