The Office of Chief Counsel issued the taxpayer-favorable Chief Counsel Advice (CCA) 200945034, which provides guidance on the proper tax accounting for defective merchandise vendor allowances. Although this advice is not a definitive statement of the IRS’s position and cannot be used or cited as precedent under Sec. 6110(k)(3), it might provide insight into the proper treatment of other types of vendor allowances.
Buyers of merchandise often receive discounts if they purchase a certain quantity or volume of goods. A vendor may also offer a discount for other reasons—for example, increasing sales on end-of-season merchandise or on merchandise with a pending removal (because the vendor has replaced it with a new product) or expiration date. To a buyer of merchandise, vendor allowances are simply adjustments to the purchase price. The allowances are meant to lower the price to help the buyer maintain its profit margin on the products sold as well as to help the products move to the end users by allowing competitive pricing in the marketplace. Unless the vendor expects or requires a service or the payment is a reimbursement of an expense, the intent of the discount is always to reduce the purchase price. Thus, the true cost of a purchase is always the net price (invoice price minus any trade discounts).
Regs. Sec. 1.471-3(b) treats trade or other discounts as a reduction in the purchase price of the inventory to which they relate, rather than as gross income. The result of treating discounts this way is generally a net deferral of taxable income to the extent goods to which the discounts relate remain on hand at the end of the year. This deferral occurs because the discount is not an item of income when the merchandise is purchased but instead remains as an adjustment to inventory cost on the balance sheet and is therefore taken into income only when the merchandise is sold. This deferral, in effect, becomes permanent as long as the inventory (under the taxpayer’s method of accounting) continues to contain discounts.
The regulations do not define the term “trade or other discount,” so taxpayers must look elsewhere for guidance. Rev. Rul. 84-41 describes a trade discount as a vendor reduction to the purchase price, which varies depending on the volume or quantity purchased or other factors established by the vendor. If a discount is always allowed regardless of time of payment, it is deemed a trade discount. (See also Thomas Shoe Co., 1 B.T.A. 124 (1924), acq., IV-1 C.B. 3 (1925).)
Increased IRS Scrutiny
The IRS designated vendor allowances in the retail industry as a Tier III issue in 2008. The Tier III designation means that the issue represents a high compliance risk within the industry but requires only that the examination team discuss the issue among themselves. The examination team need not necessarily raise the issue with the taxpayer on examination. The matter at issue is whether the appropriate characterization of the various types of vendor allowances should be (1) reported as gross income under Sec. 61, (2) treated as trade or other discounts under Regs. Sec. 1.471-3(b), or (3) treated as a reimbursement of an expense.
In CCA 200945034, the IRS analyzed whether a taxpayer should treat defective merchandise vendor allowances as income under Regs. Sec. 1.61-3(a) or as a reduction to inventory under Regs. Sec. 1.471-3(b). The taxpayer was a reseller that received vendor allowances for defective merchandise from certain vendors. The allowances were based on a fixed percentage of total purchases and were intended to cover the cost of defective merchandise inadvertently sold to the taxpayer. In general, the taxpayer had no obligation to return the defective merchandise or otherwise account for the merchandise determined to be defective. Periodically, the percentage would be adjusted based on an analysis of actual defective merchandise. Any necessary changes were usually made prospectively.
The chief counsel concluded that defective merchandise allowances were akin to trade discounts and were properly accounted for as reductions to the inventory cost rather than as part of sales receipts, despite the fact that the allowances were provided instead of actual merchandise returns and despite the fact that the allowances were characterized as compensation for the defective goods. The chief counsel reasoned that the vendor and the taxpayer had agreed upon a net sales (purchase) price. The vendor provided the allowances regardless of the amount of actual defective merchandise and did not require any action by the taxpayer, such as proof of defects or the return or other disposition of defective merchandise. The IRS further held that defective merchandise vendor allowances related to all items of inventory purchased from the vendor because the existence and amount of defective merchandise was unknown at the time of the purchase and generally did not factor into the net selling price. Accordingly, such allowances were properly treated as a reduction to the cost of all merchandise purchased from the vendor, not just the defective items.
The CCA also dealt with whether defective merchandise qualifies as subnormal goods under Regs. Sec. 1.471-2(c) or whether it should be capitalized as an indirect cost of nondefective merchandise under Regs. Sec. 1.263A-1(e)(3)(ii)(Q). After analyzing the cost accounting definitions of “rework,” “scrap,” and “spoilage,” the IRS concluded that spoilage applies only to resellers to the extent that merchandise was purchased with a defect. If the goods were damaged in the hands of the reseller (post acquisition), they would qualify as subnormal goods. Because this distinction would be impractical to administer, combined with the fact that Regs. Sec. 1.263A-1(e)(3)(ii)(Q) was intended for manufacturers, not resellers, the chief counsel concluded that defective merchandise qualifies as subnormal goods and is not required to be capitalized as an indirect cost.
Tracing Trade Discounts
Historically, the IRS has suggested that taxpayers should make the allocation of trade discounts (and cash discounts when so elected) on an item-by-item basis (see Rev. Rul. 69-619 and Regs. Sec. 1.471-3(b)). That is, the allocation should be made at the lowest level of detail as opposed to a higher grouping, such as at the product level. This approach presents significant practical difficulties, especially for resellers with many different items. However, the conclusion reached in CCA 200945034 seems to imply that the IRS may be softening its position on the tracing of trade discounts. If defective merchandise vendor allowances can be treated as trade discounts and are not required to be traced to specific inventory items, should not the same reasoning apply to other types of vendor allowances?
As noted, other types of vendor allowances are similar to defective merchandise vendor allowances in that they are adjustments the vendor and buyer have agreed upon to reach a net purchase price. These arrangements are generally not determined in isolation. The vendors take into account many factors, such as the buyer’s overall purchasing power, the mix of inventory being purchased, whether a replacement product will be launched soon, etc. As such, following the same logic used in the CCA, other types of trade discounts could also be viewed as related to all items purchased by the vendor rather than tied or traced to a specific item of inventory.
There has been much uncertainty in the treatment of vendor allowances over the last decade, especially after the issuance of Financial Accounting Standards Board Emerging Issues Task Force No. 02-16, “Accounting by a Customer (Including a Reseller) for Certain Cash Consideration Received from a Vendor,” which seemed to put the tax treatment at odds with the treatment for financial reporting purposes. Recently, the IRS and Treasury announced that they will issue guidance under the Industry Issue Resolution (IIR) program for vendor markdown allowances under the retail inventory method in response to a request from the National Retail Federation (IR-2010-40). Could CCA 200945034 and the acceptance of the IIR be a sign that the IRS may be willing to accept a more taxpayer-friendly approach to vendor allowances in the future?
Editor: Mary Van Leuven, J.D., LL.M.
Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.
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This article represents the views of the author or authors only and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein 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.