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Structuring a Bona Fide Sale of Excess or Slow-Moving Inventory for Tax Purposes [CPA Journal, The](CPA Journal, The Via Acquire Media NewsEdge) Lessons from Relevant Court Cases When preparing financial statements, corporations must typically follow GAAP. When computing federal income tax liability, corporate taxpayers are required to follow the tax law. A corporation that follows GAAP for book purposes and the tax law for tax purposes often faces significant book-to-tax adjustments. The 1RS has generally broad discretion in deciding whether an accounting method employed by a taxpayer to determine taxable income clearly reflects income for tax purposes. If this is not the case, the commissioner will prescribe a different accounting method that does clearly reflect income. In Thor Power Tool v. Comm'r [439 U.S. 522 (1979)], the U.S. Supreme Court held that a manufacturer could not write down the cost of its "excess" inventory of parts for tax purposes, even though such treatment followed GAAP for book purposes. As a result, to unlock the write-off of such inventory, a manufacturer might find it necessary to sell it to a third party. In Paccar Inc. v. Comm r [85 T.C. 754 (1985), affd 849 F.2d 393 (9th Cir. 1988)], the Tax Court held that a "completed bona fide sale that relinquishes control over the inventory" is required. This discussion examines several related court decisions involving the transfer of "excess" inventory by Volvo Cars of North America (formerly known as Volvo North America Corporation). These decisions provide insight on how to structure the transfer of excess or slow-moving inventory for tax purposes as a bona fide sale that is consistent with such rulings as Thor Power Tool and Paccar. Background Under Internal Revenue Code (IRC) section 471, a manufacturer is allowed a deduction for costs of goods sold in determining taxable income. Moreover, the maintenance of beginning and ending inventories is necessary when "the production, purchase, or sale of merchandise is an income-producing factor" (Treasury Regulations section 1.471-1). Once inventory is sold, a taxpayer may deduct the cost of such inventory, which decreases the value of the taxpayer's resulting ending inventory, increases cost of goods sold, and decreases taxable income. In addition to claiming a deduction for cost of goods sold, a manufacturer may be able to write down goods to their reduced values when they are "unsalable at normal prices or unusable in the normal way because of damage, imperfections, shop wear, changes of style, odd or broken lots, or other similar causes" [Treasury Regulations section 1.471-2(c)]. Although the terms are often used interchangeably, it is important to distinguish between a "write-off' and a "write-down" of inventory. The latter occurs when a company reduces the value of an asset on its books; this differs from the former, which eliminates an asset completely from a company's books. The financial accounting concepts of matching and conservatism underscore the intent of GAAP to ensure that revenues and expenses are recorded in the appropriate periods and assets are not overstated. For example, when applying the lower of cost or market (LCM) rule to a material write-down of inventory, "if inventory write-downs are commonplace for a company, it usually will include the losses as part of cost of goods sold. However, a write-down loss that is substantial and unusual should be reported as a separate item among operating expenses" (J. David Spiceland, James Sepe, and Mark Nelson, Intermediate Accounting, 6th ed., p. 452). This approach fosters transparency to the investor community and reflects the notion that accounting standards are designed to promote uniformity. Although a manufacturer can write down its excess or slow-moving inventory each year for financial purposes under GAAP, it must typically wait to write off such inventory for tax purposes. (For GAAP purposes, the reserve or allowance method is used, whereas for tax purposes, the direct write-off method is used in almost all situations. For tax purposes, where appropriate, the 1RS has attempted to address the inventory accounting book-to-tax adjustment on Schedule M-3 of Form 1120, U.S. Corporation Income Tax Return, and Form 8916, Reconciliation of Schedule M-3 Taxable Income with Tax Return Taxable Income for Mixed Groups.) In addition, regardless of a manufacturer's write-offs or write-downs, the valuation of its ending inventory is typically greater for tax purposes than for book purposes, due to the uniform inventory capitalization (Unicap) rules that treat certain costs expensed for book purposes as includible in ending inventory for tax purposes (IRC section 263A). Thor Power Tool In this case, a manufacturer of handheld power tools, parts, accessories, and other products used the LCM method of valuing inventories for both financial accounting and federal income tax purposes. In late 1964, new management took control of the manufacturer. It wrote off approximately $2.75 million of obsolete parts, damaged or defective tools, demonstration of sales samples, and similar items, and sold most of them at their scrap value. Management also wrote down $245,000 of parts relating to unsuccessful products. The manufacturer sold these parts at reduced prices shortly after the close of the year in which the write-down occurred. This left about 44,000 assorted items, many of which man- agement concluded were "excess" inventory that it wrote down to its "net realizable value," in accordance with GAAP. The 1RS did not contest either Thor's $2.75 million write-off or its $245,000 writedown; however, the 1RS did take issue with Thor's write-down of its excess inventory. The Tax Court upheld the IRS's disallowance of its excess inventory [64 T.C. 154 (1975)]; the U.S. Court of Appeals for tie Seventh Circuit affirmed [563 F.2d 861 (1977)]. On appeal, the U.S. Supreme Court, in a unanimous decision, examined the issue of acceptable inventory practices: There is no presumption that an inventory practice conformable to 'generally accepted accounting principles' is valid for tax purposes. Such a presumption is insupportable in light of the statute, this Court's past decisions, and the differing objectives of tax and financial accounting. [439 U.S. 522 (1979)] Inventory accounting for tax purposes is governed by IRC sections 446 and 471. IRC section 446 provides that a taxpayer's normal method of accounting is to be used for purposes of computing taxable income, unless that method "does not clearly reflect income." IRC section 471 further states- Whenever in the opinion of the [Commissioner] the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventory shall be taken by such taxpayer on such basis as the [Commissioner] may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting income. [IRC section 471(a)] In Thor Power Tool, the Supreme Court noted that a taxpayer is required to value inventory at cost unless "market5'-for this purpose, defined as "replacement cost"- is lower. Accordingly, inventory may be valued below market in the following instances, according to the Supreme Court's ruling: "(1) where the taxpayer in tie normal course of business has actually offered merchandise for sale at prices lower than replacement cost; and (2) where tie merchandise is defective." The taxpayer in Thor Power Tool made no effort to determine the replacement cost of its excess inventory on the inventory date. The taxpayer did not ascertain market value in accordance with the general rule of the Treasury Regulations, and did not provide objective evidence that its excess inventory had the value that management had ascribed to it. In addition, the taxpayer had continued to hold these goods for sale at their original prices. In light of this, the Supreme Court determined the taxpayer's write-down of its excess inventory to be "plainly inconsistent with the governing Regulations" and held that the 1RS did not abuse its discretion in disallowing the taxpayer's deduction. Paccar. This case involved a manufacturer and distributor of trucks, track parts, mining vehicles, and rail cars. Three of its divisions-Paccar Parts, Dart, and Wagner-entered into written agreements with Sajac, an unrelated third party. The Tax Court set out four factors to determine whether transfers of inventory are bona fide sales [85 T.C. 754 (1985), affd 849 F.2d 393 (9th Cir. 1988)]: * Who determined what items were taken into inventory? * Who determined when to scrap existing inventory? * Who determined when to sell inventory? * Who decided whether to alter inventory? After examining these factors, the Tax Court held that Paccar (the taxpayer) had retained dominion and control over the transferred items and denied its claimed deductions for losses based upon scrap value. On appeal, the U.S. Court of Appeals for the Ninth Circuit examined the economic substance of the transaction to determine whether it constituted a bona fide sale for income tax purposes; the court noted that, despite the form of the agreement between Paccar and Sajac, Paccar did retain control equivalent to ownership over the transferred parts. Specifically, the court held that Paccar and Sajac- verbally agreed Sajac would not sell the parts to anyone but Paccar; developed 'procedural controls' and 'monitoring devices' for Sajac's management of Paccar inventory; transferred inventory to Sajac 'as a matter of course ... to attempt to achieve the tax benefits as if the inventory had been sold'; described the Sajac 'program' as a 'warehouse' and 'inventory management company'; verbally agreed to resell the material to Paccar at the scrap price if the tax benefits were disallowed; and treated the transfer as a sale/purchase for tax and accounting purchases even though Paccar admittedly knew that 1RS regulations precluded the write-off of the material as scrap where it had not been defaced or made unusable. Accordingly, the Ninth Circuit affirmed the Tax Court's decision disallowing the taxpayer's deductions for inventory losses. Qark Equipment In Qark Equipment v. Comm'r [55 T.C.M. (1988)], another decision involving Sajac in the role of an unrelated third party and transferee, the Tax Court examined the four-factor test set forth in Paccar. The Tax Court in Qark Equipment noted that- Sajac accepted all inventory shipped by petitioner, stored it until petitioner needed it again, sold it to no one other than petitioner, and destroyed or altered it at petitioner's instructions. The only substantial right obtained by Sajac under the agreement was the right to receive an agreed amount for any item 'repurchased' by petitioner. Based upon these facts, the Tax Court held that the taxpayer/petitioner could not recognize its inventory loss for tax pur- poses because it did not transfer dominion and control of its inventory. Administrative Guidance The 1RS has provided administrative guidance indicating that certain purported sales of inventory, such as those featured in the Thor Power Tool, Paccar, and Clark Equipment decisions, constitute attempts to circumvent existing tax regulations pursuant to IRC section 471(a) involving the valuation of inventory at cost. (See Settlement Guidelines for Excess Parts Inventory, p. 7, http://www.irs.gov/pub/irsutl/motorveh_excess_parts_inventory.pdf.) In "Coordinated Issue Motor Vehicle Industry Excess Parts Inventory (Revised September 30, 1998)," the 1RS noted that some manufacturers have attempted to circumvent the Supreme Court's ruling in Thor Power Tool by entering into arrangements with third-party warehousing companies, such that the taxpayers "do not surrender all benefits and burdens of ownership but continue to exercise control so as to remain the exclusive source of the parts for their customers. These arrangements provide for buy-back or similar provisions, either stated or implied." By adopting a "substance-over-form" approach, friese guidelines systematically and significantly increase audit risk to any taxpayer who transfers excess parts inventory to a third party. ["Coordinated Issue: Motor Vehicle Industry Excess Parts Inventory" also notes that in cases where a taxpayer has excluded items from inventory in prior years, an IRC section 481(a) catch-up adjustment can be made to include in current inventory all items impermissibly excluded.] Volvo. Several tax cases have focused upon the transfer of excess inventory by Volvo Cars of North America (formerly known as Volvo North America Corporation) to Sajac Corporation. In Volvo Cars of North America LLC v. U.S., the taxpayer entered into contracts in 1980 and 1983 to sell its obsolete inventory to Sajac. Volvo then sought to write off the inventory for tax purposes. The 1RS took the position that Volvo had maintained control over the inventory transferred to Sajac under both the 1980 and 1983 contracts and that, as a result, no bona fide sales had occurred. Volvo continued to sell inventory at scrap prices to Sajac for several years subsequent to the 1980 contract. The 1RS did not challenge the value of the inventory transferred to Sajac, only whether such transfers constituted bona fide sales [80 AFTR.2d 6094 (1997)]. Although the original contract in 1980 transferred title to the inventory from Volvo to Sajac upon its delivery, the contract also contained several provisions that allowed Volvo to retain control over the inventory after its transfer. Moreover, under the original contract, restrictions upon Sajac's ability to sell the inventory to third-party purchasers included 1) an option that allowed Volvo to repurchase any of the inventory it sold to Sajac on demand at a price below "standard cost"; 2) a provision requiring Sajac to notify Volvo in advance of any planned disposition of inventory; and 3) a provision requiring Sajac to provide Volvo with periodic listings of available inventory and allowing Volvo to audit the inventory held by Sajac. In most situations, contract law relating to the sale of goods is aligned with revenue recognition under GAAP. Accounting standards prescribe that revenue is recognized when realized (or realizable) and earned. Revenue generally is recognized when all of the following criteria under Accounting Standards Codification (ASC) 605-10-599 are met: * There is persuasive evidence that an arrangement exists. * Delivery has occurred or services have been rendered. * The seller's price to the buyer is fixed or determinable. * Collectability is reasonably assured. * A transfer of "significant" risks has occurred. In order to remedy certain terms in the 1980 contract, Volvo signed a new sales agreement with Sajac in 1983; this agreement transferred all rights and ownership interests in the excess inventory to Sajac. Furthermore, Sajac no longer had any obligation to make inventory or information available to Volvo. At trial, the district court submitted two questions to the jury. The first required the jury to determine whether the inventory physically transferred before the 1983 contract's execution was the subject of a bona fide sale in 1983. The second question required the jury to determine whether the inventory transfers from Volvo to Sajac after the 1983 contact's execution date constituted bona fide sales. The jury returned a verdict in favor of Volvo on both counts. The government then filed a renewed motion for judgment as a matter of law under Rule 50(b) of the Federal Rules of Civil Procedure. The district court rejected the government's motion with regard to the inventory transfers that took place after the 1983 contract's execution date; however, the court granted the government's motion with regard to the inventory transfers by Volvo to Sajac prior to that execution date. The court concluded as a matter of law that the 1980 contract applied to such inventory, whereas the 1983 contract had not addressed it. The U.S. Court of Appeals for the Fourth Circuit examined whether the 1983 contract superseded the 1980 contract, thereby permitting a write-off for inventoiy transferred during the 1980-1983 period [571 F. 3d 373 (2009)]. The appellate court examined both the course of performance and commercial context pertaining to the inventory transfers under applicable state law. (The trial court examined contract law of the State of Wisconsin.) The court determined the following: * The reason for entering into the 1983 contract involved reformulating the 1980 contract in light of the guidance provided by Paccar. * Both the 1980 contract and the 1983 contract addressed the same subject matter, and no evidence existed that the parties intended to divide inventory. * The method by which Sajac maintained its inventory of all excess parts transferred to it by Volvo remained the same (and Sajac made no distinction between the inventory transfers before and after the 1983 contract). * When Sajac went out of business, it sold all of its inventory without providing any notice to Volvo. Based upon the evidence presented, the appellate court ruled that the district court had erred in setting aside the jury's verdict in favor of the taxpayer on this issue. Accordingly, the appellate court vacated the trial court's judgment and remanded it back with instructions for the trial court to enter judgment consistent with the jury's verdict in favor of the taxpayer on this issue. Learning from the Past Although IRC section 471 permits a taxpayer to write down subnormal or obsolete inventory to a reduced value, such inventory typically must be readily identifiable as impaired (i.e., below market price) and immediately scrapped or sold at reduced prices. Treasury Regulations sections 1.471-2(c) and 1.471-4(b) place the burden of proof squarely on the taxpayer to demonstrate evidence of reduced market value to substantiate a write-down of inventory below its replacement cost. In Paccar, the Tax Court introduced a four-factor test to determine whether a bona fide sale of excess inventory has occurred. This test examines whether the taxpayer has relinquished complete dominion and control over the inventory involved in the transaction. In particular, this test focuses upon which party determines 1) the composition of the inventory transferred, 2) when to scrap inventory, 3) when to sell inventory, and 4) when to alter inventory. Using this four-factor test, the Tax Court in Paccar disallowed the inventory writedown claimed by the taxpayer. The taxpayer in Volvo relied upon the Tax Court's approach in Paccar. To satisfy the four-factor test, Volvo restructured and replaced its existing contract with the transferee of its inventory. The nature of the actual working relationship between the taxpayer in Volvo and its transferee also changed after the effective date of the new contract. In particular, Volvo transferred all rights and ownership interests to its inventory to Sajac, an unrelated third party. Taken together, the Thor Power Tool, Paccar, and Clark Equipment decisions illustrate how not to structure the sale of excess inventory. Taxpayers should be aware that the 1RS intends to closely scrutinize many of the arrangements involving the sale of excess inventory by a manufacturer to an unrelated third party. In its coordinated issue paper on motor vehicle industry excess parts inventory, the 1RS states that it will examine whether the taxpayer has made a bona fide transfer of the benefits and burdens of ownership to an unrelated third party. On a brighter note, the Tax Court's fourfactor test in Paccar provides a "road map" for structuring transfers of excess inventory. By restructuring its existing agreement that involved its sale of excess or slow-moving inventory to a third party, the taxpayer in Volvo "rode the learning curve" to a favorable outcome at trial and on appeal. These decisions provide insight on how to structure the transfer of excess or slow-moving inventory for tax purposes as a bona fide sale. Mark Wills, CPA, is an instructor in the accounting department at the Langdale College of Business, Valdosta State University, Valdosta, Ga. Bruce M. Bird, JD, CPA, is a professor of accounting, and Michael Sinkey is an assistant professor of economics, both in the Richards College of Business, University of West Georgia, Carrollton, Ga. (c) 2014 New York State Society of Certified Public Accountants |