IRS Changes Position on Advance Trade Discounts

By Larry Maples

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DECEMBER 2007 - Volume-related vendor allowances are routinely treated as reductions in the purchase price of the related inventory under Treasury Regulations section 1.471-3(b). But when allowances are received in advance, the IRS has been reluctant to allow amounts for purchase volume rebates, slotting fees, and cooperative advertising to be deferred in inventory. The recent decision in Westpac Pacific Food v. Comm’r [2006-2 USTC 50,369 (CA-9), rev’g 82 TCM 175] has prompted the IRS to change its position. Revenue Procedure 2007-53 (2007-30 IRB, 7/2/2007) now provides that if certain criteria are met, advances may be deferred as inventory reductions.

Westpac

Because the first sentence of Revenue Procedure 2007-53 says the IRS will “In general … follow Westpac,” it is crucial to observe the facts of that case and the reasoning of the Ninth Circuit Court of Appeals. A typical contract in Westpac provided a cash advance for which the taxpayer or retailer agreed to be an exclusive supplier of GTE Sylvania lamps, to aggressively and regularly advertise GTE Sylvania products, to dedicate a certain minimum amount of shelf space to the products, and to purchase $17 million in lamp products during the term of the agreement. Westpac received 10% ($1.7 million) of the volume commitment as an advance. When Westpac terminated the agreement after four years, it reimbursed GTE Sylvania the prorated portion of the unearned allowance.

Westpac treated the advance as a liability and annually reported the earned portion as either other income or a reduction in cost of goods sold. The Tax Court had said that the deferral was inappropriate because the advance was an accession to wealth over which the taxpayer had complete dominion under the Supreme Court’s rationale in Glenshaw Glass (55-1 USTC 9308, 348 US 426). But the Ninth Circuit overturned the Tax Court, reasoning that the advance was not an accession to wealth because it had to be refunded to the extent the volume commitment was not met. The Ninth Circuit said the advance was analogous to the security deposits in Comm’r v. Indianapolis Power (90-1 USTC 50007, 493 US 303), which the Supreme Court said were not income because they were subject to repayment.

Revenue Procedure 2007-53

The IRS now says that it will treat an advance as a trade discount if several conditions are met:

  • The payment must be for a commitment to purchase a minimum amount of merchandise for a period not to exceed five years.
  • It must be intended as a merchandise discount.
  • The taxpayer must be obligated by the contract or industry custom to repay an allocable portion if the purchase commitment is not met.
  • Finally, the taxpayer may not treat an advance as a discount if it has been treated as a payment for services in its financial statements.

These conditions appear to be straightforward—except for the intent requirement. The crucial question is how much difficulty the requirement that “the payment is intended to be a discount” will cause taxpayers. This intent requirement appears to be aimed at the problem of distinguishing between advances for merchandise purchase commitments and advances for services. Revenue Procedure 2007-53 is clear that payments for services such as cooperative advertising are not to be treated as trade discounts. It states that if a taxpayer receives a payment that is partially allocable to a volume commitment and partially allocable to cooperative advertising, the taxpayer may use the advance trade discount method only for the portion that can be demonstrated by “objective criteria” as an advance trade discount. Thus, taxpayers who enter into contracts to receive advances for a bundle of service and volume commitments may continue to have to justify the allocation of the amount of the advance attributable to the volume commitments.

There are, however, two bits of good news for taxpayers faced with these allocations. First, exclusive supplier agreements and shelving (slotting) allowances do not have to be separated from the purchase commitment, as required by earlier IRS pronouncements. Amounts allocable to these agreements will be treated as advance trade discounts under Revenue Procedure 2007-53. The hurdle to receiving this treatment is that the agreement obligates the taxpayer to repay an allocable portion of these amounts if the purchase commitment is not met. Presumably, this means that the entire advance can be treated as a trade discount unless a portion of it is carved out as nonrefundable.

The other piece of potentially good news is that even though Revenue Procedure 2007-53 clearly prohibits treating amounts allocable to cooperative advertising as trade discounts, a portion of the advance may not have to be carved out for cooperative advertising if the refund feature depends solely on fulfilling the purchase commitment. It is common for a vendor to require the retailer to perform cooperative advertising, but to condition the earning of the advance solely upon the volume of merchandise purchased. That appears to have been the arrangement in Westpac, and the issue of cooperative advertising was not raised in that case.

One point, however, remains unclear. Revenue Procedure 2007-53 section 4.05 states that if a taxpayer receives a payment that is partly trade discount and partly cooperative advertising, the taxpayer may use the Advance Trade Discount Method “only with respect to the portion of the payment that is allocable to the advance trade discount based on objective criteria.” There is no mention of whether the obligation to repay is crucial in carving out part of the advance as cooperative advertising. A window into what the IRS means by “objective criteria” might be found in Technical Advice Memorandum (TAM) 200605010. In a situation where advertising services were required, the IRS thought the agreement was too vague to create a legal obligation to provide advertising and marketing services. But if there is enough specificity in the agreement to create a legal obligation to provide advertising, the IRS seems to be leaving the door open to require that a portion of the advance not be deferred.

Taxpayer Reaction

The IRS will no longer raise the issue of advance trade discounts for returns filed before July 2, 2007, if the taxpayer meets the conditions of Revenue Procedure 2007-53 and accounts for the discount in a manner consistent with the taxpayer’s financial statements. A taxpayer within the scope of this revenue procedure may change to the advance trade discount method by following the automatic change in the method of accounting procedure under Revenue Procedure 2002-9, as modified.

Some taxpayers have structured advances as loans in order to bypass previous IRS objections to treating an advance as a discount. The loan technique has received mixed reviews in the Tax Court, but Revenue Procedure 2007-53 should allow retailers to steer clear of this controversy.


Larry Maples, DBA, CPA, is the Alumni Professor of Accounting at Tennessee Technological University, Cookeville, Tenn.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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