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Pay now or defer: no income deferral if services are involved.


* THE DEFERRAL OF TRADE DISCOUNTS BY RETAILERS has caused the INS to closely police whether allowances contingent on services performed are really trade discounts. If a discount is strictly volume-related, receiving it in advance should not prevent deferral. But it may be very difficult to convince the INS that an advance discount is not tied to services.

* MANY RETAILERS RECEIVE COOPERATIVE advertising allowances that are volume-based. The INS interprets these arrangements as vendor payments for advertising services rendered by the retailers.

* SLOTTING FEES PAID BY MANUFACTURERS may be viewed as a way for retailers to negotiate the lowest inventory costs. But the INS usually views them as a performance related service that should be treated as income as shelf space is made available.

* PERFORMANCE-RELATED ALLOWANCES may be deferred if they are structured as loans. IRS Publication 3106 outlines how payments received under an "image upgrade program" can be treated as a nontaxable loan. There appears to be no reason that other advances such as cooperative advertising could not also be structured as loans.

* THE EMERGING ISSUES TASK FORCE (EITF) has established a presumption that cooperative advertising allowances are to be deferred in inventory unless it is clear they are payment for services. Since the INS presumption is precisely the opposite, there is a conflict between these positions.


Walk into your favorite grocery store and it's clear that some products get preferential treatment. One brand of soup may be at eye level, while others are on the bottom shelf, or a new product may be on prominent display at the end of an aisle. In many cases these product placements are not accidental; manufacturers may be paying the grocery chain for prime positions. Such payments are known as "slotting fees" and have become common in other business sectors such as computer software, books and magazines, tobacco products and automotive parts. "Slotting" is a generic term for a variety of fees paid by product manufacturers, including "display," "pay-to-stay" "failure" and "presentation" fees.

Retailers of all kinds receive money from manufacturers not only for slotting allowances, but also for purchase volume rebates and cooperative advertising allowances. The tax treatment of these promotion allowances has spawned a debate between retailers and the IRS. Some of the controversy arises from timing issues such as when payment is received and when claims are submitted, but IRS efforts to accelerate the taxation of these allowances usually is tied to its position that they are for services rendered by the retailer. In this article CPAs will learn when the IRS acceleration argument is vulnerable and how structuring advances as loans can result in deferral of income.


In most cases discounts, allowances and rebates are tied to the volume that manufacturers and other vendors sell. Revenue ruling 84-41 defines trade discounts as a vendor's reduction of the purchase price depending on the quantity purchased. Regulations section 1.471-3(b) requires a trade discount to be treated as a reduction in purchase price of inventory rather than as an item of gross income.

This treatment results in income deferral to the extent the discounted goods remain in inventory at year-end. This deferral-of-income opportunity prompted the IRS to take an aggressive stance on allowances that are paid up front or that are contingent on services performed by the retailer.


Retailers often obtain reimbursements of a portion of advertising costs from vendors under cooperative advertising plans, where they receive allowances based on their volume of business with a particular vendor. These agreements may stipulate the media to be used, the time of the ads and other conditions and require certain documentation. If the advertising allowance is volume-based, the vendor usually reduces the retailer's outstanding receivable or issues a credit for future purchases. Taxpayers have argued that those volume-based advertising allowances should be treated as reductions in the purchase price of the inventory per the trade discount rules discussed below.

The IRS, however, has viewed such allowances as reimbursements for resellers' services instead of reductions in inventory cost. In FSA 199915011 the IRS stated that income from cooperative advertising services should be accrued in the year the advertising is placed and stressed that the vendor is compensating the retailer for services rendered. The IRS disregards the fact the discounts are conditional on the retailer's purchases of merchandise. The economic reality is that the dominant factor in many of these agreements is the volume of purchases. The IRS position is based on looking at the form of the agreement that specifies advertising. But it should be noted that a retailer might choose to advertise whether or not a particular vendor's product is purchased.

Perhaps the best approach to solving this tax problem is to view these allowances from the retailer's business perspective. A trade publication, Beverage World, makes the following statement in a column dealing with whether retailers should consider private label soft drinks:
 "Most major retailers participate in calendar marketing
 agreements or cooperative marketing agreements
 with their major soft drink suppliers. And, while it
 may appear that soft drink margins are slim to none
 when comparing retail pricing to invoiced cost, this is
 an outsider's interpretation of the business. Once ad
 allowances, display allowances, performance incentives
 and incremental incentives are put back into the
 profit picture, nationally branded soft drinks are
 tough for anyone to compete with from a profit perspective"
 (Beverage World, November 1992, page 75).

This comment should make it clear that a retailer's decision to obtain advertising or other allowances is primarily a margin-related decision. Margin-related costs arguably should be reflected in cost of goods sold. FSA 199915011 undoubtedly will not be the last word on the subject, particularly since the Emerging Issues Task Force took a position at odds with the IRS (see page 94).

CPAs should be aware that if the agreement provides for advertising, the IRS likely will not permit deferral even if it appears that volume is the real key to the agreement. But see the discussion on page 93 if the agreement is structured as a loan.


A business that receives a volume discount as goods are purchased should have no problem accounting for the discount as a reduction in cost of the goods purchased under regulations section 1.471-3(b), unless the discount is partially for services rendered. If the discount is strictly volume-related, receiving it in advance is not a bar to deferring recognition until the goods are sold. However, an advance or lump-sum payment raises IRS suspicion that a payment for services has been made. Long ago the IRS succeeded in establishing the precedent that an advance payment received for services may not be deferred (see Schlude, 372 US 128 (1963)).

For example, in TAM 9719005, the IRS ruled that lump-sum payments received in exchange for agreements to purchase a stated volume within a specified time were income when received. If the purchaser did not reach the stated volume within the time specified, the time period could be extended or the purchaser could be required to refund a pro rata portion of the cash received. The vendor also received the right to be the purchaser's exclusive or primary suppler of certain types of goods.

The taxpayer took the position that the cash payments were trade discounts for goods to be purchased over a number of years. The IRS argued the payments were current income paid in exchange for the right to be an exclusive supplier. The IRS did not attempt to characterize the payments as either a trade discount or payment for a service. It took the position that the fact that the taxpayer had to do more than just purchase goods, and that the allowances were paid prior to the execution of the agreements, "undermine the notion that the payments are exclusively for trade discounts." Thus, the IRS approach seems to be that a trade discount mixed with other elements does not qualify as a trade discount for tax purposes.

Could a pure trade discount received in advance and based entirely on volume be deferred? Although this is not the fact pattern in TAM 9719005, the IRS hints at its answer by stating, "We have found no case in which a purported 'advance payment' for a trade discount was permitted to be deferred beyond the year of receipt."

CPAs should be aware that unless the facts establish clearly that no services are involved, the IRS will tax advances as they are received. CPAs recommending a deferral position should inform the client that a court test is likely unless the agreement is structured as a loan. (See discussion under the "Image Upgrade Programs as Loans" section at right.)


Some argue that charging suppliers slotting fees for prime placement of products is simply a way of negotiating a lower inventory cost. In this respect, it is instructive to note that big discounters such as Wal-Mart and Costco do not charge slotting fees, but rather demand rock-bottom wholesale prices and stock only the fastest-moving items. Thus, some view slotting fees as another angle on negotiating the lowest inventory cost. But others view slotting as simply renting space to manufacturers. The IRS agrees with the latter assessment and lumps slotting allowances, cooperative advertising and other discounts as "performance-related" vendor allowances. Performance-related allowances should not be deferred in inventory, but reported as income as services are rendered. CPAs pondering a deferral position therefore are unlikely to succeed unless the client is prepared for a court test. Again, the loan structure discussed next may be an alternative.


The problem of including performance-related allowances in income may be overcome if the advances are structured as loans. In Publication 3106, Overview of Imaging Reimbursement Program, the IRS outlines the circumstances in which payments received under an "image upgrade pro gram" can be treated as nontaxable loans. This brochure considered a hypothetical situation in which a petroleum company makes payments to enable a station owner to make certain improvements to upgrade the station's image. The station owner retains ownership of the improvements. His right to receive or retain the payments may be contingent on purchasing a specified volume of petroleum products and/or making the specified improvements. If the payments are bona fide loans, they will not be taxable whether received up front as a lump sum or as a series of payments. Expenditures made with the loan proceeds will be recovered as deductions immediately, or as depreciation or amortization if capitalization is appropriate.

The IRS looks for the following factors in determining whether a bona fide loan exists:

* A true debtor-creditor relationship between the payor and the recipient.

* An intent on the part of the recipient to repay the loans.

* An intent on the part of the payor (creditor) to enforce the obligation.

* A written loan agreement.

* Regular payment of interest and principal.

* A specific date for repayment.

* An unconditional obligation for repayment not contingent upon future events.

In a discussion I had with an IRS field agent, she related an audit situation in which the issue was whether image upgrade payments from a petroleum company were includable in income by a service station owner. The taxpayer, the owner of several retail petroleum LLCs, received an advance from the distributor, which the agent tested with the above criteria to determine whether it was income or a bona fide loan. The agreement was structured so that the advance would be repaid by a quantity discount on sales that exceeded certain monthly quotas. The agent found the agreement complied with the criteria, and therefore the advance was a loan and not income.

Although Publication 3106 deals specifically with an image upgrade program, there seems to be no reason CPAs cannot suggest that advances for other purposes, such as cooperative advertising, also could be structured as loans. But IRS Publication 3106 is clear that merely labeling an agreement as a "loan" does not mean it will be treated as a loan for tax purposes. The agreement must meet the criteria discussed above. See the exhibit below for a summary of the IRS rationale in each of the areas discussed.


The Emerging Issues Task Force concluded that payments received by a reseller from a vendor for cooperative advertising are presumed to be product price reductions to be reflected as reductions in cost of goods sold as the products are sold (FASB, Emerging Issues Task Force, Issue no. 02-16). This presumption is overcome if the consideration is either a payment for assets or services or a reimbursement of costs the reseller incurred to sell the vendor's products. Payments for assets or services should be reported as income; cost reimbursements should be reported as reductions of that cost when it is recognized in the seller's income statement.

This EITF approach will change the period in which many reimbursements for cooperative advertising are recognized. For example, a company that previously had classified cooperative advertising reimbursements as reductions in advertising expense now should classify them as reductions in inventory costs, unless it is prepared to demonstrate that services have been rendered (or costs incurred) that would not have been reduced but for the "reimbursement." This would be difficult to demonstrate in the typical situation where cooperative advertising allowances are based on sales volume.

The EITF approach sets up a conflict between accounting rules and the IRS's treatment of cooperative advertising allowances. Income statement recognition now will occur generally in the period inventory is sold, whereas under the IRS approach the allowance will not be deferred in inventory. GAAP is normally considered to clearly reflect income (regulations sections 1.446-1 (a) (2) and (c) (2)(ii)) unless the tax code or regulations specifically provide for an alternative method. The regulations are silent on cooperative advertising allowances, but the IRS continues to view them as producing income when advertising services are performed. The IRS view is open to criticism primarily because trade discounts attributable to cooperative advertising may have little relationship to actual advertising expenditures by the reseller. For example, a decision to increase advertising for a particular product may have no relationship to the advertising allowances available. And increasing a vendor's discount may not affect the reseller's total advertising budget.

The rationale behind the EITF approach may be very useful to CPAs who are considering taking the position that cooperative advertising or other promotion costs should be deferred.


CPAs should keep an eye on developments in this area. The unilateral IRS position that trade channel promotion costs should be taxed when received may be vulnerable and subject to revision. The lack of case law and the contrary position of the EITF are reasons to monitor developments. CPAs also may want to experiment with extending the loan structure rationale beyond image upgrades to the other costs discussed in this article.

Retail Allowances Help

Profits fell 31% at Safeway and 6% at Albertsons in 2004. Without cash vendor allowances and slotting fees paid to grocery stores by food companies for prominent placement of their products, things would have been even worse.

Such payments hit $100 billion in 2003.

Source: "Food Porn" by Seeth Labone, Forbes, p. 102, February 14, 2003.


* FASB, Emerging Issues Task Force, Issue no. 02-16.

* "How to Keep the SEC Happy," Supermarket News, December 13, 2004, page 28. Short article on the effects of Sarbanes-Oxley on trade promotion accounting practices.

* Internal Revenue Manual, Vendor Rebates and Allowances.

* IRS Publication 3106, Overview of Imaging Reimbursement Program,


* When recommending a deferral position, inform the client that a court test is likely unless the agreement is structured as a loan.

* Although Publication 3106 deals specifically with an image upgrade program, consider structuring advances for other purposes, such as cooperative advertising, as loans.

* Before taking the position that cooperative advertising for other promotion costs should be deferred, carefully study the rationale in the EITF approach discussed in the article.

LARRY MAPLES, CPA, DBA, is COBAF Professor of Accounting at Tennessee Technological University in Cookeville. His email address is
Trade Promotion Income Issues

promotion cost Likely IRS treatment Rationale

Trade discounts Reduction in inventory Tied to volume per
 costs Reg. section 1.471-3(b)

Advance trade Income upon receipt If services performed,
discounts follow the Schlude line
 of cases. If no services,
 weak IRS argument based
 on lack of case law
 (see TAM 9719005)

Cooperative Income when advertising Form of agreements
advertising is placed provide for advertising
 (see FSA 1999915011)

Slotting fees Income as services are Performance-related
 rendered vendor allowance
 (space rental)
 (see Internal Revenue

Image upgrades Income as improvements Publication 3106 gives
 are made unless criteria for loan
 structured as loan treatment
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Author:Maples, Larry
Publication:Journal of Accountancy
Date:Nov 1, 2005
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