Changes Position on Advance Trade Discounts
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.
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
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
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.
the taxpayer may not treat an advance as a discount if it has
been treated as a payment for services in its financial statements.
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
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
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.
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.
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.
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.
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
Maples, DBA, CPA, is the Alumni Professor of Accounting
at Tennessee Technological University, Cookeville, Tenn.