Final regulations issued Thursday restate and clarify retailers’ computation of ending inventory value, including the application of common vendor discounts (T.D. 9688).
The amendments to Regs. Sec. 1.471-8 are intended to render that section’s provisions in plainer language and provide rules for how sales-based vendor allowances and vendor markdown allowances and margin protection payments are taken into account under the retail-inventory method. They adopt, with modifications, proposed regulations issued in October 2011 (REG-125949-10).
Existing Regs. Sec. 1.471-2(c) prescribes either of two methods for valuing inventory: (1) cost, or (2) cost or market, whichever is lower (LCM). Retail taxpayers may use the retail method under Regs. Sec. 1.471-8 to approximate cost or LCM. Under this method, a taxpayer computes the value of ending inventory by multiplying a cost complement by the retail selling prices of the goods on hand at the end of the tax year.
The cost complement is a ratio with a numerator that is the value of beginning inventory plus purchases during the tax year and a denominator that is the retail sales price of beginning inventory plus the initial retail price of purchases. Under the retail-cost method, the denominator is adjusted for all permanent markups and markdowns. Taxpayers using the retail-inventory method to value inventories at LCM (retail-LCM method) generally do not make adjustments to the denominator for markdowns.
Sales-based vendor allowances
Regs. Sec. 1.471-3 provides that the cost of purchases during the tax year generally includes invoice price, less trade or other discounts. To clarify the interaction of proposed regulations under Prop. Regs. Sec. 1.471-3(e) with the treatment of sales-based vendor allowances (discounts from a vendor based on a retailer’s sales volume) under the retail-inventory method, the proposed regulations excluded these allowances from the numerator of the cost complement. The final regulations modify this provision to apply only to sales-based vendor chargebacks and reserve ruling on other types of sales-based vendor allowances, pending further guidance under Regs. Sec. 1.471-3(e).
Markdown allowances and margin protection payments
A markdown allowance or margin protection payment is provided by a vendor to a retailer in exchange for the retailer’s temporary or permanent reduction in the retail selling price of its inventory. Generally, under the retail-inventory method, such an allowance or payment is reflected both as a reduction of the numerator of the cost complement and in the final inventory retail price. For a retail-LCM-method taxpayer, this does not clearly reflect income or provide an ending inventory value comparable with that of some similarly situated taxpayers.
Therefore, the final regulations provide that a retail-LCM-method taxpayer may not reduce the numerator of the cost complement for discounts, allowances, or price rebates that are related to or intended to compensate for a permanent markdown of retail selling prices.
In answer to commenters’ concerns about undue recordkeeping burdens of identifying and tracking these particular kinds of vendor payments, discounts, and allowances, the final regulations also allow two alternative methods for computing the cost complement:
- Retail-LCM taxpayers receiving margin protection payments are not required to distinguish these payments from the amounts of other vendor allowances (except for vendor allowances required to be allocated to costs of goods sold). Instead, retail-LCM taxpayers reduce the numerator for margin protection payments and must quantify and reduce the denominator for the related markdowns.
- Taxpayers unable to track the related markdowns but that can determine the amount of their margin protection payments may reduce the numerator by the payments. They must then adjust the denominator by the amount that, in conjunction with the reduction of the numerator, maintains what would have been the cost-complement percentage before taking into account the margin protection payments and related markdowns.
A retail-LCM taxpayer must use one of these three methods (the general method and the two alternative methods) for computing all of its cost complements. A change from one to another of these methods is a change in method of accounting.
Retail-LCM taxpayers also allow taxpayers to facilitate identifying margin protection payments and related markdowns by using statistical sampling as provided in Rev. Proc. 2011-42.
The final regulations apply to tax years beginning after Dec. 31, 2014.
Paul Bonner (
) is a JofA senior editor.