# IRS issues prop. Regs, on retail-inventory method.

Many department stores and large retailers use the retail-inventory method (RIM) as a way of determining the cost or lower of cost or market (LCM) value of inventory based on retail selling price and a cost-to-retail ratio, Regs. Sec. 1.471-8 defines the cost-to-retail ratio as the ratio of the value of the beginning inventory plus the cost of purchases to the retail selling price of the beginning inventory plus the initial retail selling prices of purchases, which may be illustrated by the formula in Exhibit 1.Exhibit 1: Cost-to-retail ratio

Value of beginning inventory + Cost of purchases

Retail selling price of beginning inventory + Initial retail selling prices of purchases

According to the IRS in Field Directive LMSB-04-0910-026, under Regs. Sec. 1.471-8, a taxpayer computes the value of ending inventory under RIM by multiplying a cost-complement ratio by the retail selling prices of goods on hand at the end of the tax year. Thus, reductions in the numerator of the cost-complement ratio and reductions in the retail selling price of ending inventory both have the effect of reducing the value of ending inventory.

Under Regs. Sec. 1.471-3(b), the cost of purchases during the year generally includes invoice price less trade or other discounts for inventory valuation purposes. A discount may be based on a retailer's sales volume (sales-based allowance) or on the quantity of merchandise a retailer purchases (volume-based allowance), or it may relate to a retailer's reduction in retail selling price (markdown allowance or margin protection payment) (preamble to REG425949-10).

The IRS has consistently taken the position that sales-based royalties and inventory allowances are components of the cost of inventory rather than ordinary deductions or income. The tax treatment of sales-based royalties was addressed in Robinson Knife, 600 F.3d 121 (2d Cir. 2010), rev'g T.C. Memo 2009-9, which revolved around the capitalization of such costs for purposes of Sec. 263A. The Tax Court held that royalties made to a third party for the use of a patent, which gave the taxpayer the right to manufacture the third party's branded kitchen tools, were capitalizable to inventory under Sec. 263A because the patents directly benefited the taxpayer's production activities. The Second Circuit disagreed with the Tax Court, holding that royalties calculated as a percentage of the selling price and incurred only upon the sale of the inventory were deductible as ordinary and necessary expenses under Sec. 162.

Following the Second Circuit's decision in Robinson Knife, the tax treatment of sales-based royalties and vendor allowances has been the subject of several actions and rulings by the IRS. These documents, including a nonacquiescence in the case in AOD 2011-01 (2/8/11), Field Directive LMSB-04-0910-026, Field Directive LB&I-4-0211-002, and proposed regulations under Sees. 263A and 471 (REG-149335-08), were issued to support the IRS position that sales-based royalties and vendor allowances are capitalizable or purchase price adjustments under Sees. 263 A and 471, rather than ordinary deductions or income. Even so, the preamble to the proposed regulations under Sees. 263A and 471 points out that the treatment of these items under the proposed regulations achieves a result similar to that of treating them as ordinary deductions or income.

So, why all the fuss? Perhaps one motivating factor has been to establish and clarify the treatment of sales-based vendor allowances under RIM. IRS Field Directive LMSB-04-0910-26 points out that certain taxpayers may be reducing the cost of purchases by vendor allowances while not making a corresponding adjustment to the retail sales price for such items for purposes of computing the cost-complement ratio under RIM.

The directive, issued September 24, 2010, indicates that Regs. Sec. 1.471-8 may be interpreted to allow this treatment and instructs examiners not to expend further resources challenging such treatment. Under Prop. Regs. Sec. 1.471-3(e), the amount of an allowance, discount, or price rebate a taxpayer earns by selling specific merchandise (a sales-based vendor allowance) reduces the cost of the merchandise sold and does not reduce the inventory cost or value of goods on hand at the end of the year. The preamble to the proposed regulations (preamble to REG-149335-08) under Sees. 263A and 471 states that, although these proposed regulations do not specifically amend Regs. Sec. 1.471-8 (see below for a discussion of proposed amendments to Reg. 1.471-8), Prop. Regs. Sees. 1.263A-1 and 1.471-3 preclude a taxpayer from including sales-based royalties or sales-based vendor allowances in the cost of merchandise purchased for purposes of computing the cost-complement ratio.

Discussion

Until now, the focus on sales-based royalties and vendor allowances has centered on the treatment of these items for purposes of the uniform capitalization rules and Sec. 471. Although RIM has been mentioned in some of the IRS guidance cited above, the tax treatment of vendor allowances has not been specifically dealt with as it relates to this method. On October 6, 2011, the IRS issued proposed regulations on RIM (REG-125949-10) that restructure and restate Regs. Sec. 1.471-8 in "plain language" and add rules regarding the treatment of margin protection payments and similar vendor allowances under RIM.

The proposed regulations state that the numerator of the cost complement may not be reduced by the amount of an allowance, discount, or price rebate a taxpayer earns by selling specific merchandise. A special rule for margin protection payments and similar allowances provides that a taxpayer may not reduce the numerator of the cost complement by the amount of an allowance, discount, or price rebate that is related to or intended to compensate for a permanent reduction in the taxpayer's retail selling price of inventory (margin protection payment or markdown allowance). The denominator of the cost complement excludes markdowns, and markups must be reduced by the markdown made to cancel or correct them. Therefore, the adjustment to inventory value related to permanent markups and markdowns is made solely by the adjustment to the retail selling price of ending inventory (preamble to REG-125949-10).

The IRS notes in the preamble to the proposed regulations that an alternative to this approach would be to permit taxpayers to reduce the numerator of the cost complement for all non-sales-based allowances, discounts, or price rebates, including mark-down allowances, but would also require a reduction in the denominator of the cost complement for all permanent markdowns related to markdown allowances. Comments are requested on whether the final regulations should provide this or other alternatives to computing LCM under RIM (preamble to REG-125949-10).

In addition, the proposed regulations clarify that neither the cost complement nor ending retail selling prices should be adjusted for temporary markdowns and markups. The proposed regulations would prevent taxpayers using RIM from using margin protection payments and similar vendor allowances to reduce the value of ending inventory by reducing the numerator of the cost complement and also by reducing the retail selling price of inventory on hand at the end of the year. The preamble states that the combination of both reductions (1) generally results in a lower ending inventory value for a retail-LCM method taxpayer than for a similarly situated FIFO taxpayer that values inventory at LCM, and (2) does not clearly reflect income (preamble to REG-125949-10).

The following examples, taken from Examples 1 and 2 of Prop. Regs. Sec. 1.471-8(e), help to illustrate these rules:

Example 1: R, a retail merchant who uses the retail method to approximate LCM, has no beginning inventory in 2011. R purchases 40 tables during 2011 for $60 each for a total of $2,400. R offers the tables for sale at $100 each for an aggregate retail selling price of $4,000. R does not sell any tables at a price of $100, so R permanently marks down the retail selling price of its tables to $90 each. As a result of the $10 markdown, R's supplier provides Ra$6 per table margin protection payment. R sells 25 tables during 2011 and has 15 tables in ending inventory at the end of 2011.

The numerator of the cost complement is the aggregate cost is the tables, which may not be reduced by the amount of the margin protection payment. The denominator of the cost complement is the aggregate of the bona fide retail selling prices of all the tables at the time acquired. R excludes the markdown from the denominator of the cost complement. Therefore, R's cost complement is $2,400 -r $4,000, or 60%. R includes the permanent mark-down in determining year-end retail selling prices. Therefore, the aggregate retail selling price of R's ending table inventory is $1,350 (15 x $90). Approximating LCM under the retail method, the value of R's ending table inventory is $810 (60% x $1,350), as illustrated in Exhibit 2.

Exhibit 2: Value of ending table inventory in Example 1 Cost Retail Cost Ending inventory complement -- RIM LCM Beginning $ 0 $ 0 Inventory Purchases 2,400 4,000 Total $2,400 $4,000 60% Sales (2,250) Permanent (400) markdowns Ending $1,350 $810 inventory

Example 2: Alternatively, assume that R permanently reduces the retail selling price of all 40 tables to $50 per unit, and the 15 tables on hand at the end of the year are marked for sale at that price. In contrast to the $10 mark-down, the additional $40 markdown is unrelated to a margin protection payment or other allowance.

R excludes the markdowns from the denominator of the cost complement. Therefore, R's cost complement is $2,400 / $4,000, or 60%. R includes the markdowns in determining year-end retail selling prices. Therefore, the aggregate retail selling price of R's ending inventory is $750 (15 x $50). Approximating LCM under the retail method, the value of R's ending inventory is $450 (60% x $750), which may be illustrated as shown in Exhibit 3.

Exhibit 3: Value of ending table inventory in Example 2 Cost Retail Cost Ending inventory complement --RIM LCM Beginning $ 0 $ 0 inventory Purchases 2.400 4.000 Total $2,400 $4,000 60% Sales (1,250) Permanent (2.000) markdowns Ending $ 750 $450 inventory

The regulations are proposed to apply for tax years beginning after the date they are published as final.

Conclusion

Taxpayers using RIM should review their calculations to determine if they are currently reducing both the numerator of the cost-complement ratio and the retail selling price of ending inventory for sales-based vendor allowances and related markdowns and, if so, consider an accounting method change to use the methodology set forth in the proposed regulations. Until the regulations are finalized, such a change would likely constitute an advance consent request, which would be required to be filed by the end of the year of change pursuant to Rev. Proc. 97-27.

From Roger Wilkins, CPA, MST, Seattle, WA5 and Natalie Tucker, CPA, MTA, Jacksonville, FL

Co-Editors: Mindy Tyson Cozewith, CPA, M. Tax. Sean Fox, MPA

EditorNotes

Mindy Tyson Gozewith is a director, Washington National Tax in Atlanta, and Sean Fox is a director, Washington National Tax in Washington, DC, for McGladrey & Pullen LLP.

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Author: | Wilkins, Roger; Tucker, Natalie |
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Publication: | The Tax Adviser |

Date: | Apr 1, 2012 |

Words: | 1833 |

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