What s News in Tax Analysis That Matters from Washington National Tax

Transcription

1 What s News in Tax Analysis That Matters from Washington National Tax Final Regulations Issued under Section 471 Will Generally Require Accounting Method Changes for Taxpayers Using the Retail Inventory Method On August 15, 2014, the Treasury Department and the IRS released final regulations that modify the computation of ending inventory valued under the retail inventory method. This article summarizes the mechanics of the retail inventory method and highlights the practical complexities of complying with the revised final regulations. The final regulations are effective for tax years beginning after December 31, 2014, but taxpayers should begin to review their current methods as process or system changes will take some time to implement. Background November 24, 2014 by John Suttora and Selvan Boominathan, Washington National Tax, and Christine Newell, Accounting Methods and Credit Services Section 471 provides that a taxpayer's method of accounting for inventories must clearly reflect income. The most commonly used bases of inventory valuation are: (1) cost and (2) cost or market, whichever is lower (LCM). Retailers may approximate either cost or LCM by using the retail inventory method. 1 However, a last-in, first out (LIFO) retailer using the retail inventory method must use cost. Under the retail inventory method, the retail selling price of ending inventory is converted to approximate cost or approximate LCM with a cost complement, or a cost-to-retail ratio. The numerator of the cost complement is the value of beginning inventory plus the cost of purchases during the tax year; the denominator is the retail selling prices of beginning inventories plus the initial retail selling prices of purchases during the year. The cost complement is then multiplied by the retail selling price of ending inventory to determine the ending inventory value. 1 Treas. Reg entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. NDPPS

2 For Taxpayers Using the Retail Inventory Method page 2 The calculation for inventory valued under the retail method is described as follows: Beginning Inventory at Cost + Cost of Goods Purchased Beginning Inventory at Retail Selling Prices + Goods Purchased at Retail Selling Prices x Ending Inventory at Retail Selling Prices = Ending Inventory at Cost For inventory valuation purposes, the cost of purchases during the year generally includes the invoice price less trade or other discounts (e.g., vendor rebates and allowances). The Final Regulations The final regulations continue to allow retail merchants that value their ending inventories at retail selling prices to approximate cost or LCM by using the retail inventory method. 2 As explained below, however, the final regulations alter the retail inventory method computation by excluding certain sales-based vendor chargebacks and margin protection payments from the formula, a taxpayer favorable method permitted under the prior version of the retail inventory method regulations. The regulations do not define the term retail merchant; however, it presumably would include more than traditional brick-and-mortar retailers. Thus on-line merchants, catalog companies, and the like should be able to use the retail inventory method. This article (1) summarizes the mechanics of the retail inventory method computation; (2) analyzes the impact of sales-based vendor chargebacks and margin protection payments under the revised final regulations; and (3) highlights implementation considerations, including the availability of statistical sampling to compute the required adjustments and the procedural rules for filing an automatic accounting method change. The Retail Inventory Method Computation Unless otherwise indicated, section references are to the Internal Revenue Code of 1986, as amended (the Code ) or the applicable regulations promulgated pursuant to the Code (the regulations ). The final regulations permit taxpayers to compute cost complements at the department, class, or stock-keeping unit level. The regulations appear to grant taxpayers significant leeway in determining the groupings to calculate the cost complement; the preamble to the regulations suggests that the term department, class, or stock-keeping unit level encompass groupings such as sub-class, style, or other similar categories. 2 T.D. 9688, 79 Fed. Reg

3 For Taxpayers Using the Retail Inventory Method page 3 Under the final regulations, the numerator of the cost complement generally consists of the goods available for sale for the year valued at cost and the denominator consists of the goods available for sale for the year valued at retail selling prices. For items acquired during the year, the denominator includes the bona fide retail selling prices of the items at the time acquired. The denominator is adjusted for all permanent markups and markdowns, including markup and markdown cancellations and corrections, but not adjusted for temporary markups or markdowns. The cost complement is multiplied by the ending inventory valued at retail selling prices ( the multiplicand ), including adjustments for permanent mark-ups and markdowns. Subject to the adjustments discussed below, the final regulations permit a taxpayer to approximate LCM under the retail inventory method by not reducing the retail selling prices in the denominator of the formula for permanent markdowns. Theoretically, any downward trend in retail selling prices between the denominator and the multiplicand reflects the downward trend between the actual cost and the replacement cost, or market value, of the ending inventory. Sales-Based Vendor Chargebacks The final regulations provide that taxpayers may not reduce the numerator of the cost complement by the amount of an allowance, discount, or price rebate that is required under Treas. Reg (e) to reduce only the cost of goods sold, which currently includes only sales-based vendor chargebacks. The regulations define a sales-based vendor chargeback as an allowance, discount, or price rebate that a taxpayer becomes unconditionally entitled to by selling a vendor s merchandise to specific customers identified by the vendor at a price determined by the vendor. For example, a drug store chain might receive chargebacks from a pharmaceutical company for selling products to customers that carry a particular medical insurance policy at a price negotiated between the pharmaceutical company and the customer s insurance company. The majority of retailers, however, will not need to make an adjustment for sales-based vendor chargebacks because they do not receive these types of allowances.

4 For Taxpayers Using the Retail Inventory Method page 4 Margin Protection Payments In addition to sales-based vendor chargebacks, the final regulations provide that the numerator of the cost complement may not be reduced by the amount of a margin protection payment, which is 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. In order to comply with this provision, taxpayers will need to separately identify margin protection payments from other types of vendor allowances. Whether a payment qualifies as a margin protection payment under the final regulations may not be clear. Often, vendor rebates are negotiated after, rather than in advance of, the inventory purchase. In negotiating the markdown, the taxpayer may use a variety of factors, such as inventory turnover, markdowns, and performance against other items in the class. In those instances, there may not be significant linkage between the markdowns incurred and the vendor allowances received. In addition, taxpayers will need to distinguish margin protection payments that relate to permanent markdowns from those intended to support only a temporary reduction in retail selling prices. Some retailers maintain more than one retail selling price within their various inventory and merchandise systems. As a practical matter, there should be a permanent reduction in the retail selling price that is used to value inventory for financial statement purposes for this provision to be applicable. Markdowns taken at the point of sale should not result in a permanent reduction in the retail selling price of inventory in instances when the system price used to value ending inventory remains unchanged. In an effort to reduce the burdensome recordkeeping requirements, the final regulations provide two alternative methods for retailers using the LCM retail inventory method to reduce the numerator of the cost complement with other corresponding adjustments. The first alternative is intended to ease the burden of separating margin protection payments from other types of vendor allowances (other than the sales-based vendor chargebacks described above). This alternative allows retailers using the LCM retail inventory method to reduce the numerator of the cost complement for margin protection payments with a corresponding reduction to the denominator for the associated retail

5 For Taxpayers Using the Retail Inventory Method page 5 markdowns. This method is useful for retailers that are able to identify and quantify the markdowns related to margin protection payments. The second alternative method allows retailers that cannot track the markdowns related to margin protection payments to reduce the numerator of the cost complement by the amount of the margin protection payments, and also to reduce the denominator by an amount that maintains the same cost complement percentage before taking into account the margin protection payments. This method is useful for taxpayers that maintain records of the initial cost complement percentage, but do not track markdowns for related margin protection payments. A retailer may use only one of the above three methods to calculate all of its cost complements, if it calculates more than one. A change from any method to another is a change in accounting method which would require consent from the IRS. Use of Statistical Sampling The final regulations attempt to ease recordkeeping burdens by allowing retailers using LCM and any of the above-mentioned margin protection payment methods to use statistical sampling in accordance with Revenue Procedure A retailer that uses statistical sampling must use it for all margin protection payments and related markdowns associated with the inventory items valued by a particular cost complement. However, a retailer is not required to use statistical sampling for all cost complements (if it calculates more than one). Importantly, a change either to or from using statistical sampling to calculate margin protection payments and associated markdowns is not a change in method of accounting. Compliance with the new regulations generally rests on a taxpayer s ability to handle large amounts of data. While many companies have made significant strides in record retention, the required data is generally not readily available for use in revaluing opening inventories because taxpayers have no reason to capture this information other than for tax purposes. Thus, retailers may choose to use statistical sampling in the initial year of adoption and forgo the use as they modify their systems to obtain the information needed to comply with the new rules I.R.B. 318.

6 For Taxpayers Using the Retail Inventory Method page 6 Automatic Accounting Method Changes Revenue Procedure describes the procedures that taxpayers must follow to implement changes to the retail inventory method to be compliant with the final regulations. Revenue Procedure modifies Revenue Procedure , which provides automatic consent for the method changes listed in the Appendix, by adding a new Appendix section specific to the final regulations modifying the retail inventory method. Specifically, Revenue Procedure grants automatic consent for the following changes: 1. To discontinue adjusting the numerator of the cost complement by the amount of an allowance, discount, or price rebate that is required under section (e) to reduce only cost of goods sold; 2. To discontinue adjusting the denominator of the cost complement for temporary markups and markdowns; 3. For a retailer using LCM: a. To discontinue adjusting the numerator of the cost complement for margin protection payments, b. To discontinue adjusting the denominator of the cost complement for permanent markdowns, or c. To use any one of the alternative methods to account for margin protection payments; 4. For a retailer using cost, to begin adjusting the denominator of the cost complement for permanent markups and markdowns. Revenue Procedure allows taxpayers to use either a section 481(a) adjustment or a cut-off approach if making the change for a tax year beginning within two years of the close of A cut-off approach would be used to calculate ending inventories for the year of change without adjusting the inventory as of the beginning of the year of change. Revenue Procedure also waives certain scope limitations for accounting method changes made during the first two years that the final I.R.B C.B. 330.

7 For Taxpayers Using the Retail Inventory Method page 7 regulations are effective. For example, a taxpayer may file the automatic accounting method changes described above even though it (or the consolidated group that it was a member of) is under examination, or even though the method of accounting for this same item was changed within the last five years. It should be noted that the scope limitations are not waived if the year of change is the taxpayer s last year of its trade or business, or if the taxpayer made an overall change in method of accounting within the last five years. Contact Information For additional information regarding the final regulations, please contact any of the following KPMG professionals: Eric Lucas, Carol Conjura, John Suttora, Mathew Borrack, or Selvan Boominathan. What's News in Tax is a publication from the Washington National Tax practice of KPMG LLP ( KPMG ) that contains thoughtful analysis of new developments and practical, relevant discussions of existing rules and recurring tax issues. The information contained in this article is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of KPMG LLP.