since it is but the agent of the patron.13 The validity of the exclusion of the patronage refund from cooperative income is disputed in terms of its appropriate characterization as a price adjustment, a distribution of profits, or the discharge of a debt.14

In this paper the issue is narrowed to a determination of whether, in terms aside from structure and distributive function, the characterization of money-flows, that is of receipts and disbursements in the hands of the cooperative, differs materially from those of the proprietary corporation. Some comparison of structural and functional elements noted earlier is relevant, but they are ancillary to the underlying economic characterization of the receipts and the distributions of the cooperative.

To focus sharply on the differences, if any, in the characteristics of the money receipts and distributions of the cooperative corporation as contrasted with the proprietary corporation, a hypothetical model is useful. In the comparison which follows the former will be referred to as the cooperative; the latter will be termed the ordinary corporation. Tentative conclusions derived from such comparison can be evaluated as the more limiting assumptions of the model are withdrawn. A marketing cooperative is assumed for the model; by a parity of reasoning the conclusions would be valid for a purchasing cooperative.

The thesis which the comparative models will test is that there is at least analytically, a distinctive characteristic of cooperative moneyflows. This is a determination drawn from the economic context of the receipts. In this framework the receipts of the cooperative are distinguished from those of the ordinary corporation by the characterization of a return from the economies of service, while the ordinary corporation's receipts are viewed basically as a return from invested capital. This distinction, if valid, is the lynch-pin of the central question in cooperative taxation. As one commentator has put it:

The patronage refund is not income but merely a return of an overcharge, so long as it represents economies in operation rather than a return on invested capital. By the same line of reasoning, it is not taxable income so far as the cooperative is concerned.15

For purposes of testing the validity of this hypothesis, assume that there are two new firms competing in the same market. These are alike in all respects except that the one is organized by primary crop producers under local law as an agricultural (stock) marketing cooperative; the other is also a creature of local law, but it is organized as an ordinary business corporation to sell agricultural produce. There are no nonmember patrons of the cooperative. The cooperative shares are sold at par value and bear the customary restrictions as to rate of dividends to be paid. There are in total 1,000 patron members. The ordinary corporation has authorized and issued 1,000 shares of common stock at par value which are held in unequal amounts by 800

13 Nourse, The Legal Status of Agricultural Cooperation 30 (1927); Mather, "Handbook on Major Regional Cooperatives Handling Farm Supplies 1956 and 1957,' Department of Agriculture, Farmer Co-op Service (1959); Nieman, "Multiple Contractual Aspects of Cooperatives' Bylaws," 39 Minnesota Law Review 135, 139 (1955).

14 Ravenscroft, op. cit. infra, note 42 at 155 ff. Dunsdon, Marcovich, and Ugent, "Economic and Legal Aspects of Pooling by Cooperative Associations," 1954 Wisconsin Law Review 686; "An Introduction to Cooperative Practice," International Labour Office, N.S. 32, 8 (1952).

15 Due, Government Finance, Rev. Ed., 248 (1959).

shareholders. The cooperative shares are restricted in voting rights to one vote only per member and each member is required to execute a marketing agreement. Both the cooperative and the corporation rent office and warehouse space; each owns some transportation equipment. Each has a manager and clerical personnel. All sales of agricultural produce in which both are engaged (and each has an equal share of the market) take place in October, and all accounts relating to such sales are settled among all parties by the end of November. The corporation purchases produce outright for cash or on short-term credit; the cooperative takes produce from producer-member-patrons under a typical marketing agreement which provides payment of advances and patronage refunds. The revenue from the sale of the agricultural produce is the only source of revenue for both firms.

In the first comparison, assume that the two entities operate precisely in the same fashion. Everything is identical even to the payment by the corporation of patronage dividends based on amount of business transacted. This comparison suggests identity between the money receipts of the two entities. The tax liability of the two entities would be substantially the same.16 But this is an unstable and unrealistic position for the corporation. If it operated this way during the first period, it is certain that some shareholders who were not participating in the services of the cooperative but who had substantial shareholdings would agitate for a change in the policy of the corporation requiring it to provide a return on their equity holdings. It is at the point of pressure for change of policy of the ordinary corporation that the distinction between the two emerges. This is not, however, a distinction by terms of structure. The legal incidents of the stock certificates imply investment in both cases. Both the cooperative and the ordinary corporation have exchanged shares of stock for the necessary liquid assets required to operate.

The circumstances of this capital in the two firms is different. Quantitatively, the capital of the cooperative may be identical with that of the ordinary corporation. It would, however, reflect a different dispersion of shareownership and thus a different basis of contribution to capital insofar as the cooperative statutes of many States limit stockownership to one share per member. The cooperative is limited as to dividends which it may pay. There is also a different distribution of power within the two corporate structures to the extent that local law usually restricts the voting power of the cooperative shareholder to one vote.

The basic characterization of an investor is more fittingly applied to the shareholder of the ordinary corporation. In the ordinary corporation, the sale of a share or shares of stock is a transaction wherein

16 There is some uncertainty concerning the treatment of a patronage refund as a deduction within the meaning of I.R.C. 1954, sec. 162(a) by a proprietary_corporation. There is, however, some_authority for this position. See statement by A. Lee Wiggins, Under Secretary of the Treasury, hearings, House Committee on Ways and Means, 80th Cong., 1st sess. 1881 (1947): "Under present law, farm cooperative associations are authorized to exclude patronage refunds from gross income. This, however, is not the exclusive privilege of cooperative associations. The privilege is available to any corporation which makes payments to its customers under the conditions prescribed by the Commissioner *** and the courts."

See Railway Express Agency, Inc. v. Commissioner, 169 F. 2d 193 (2d Cir. 1948), cert. den., 336 U.S. 944 (1949); Uniform Printing and Supply Co. v. Commissioner, 88 F. 2d 75 (7th Cir. 1937). The treatment of a patronage refund under section 522 is not a deduction in the statutory sense, but is rather an exclusion. See I.T. 3208, 1938-2, Cum. Bull. 127.

the stock certificate becomes the primary link of the shareholder with the corporation both for purposes of voting and for purposes of participation in the distribution of earnings. In the cooperative, transactions take place between the patrons and the cooperative on the one hand, and the cooperative and outside persons on the other. In the corporation there are many shareholders whose only transactions with the corporation are in the distribution of earnings.

It is otherwise with the cooperative. The share of stock in this case is but a prerequisite to membership in the stock cooperative, serving neither to allocate voting power nor to count participation in the distribution of net revenue. As for the distribution of net revenue, it is a function of the underlying marketing agreement—an instrument which the bylaws of many stock cooperatives require each member to sign as a condition of membership.

Moreover, the parameters of action which are open to the managemen of the cooperative and accordingly the function of the cooperative are different. In the cooperative, unlike the corporation, it is necessary to turn to the group as a whole rather than to majority stockholders where issues requiring shareholder approval are raised. In the cooperative, the contract governing the marketing of produce, the marketing agreement, limits the area of open decision to those regarding the performance of the stated service-the marketing of goods. The binding terms of the marketing agreement epitomize the function of the cooperative. This agreement delineates the essential features of service and the relationship of a closed transaction which distinguishes the cooperative. The goal reflected in the basic statutes empowering cooperatives, their bylaws, and the typical marketing agreement is the performance of certain services relating to the marketing of the produce. The marketing agreement links the patron to the cooperative service in a closed transaction.

Tentative conclusions

If this functional, economic distinction is valid within the restrictive assumptions of the hypothetical example, it remains to be shown that it has any meaning when these are removed. Specifically, if the assumption of the 2-month period of sale and distribution of net revenues is removed, is it still appropriate to treat the patronage refund as a price adjustment where a calendar year elapses between the commitment of goods for sale and the final return of the patronage fund? This longer time interval does not disturb the basic characterization. The basic concept of an accounting period is accepted by the Revenue Code and would apply for this period." Moreover, there is precedent for this view in the tax treatment of gain on the purchase of foreign currency.1

18

The closed transaction similar in nature to the cooperative refund is recognized by the code in connection with gain on the purchase of foreign currency. The foreign currency problem involves two transactions by a U.S. taxpayer-the purchase of goods to be paid for in foreign currency and the purchase of the foreign currency to pay for the goods. The character of the taxable gain arises from a devalua

17 I.R.C., sec. 441 (1954).

18 Kades, "Devaluation Revalued," 28 Taxes 365 (1950); Roberts, "Borrowing in Foreign Currencies." 26 Taxes 1033 (1948).

tion in the foreign currency as against the dollar in the interim between the contraction of the debt and its payment. If this gain is from the independent transaction of speculation or invetsment in foreign currency it is like the sale or exchange of a capital asset, but if it arises from the closed transaction of purchasing goods, it is in the nature of a single transaction in which the sole characteristic is that an existing debt is satisfied at a saving in a related transaction involving foreign currency, which takes ordinary income treatment. Aside from the troublesome Kerbaugh-Empire case,19 the courts have had little difficulty in characterizing the transaction of purchase of the foreign currency which gives rise to the gain, as a transaction integral to the purchase of the goods. As the Tax Court has recently stated in this connection:

While the events here may be viewed as two separate transactions, they certainly are not unrelated."

Moreover, the unity of the related transactions has been recognized over substantial time intervals. In most cases these related transactions take place within the same tax year, but the relationship has been judicially recognized over longer periods.21 Thus the consistent position of the Treasury in viewing patronage refunds as price adjustments is grounded in the characterization of the refund as a part of a related or closed transaction.22 A patronage refund is not excludable from the gross income of a cooperative unless paid under a preexisting agreement even though it was computed on the basis of patronage.2

23

When further steps in relaxing the limiting assumptions of the model are taken, the criterion begins to fail. By exchanging the model of a new and small marketing cooperative for a long-established federated cooperative engaged in marketing, purchasing, processing, and service operations both directly and through controlled subsidiaries, the basic distinction between the receipts of a cooperative and those of an ordinary corporation become blurred. 24

It is to be noted that the present reference to a larger cooperative business unit does not introduce size as a variable in the analysis. There may, over a range, be a rough correlation between size and the subservience of the service function to the investment function. The service function remains the basic criterion. It is only that in taking the largest federated unit, where cooperatives themselves become patrons and where manufacturing operations are present, that the opportunity for investment activities emerges.

Clearly, some degree of investment is present in every cooperative operation. Were it not for the profit motive and freedom of contract, the organization of the cooperative would not come about. The distinction is one of degree in that where the service function is the predominant feature, investment is de minimis. Recognition of this lim

19 Bowers v. Kerbaugh-Empire Co., 271 U.S. 170 (1926).

20 America-Southeast Asia Co., Inc. v. Commissioner, 26 T.C. 198, 200 (1956).

21 Church's English Shoes, Ltd. v. Commissioner, 24 T.C. 56 (1955), aff'd per curiam, 229 F.2d 957 (2d Cir. 1956).

23 Rev. Rul. 54-10, 1954-1. Cum. Bull. 24. A historical summary of this position is given by the General Counsel of the Treasury in hearings before House Committee on Ways and Means, 82d Cong., 1st sess., pp. 2858-2859 (1951). See Farmers Cooperative Company v. Birmingham, 86 F. Supp. 201, 228 (N.D. Iowa 1949).

23 Treasury Regulations, sec. 1.522-3 (1) (1958).

24 See supra, note 15.

itation on investment is manifested in the provision of local cooperative statutes restricting the percentage of dividends which may be paid.25 For the cooperative now postulated as an alternative to the model, there would necessarily be substantial capital holdings. And where such capital is directly invested, as in the capital stock of a subsidiary engaged in oil production property where the subsidiary operates a pipeline, this function will give rise to receipts in the hands of the cooperative which would not be related to the service function in the same degree as in the model. Such a cooperative may simultaneously be operating in a service capacity, but now its receipts would bear the characteristics both of the service and of the investment activities. It is in this situation that the basic criteria encounter difficulty in identifying the separate elements. As Due has noted

*** the earnings of the cooperative from invested capital and the payments of these to the members are certainly income in the usual concept of the term. The difficulty arises, however, in distinguishing those elements from the ones which represent economies in operation.

26

This difficulty of distinguishing between the two categories of receipts when they are intermingled within the same cooperative unit does not deprive the basic distinction of its meaning. By serving to isolate the basic economic function of the cooperative in the context of its legal elements, the model provides a characterization of moneyflows which will support conclusions as to their taxation. The basic utility of this functional distinction is that it isolates the underlying process in terms of which an arrangement of statutory and regulatory provisions may be ordered to establish a workable distinction between the two categories of receipts. If one grants the validity of the basic distinction, it serves to clarify the question of erosion of the tax base in connection with cooperative taxation. It would, for example, seem unwise to embrace legislative proposals such as the Mason bill which would obliterate all distinctions in taxation between a cooperative and an ordinary corporation.27 Such a proposal is grounded in the view that the present tax treatment of cooperatives is unwarranted. However, in terms of the characterization of cooperative money-flows derived from the model, the present distinctions which the code makes for cooperatives is congruent with the nature of the receipts and is, therefore, warranted. This is not to say that the present code provisions are entirely adequate; this question is the subject of part II. It is rather to conclude that a distinction of the general nature of the present code provisions is warranted, subject to the modifications noted in part II below.

Moreover, the characterization of the model serves as a guide to clarification of such provisions. If the goal of tax policy for cooperatives is to be the recognition of economies of operation and service, then the remaining problems are definitional ones. It becomes necessary to transpose the criteria of the functions of operation and service into workable statutory and regulatory provisions to isolate the re

25 Hulbert and Mischler, op. cit., supra, note 9 at pp. 315-316.

26 Due, op. cit., supra, note 15.

27 H.R. 199, 86th Cong., 1st sess. (1959). H.R. 3848, 86th Cong., 1st sess. (1959) would tax cooperative corporations on total earnings while allowing the patron a tax credit against his individual taxes. H.R. 199 would repeal the present secs. 521 and 522 and deny any exclusion on account of patronage refunds.