Comment Letter On TAM 200603027 Regarding LIFO Inventory Method

May 2, 2006

Robert M. Brown, Esq. Associate Chief Counsel (Income Tax & Accounting) Office of Chief Counsel Internal Revenue Service 1111 Constitution Avenue, NW Washington, D.C.20224

Dear Mr. Brown:

The American Institute of Certified Public Accountants (AICPA) is writing this letter regarding TAM 200603027, which holds that a taxpayer’s LIFO election must be extended to all items within a dollar-value LIFO pool under the inventory price index computation (IPIC) pooling method. These comments were developed by members of our Tax Accounting TRP and approved by the AICPA Tax Executive Committee.

As indicated in the attached comments, we have serious concerns that the conclusion in the TAM is inconsistent with a plain reading of the section 472 regulations and violates basic policy ramifications of the LIFO IPIC method rules.

We appreciate your consideration of our comments in this matter, and we are available to discuss this matter at your convenience. If you have any questions, please contact me at [email protected]; or Christine Turgeon, Chair, AICPA Tax Accounting, at [email protected]; or George White, AICPA Technical Manager, at [email protected].

Sincerely,

Thomas J. Purcell III Chair, AICPA Tax Executive Committee AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

Comments on TAM 200603027 Requiring that a LIFO Election Extend to All Items Within a Dollar-Value IPIC Pool

Approved by the

TAX ACCOUNTING TECHNICAL RESOURCE PANEL

and the

TAX EXECUTIVE COMMITTEE

May 2, 2006

Developed by the TAM 200603027 Task Force

Barry Tovig, Task Force Chair James Martin Dwight Mersereau Karen Rodriguez Jane Rohrs Jan Skelton John Suttora Christine Turgeon George White, AICPA Technical Manager

2 AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

Comments on TAM 200603027 Requiring that a LIFO Election Extend to All Items Within a Dollar-Value IPIC Pool

In TAM 200603027, the IRS National Office advised that a consolidated group’s “last-in, first- out” (LIFO) election must extend to all items within its dollar-value Inventory Price Index Computation (IPIC) pools. Significantly, the Service also revoked the group’s letter ruling granting consent to terminate the use of LIFO for some (but not all) items in the taxpayer’s LIFO pools and revoked the group’s automatic method change in which it elected to use IPIC pooling. The TAM’s conclusion represents a stark change in position from prior rulings, including the ruling reversed by the TAM, in which the Service has historically granted permission to terminate the use of LIFO for some (but not all) items in a particular LIFO pool.

As explained in the following comments, the AICPA takes the position that requiring a taxpayer to expand its LIFO election to include all items within its dollar-value IPIC pools is improper in light of a plain reading and basic interpretation of the section 472 regulations addressing LIFO pooling and LIFO elections and violates basic policy ramifications of the LIFO IPIC method rules.

BACKGROUND

In TAM 200603027, the IRS concluded that the scope of a LIFO election is “linked” to the LIFO pooling method used by the taxpayer and that the taxpayer’s LIFO election must extend to all items that fall within the taxpayer’s LIFO pools.

The taxpayer used the dollar-value, inventory price index computation (IPIC) LIFO method. The taxpayer had received IRS consent (through an automatic method change) to use the IPIC pooling method for its LIFO inventory. Prior to this change, the taxpayer had received IRS advance consent to use a non-LIFO method to account for certain departments and/or categories of inventory. Generally, the taxpayer’s non-LIFO inventory items experienced deflation rather than inflation. If the taxpayer had used the LIFO method to account for these inventory items, the items would fall within the taxpayer’s IPIC pools.

Under reg. section 1.472-8(a), the dollar-value LIFO method is a method of determining the cost of a pool of goods. A taxpayer using the dollar-value LIFO method treats all goods inventoried under the LIFO method that fall within a pool as fungible. Instead of measuring quantity changes based on the number of units of specific goods in ending inventory, the taxpayer computes, for the pool as a whole, the net change in inventory investment measured in terms of equivalent value dollars.

The IPIC pooling method requires that LIFO inventory be grouped according to the two-digit commodity codes in Table 6 of the Producer Price Index Detailed Report or according to the

3 general expenditure categories in Table 3 of the Consumer Price Index Detailed Report. The IRS concluded that the IPIC pooling method used by the taxpayer did not clearly reflect income because the taxpayer used a non-LIFO method for inventory items that would be included in the taxpayer’s IPIC pools if the taxpayer had used the LIFO method to account for those items.

As a result of this holding, the IRS revoked the method change granting the taxpayer consent to use a non-LIFO method to account for certain departments and/or categories of inventory. In addition, the IRS revoked the automatic method change granting the taxpayer consent to use the IPIC pooling method for its LIFO inventory.

DISCUSSION

I. TAM 200603027 Is Inconsistent with the Pooling Rules in the Regulations

The National Office’s conclusion in TAM 200603027 is inconsistent with the pooling rules as contained in reg. section 1.472-8(b). The pooling rules for IPIC pools (as well as all other pooling methods other than natural business unit (NBU) pooling) contain no provision requiring the inclusion of all items that would otherwise fit within the pools. Instead, the IPIC pooling rules in reg. sections 1.472-8(b)(4) and 1.472-8(c)(2) merely provide that a retailer, manufacturer, or processor electing to use the IPIC method “may elect to establish dollar-value pools for those items accounted for using the IPIC method.” In contrast, in defining the pooling requirements for NBU pools, the regulations contain an express provision similar to the National Office’s conclusion in the TAM. Specifically, reg. section 1.472-8(b)(1) requires an NBU pool to “consist of all items entering into the entire inventory investment for a natural business unit.”

The fact that the “all-items” requirement was specifically provided within the NBU pooling rules but was excluded from the regulatory guidance for IPIC and other pooling methods suggests that it was, in fact, specifically limited in application to NBU pooling regimes and not intended for application to IPIC method pooling and other permitted pooling methods. The National Office’s conclusion in the TAM, contrary to standard regulatory interpretation, attempts to generalize the NBU-specific “all-items” rule to apply it to all pooling regimes. Furthermore, the reference in the IPIC pooling method regulations to “those items” implies that the taxpayer can choose discrete items to which it will apply the IPIC pooling regimen.

By relying on the Commissioner’s authority to require a clear reflection of income as the basis for the TAM’s conclusion, the National Office implicitly concedes that there is no general rule in the regulations requiring the result reached in the TAM. Nevertheless, the National Office attempts to promulgate a general rule (where none was provided by Treasury) under its authority to require clear reflection of income. We believe that if Treasury thought it was necessary in every case to apply the LIFO method to all items that could fit within a pool in order to clearly reflect income, Treasury would have included a general rule in the IPIC pooling regulations, just as it did with the NBU regulations. The Commissioner should not use his interpretative authority to require a clear reflection of income as a direct or implied tactic to circumvent Treasury’s policy making function.

4 Moreover, the AICPA believes use of a clear reflection argument to override rules intended to be safe harbors, such as the IPIC pooling rules, creates significant uncertainty and controversy and should be avoided. In fact, presumably for these reasons, the IRS and Treasury have rejected the use of clear reflection arguments to override safe harbor rules in the past. For example, in TAM 9810003, the National Office found that although a taxpayer’s section 263A absorption ratio as applied under the Historic Absorption Ratio (HAR) method would not otherwise meet standards of reasonableness, the simplified HAR rules were safe harbors, not subject to a reasonableness requirement. Although in this case, the HAR rules yielded a result that did not clearly reflect income, the National Office chose not to invoke a clear reflection argument to circumvent the safe harbor of the simplified method, but rather proposed regulations to modify the safe harbor. After receiving comments from the industry, the regulations project was withdrawn to preserve the simplicity and certainty of the existing safe harbor.

Even if the National Office’s use of a clear reflection argument is proper, it is not clear that the use of LIFO to account for deflationary items more clearly reflects income than the use of a FIFO method. While LIFO and FIFO methods clearly produce different taxable income results, both may clearly reflect income. Rather than simply showing that a different method produces a different result, the National Office must show that the taxpayer’s method is distortive to support a clear reflection argument. The National Office’s argument that the inventory price index of the pool was overstated by virtue of the exclusion of certain deflationary items from the LIFO election ignores the fact that the determination of the pool’s index was computed correctly in accordance with the guidance in the regulations for all items in the pool. Moreover, LIFO is intended to remove inflationary profits from gain recognition, not to create phantom profits from price deflation. Thus, it is arguable that including deflationary items in a pool results in a distortion of income, and does not clearly reflect income.

II. TAM 200603027 Elevates Pooling Above the Scope of LIFO Election

The National Office’s conclusion in the TAM seemingly supports the notion that pooling concepts control the scope of a LIFO election, while the regulations generally apply pooling rules subsequent to and to the extent of a LIFO election. For example, reg. section 1.472-8(b)(4) permits IPIC pools based on 2-digit commodity codes to be established “for those items accounted for using the IPIC method.” Presumably, according to the plain reading of the regulations, the pooling requirements would not apply to goods for which no IPIC LIFO method election was made. Such an interpretation is consistent with other regulatory language regarding the scope of LIFO elections. For example, reg. section 1.472-1 indicates that a taxpayer “may elect [LIFO] with respect to those goods specified in his application,” and that a “manufacturer or processor who has adopted the LIFO inventory method as to a class of goods” may make certain elections. Similarly, reg. section 1.472-2 on the adoption of LIFO contains language indicating that a taxpayer must “file an application to use such method specifying with particularity the goods to which it is to be applied.” And again, reg. section 1.472-3 on the manner of making the LIFO election requires that a statement on the Form 970 include, “an analysis of all inventories of the taxpayer … for which the LIFO inventory method is proposed first to be used.” Existing regulatory guidance all suggests that the pooling rules are subject to the overall LIFO election, and not the other way around.

5 Form 970, Application to Use LIFO Inventory Method (Rev. December 2005), further evidences that the question of the scope of a LIFO election comes before the question of pooling. In Part I, Questions 1 and 5 of the Form 970, the taxpayer is asked to provide a list of the goods which will be included and excluded from the LIFO election. Part II then reviews the requirements of the LIFO election. It is not until Parts IV and V that the taxpayer is asked to describe the method of pooling that it will use “for the goods covered by this election.” Thus, the Form 970 subordinates the question of LIFO pooling to the question of goods for which a LIFO election has been made.

The National Office’s position in the TAM is inconsistent with the general reading of the LIFO election and pooling rules in the regulations and with the step-after-step sequence of the questions of the Form 970, which all imply that the LIFO pooling method (other than the NBU pooling method) does not control the scope of LIFO election. Accordingly, the AICPA believes the conclusion in the TAM is inappropriate absent a change to the IPIC pooling regulations. Moreover, as discussed below, we believe such a change to the regulations would be unwise on policy grounds.

III. The Conclusion in TAM 200603027 Is Undesirable on Policy Grounds

The National Office’s position, when followed to its logical end, leads to some unfortunate and unusual results from a policy standpoint. Consider as an example a taxpayer operating convenience stores that has elected to use IPIC LIFO and IPIC pooling for tobacco products only. Also, the taxpayer has elected to compute the inventory price index based on producer price index (PPI) commodity codes. Since all of the taxpayer’s tobacco products fall within PPI general commodity code 15 (miscellaneous products), the taxpayer has established a single IPIC pool based on this commodity code. If this taxpayer is forced to follow the conclusion reached in TAM 200603027, then it would have to extend LIFO to film, medical supplies, pens, pencils, toothbrushes, hair brushes, tapes and CDs, and other miscellaneous products in its inventory, not only for tax purposes but also for financial accounting purposes in order to avoid a conformity violation. Alternatively, the taxpayer would have to incur the time and expense to change to a different LIFO pooling method (by filing an application to change its accounting method). If the taxpayer changes to a different LIFO pooling method, the taxpayer would most likely continue to use one LIFO pool for all tobacco products under the new pooling method. It is illogical to conclude that one LIFO pool for tobacco products under IPIC pooling does not clearly reflect income while one LIFO pool for tobacco products under a different LIFO pooling method does clearly reflect income. Yet, this is the result under the conclusion reached in the TAM.

Other policy considerations oppose the National Office’s conclusion in TAM 200603027. The TAM’s application to IPIC pooling, for instance, seems to cut against the intent of the IPIC pooling rules that were designed to encourage the use of the IPIC method and eliminate controversy. While Treasury’s intent behind the IPIC rules was to create a simplified and clear set of rules and reduce LIFO controversy (according to the preambles of both the proposed and

6 the final regulations)1, the National Office’s new interpretation does the opposite – creating fresh ground for controversy and contention over the application of LIFO rules. The TAM adds a layer of uncertainty to IPIC pooling and will certainly incite controversy, contrary to the intent and understanding of Treasury and the taxpayers that have adopted or changed to the IPIC pooling rules. The TAM makes IPIC LIFO – commonly referred to as “Safe Harbor LIFO” or “Simplified LIFO” – more uncertain and complex.

CONCLUSION

In light of the comments above and the significance of this issue to many U.S. taxpayers using the IPIC LIFO method of accounting for inventories, we would ask the IRS National Office to reconsider its conclusion in TAM 200603027. Further, we believe that it would be prudent for the National Office to issue a revenue procedure or ruling clarifying the position that the IPIC pooling rules do not impact the scope of a taxpayer’s LIFO election. Issuing guidance on which all taxpayers may rely, would give the Service an opportunity to clarify the regulations and its position for general and consistent application.

1 See the Preambles to the Proposed Regulations (REG-107644-98, 65 Fed. Reg. 31841, 2000-23 IRB 1229 (5/19/00) and the final Regulations (TD 8976, 1/8/02).