IRS issues proposed regulations on retail inventory method

Background
The retail inventory method (RIM) is used by department stores and large retailers 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, or cost complement. Reg. section 1.471-8 provides that the cost complement is 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. The cost complement is multiplied by the retail selling price of ending inventory to determine ending inventory value. 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 Reg. section 1.471-3, 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 may relate to a retailer's reduction in retail selling price (markdown allowance or margin protection payment). Under Prop. Reg. section 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) is a reduction in 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.

Following the Second Circuit's decision in Robinson Knife Manuf. Co. v. Commissioner, 600 F. 3d 121 (2d Cir. 2010), rev'g T.C. Memo 2009-9, the tax treatment of sales-based royalties and vendor allowances has been a subject of several actions and rulings by the IRS, including a non-acquiescence of the case in AOD 2011-1 (Feb. 8, 2011), Field Directive LMSB-04-0910-026, Field Directive LB&I-4-0211-002 and proposed regulations under section 263A (REG-149335-08). The IRS Field Directives point 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. The preamble to the proposed regulations under section 263A states that although the proposed regulations do not specifically amend Reg. section 1.471-8, Prop. Reg. sections 1.263-1 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 UNICAP. Although RIM has been mentioned in some of the IRS literature cited above, the tax treatment of vendor allowances has not been specifically dealt with as they relate to this method. On Oct. 6, 2011, the IRS issued proposed regulations on RIM (REG-125949-10) that restructure and restate Reg. section 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 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.

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 markdown 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 or not the final regulations should provide this or other alternatives to computing LCM under RIM.

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 both 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 first-in, first-out (FIFO) taxpayer that values inventory at LCM, and (2) does not clearly reflect income.

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

Implications
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 markdowns and, if so, consider an accounting method change to use the methodology set forth in the proposed regulations. Until such 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.

Natalie Tucker, director, McGladrey