TEI urges retention of the LIFO inventory method.

On June 9, 2006, Tax Executives Institute President Michael P. Boyle submitted the following letter to Senators Charles Grassley and Max Baucus, Chair and Ranking Member of the Senate Finance Committee, respectively, urging retention of the LIFO method of accounting.

On behalf of Tax Executives Institute (TEI), I am writing to urge that the Last-In, First-Out (LIFO) inventory accounting method be retained as part of the Internal Revenue Code. A proposal to repeal the LIFO method was included in proposed legislation entitled the Gas Price Relief and Rebate Act of 2006, but was subsequently withdrawn in order to afford Congress additional time to study the LIFO method's utility and purposes. As the preeminent global association of in-house business tax professionals, the Institute believes that repealing the LIFO method--which the Code has permitted for nearly seven decades--would adversely affect many business taxpayers by increasing their tax bills, potentially leading to a significant loss of U.S.-based jobs.

Tax Executives Institute is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the costs and burdens of administration and compliance to the benefit of taxpayers and government alike. TEI's 6,000 members represent 2,800 of the leading companies in the United States, Canada, Europe, and Asia. The Institute is committed to maintaining a system that works--one that builds upon the principle of voluntary compliance and is consistent with sound tax policy, one that taxpayers can comply with, and one in which the IRS can effectively perform its audit function without unduly burdening taxpayers.

Stated simply, TEI believes the inclusion of the LIFO repeal proposal in the Gas Price Relief and Rebate Act was misguided. The objective of the LIFO accounting method is to permit taxpayers to properly match their current sales revenues with the current replacement costs and thereby compute--and pay taxes on--a meaningful gross profit amount. Under LIFO, changing prices for various components of manufactured or purchased inventory are reflected immediately in the cost of goods sold rather than being capitalized in inventory. As a result, in a period of rising prices, the LIFO method tempers the distortive effect of inflation on the taxpayer's reported profits. Under the LIFO method, U.S. businesses are able to recoup more quickly the rapid increases in the replacement cost of the products they manufacture or purchase. (1)

The LIFO accounting method for inventories was first permitted in the Revenue Act of 1938 and was quickly extended to all taxpayers in the Internal Revenue Code of 1939. Section 472 of the Code continues to the current day --without material change--the 1939 codification of the LIFO method. Because of its longstanding acceptance, the LIFO method is widely used by many taxpayers, including large and small businesses, public and private, alike. Indeed, the LIFO method is likely the predominant method of accounting in industries that carry inventories of goods, especially those engaged in manufacturing, mining, wholesaling, retailing, distribution, and energy production.

Repeal of the LIFO method would increase the tax bills of many U.S. companies in two ways. First, the accumulated LIFO reserve--the difference between the dollar value of the inventory under the First-In, First Out (FIFO) accounting method and the dollar value of the LIFO-based inventory--would be subject to tax on a one-time basis. Absent a special transition rule, the LIFO reserve would be included in income and either taxed immediately or over the four-year period set by the IRS for changes in accounting method. In addition, on a prospective basis, because taxpayers would no longer be able to match current replacement costs with current revenues, they would be taxed on the appreciation in the value of their inventory investments. (2)

Second, the cash that affected companies would pay in higher taxes on the recapture of the LIFO reserve or on ongoing operations under the FIFO method would not be available to replenish the inventory sold. In order to maintain the same level of physical inventory, companies would be compelled to borrow additional money to pay the higher replacement cost. The increased debt loads to finance the higher tax bills and the higher cost of inventory would adversely affect the financial condition and competitiveness of U.S. businesses.

TEI fails to see what tax policy goal would be served by repealing the LIFO method of accounting. For nearly 70 years, the LIFO method has provided for the proper matching of revenues and expenses in the computation of the cost of goods sold and taxable profits, especially in periods of rising prices. Moreover, taxpayers may only use the LIFO method if their financial accounting treatment of inventory conforms with their tax accounting method. Because of the Internal Revenue Code's consistency requirement, the use of the LIFO method for tax purposes promotes transparency in reported book and tax gross profits. (3)

Before repealing LIFO, the Committee should carefully weigh whether such action should be considered outside the context of fundamental tax reform, where substantially reduced corporate tax rates or other broad-based changes in the U.S. corporate tax policy are considered. Only by considering these larger issues can the Committee ensure that U.S. tax system--and U.S.-based businesses--remain competitive. Raising the taxes of a significant segment of the U.S. economy--LIFO users--without considering the anti-competitive effects of LIFO's repeal on those businesses is short-sighted and may produce unintended consequences that are far greater than the immediate tax revenues obtained.

For these reasons, TEI urges the Committee on Finance to affirm the utility and purposes of the LIFO method.

If you have any questions about TEI's position on the LIFO method of accounting please feel free to contact TEI's Executive Director, Timothy J. McCormally, or Chief Tax Counsel, Eli J. Dicker, at 202.638.5601. TEI would be pleased to serve as an information resource for the Committee in respect of the LIFO method of accounting and would be willing to participate in any hearings that the Committee might hold on the subject.

1. Conversely, in a period of declining prices or inventory levels, the LIFO method will produce higher taxable profits. Taxpayers who elect the LIFO method must accept this risk as a consequence of their election.

2. In a period of rising prices, the difference between the taxpayer's original inventory acquisition costs (i.e., its beginning of the year inventory) and the replacement goods purchased during the year is subject to tax in the current year because the increased purchase cost is capitalized in inventory rather than deducted as part of the cost of goods sold.

3. While LIFO is not widely accepted as a financial accounting method outside of the United States, a number of the U.S.'s major trading partners (e.g., Japan Korea, Germany, Belgium, the Netherlands, and Spain) do accept LIFO for tax or financial reporting purposes.