IRS Grants Automatic Consent for Certain Sales-Based Royalty and Vendor Chargeback Method Changes. (Parker Tax Publishing May 12, 2014)

In January, the IRS issued taxpayer-favorable regulations that changed how taxpayers could account for sales-based royalties and certain sales-based vendor allowances known as "vendor chargebacks." As a result, affected taxpayers may need to change their accounting methods; however, the final regulations contained no procedural guidance on how to make these changes. On Tuesday, the IRS issued such guidance in Rev. Proc. 2014-33. The new procedure amends Rev. Proc. 2011-14, the automatic accounting method change procedure, to add automatic IRS consent for the following method changes:

- a change in method of accounting for sales-based royalties that are properly allocable to inventory property;

- a change in method of accounting to no longer include cost adjustments for sales-based vendor chargebacks in the formulas used to allocate additional Code Sec. 263A costs to ending inventory under a simplified method; and

- changes to a method of accounting to treat sales-based vendor chargebacks as a reduction in cost of goods sold.

Background

Earlier this year, the IRS issued final regulations in T.D. 9652 (1/13/14) that dealt with the accounting treatment of royalties incurred on the sale of property produced or property acquired for resale (sales-based royalties) and the adjustment of inventory costs for certain allowances, discounts, or price rebates earned on the sale of merchandise (i.e., sales-based vendor allowances).

With respect to the accounting for sales-based royalties, proposed regulations had provided that sales-based royalties required to be capitalized could only be allocated to property that had been sold or, for inventory property, deemed to be sold under the taxpayer's inventory cost flow assumption. The final regulations changed this rule and provided that the allocation of sales-based royalties to property sold is optional rather than mandatory.

Therefore, under the final regulations, taxpayers can either allocate sales-based royalties entirely to property sold and include those costs in cost of goods sold or allocate sales-based royalties between cost of goods sold and ending inventory using (1) a facts-and-circumstances cost allocation method described in Reg. Sec. 1.263A-1(f) or (2) a simplified method provided in either Reg. Sec. 1.263A-2(b) (the simplified production method) or Reg. Sec. 1.263A-3(d) (the simplified resale method). The final regulations also clarified that sales-based royalties that a taxpayer allocates entirely to inventory property sold are included in cost of goods sold and cannot be included in determining the cost of goods on hand at the end of the tax year regardless of the taxpayer's cost flow assumption.

With respect to accounting for sales-based vendor allowances, the proposed regulations had provided that the amount of an allowance, discount, or price rebate that a taxpayer earned by selling specific merchandise was a reduction in the cost of the merchandise sold or deemed sold under a taxpayer's cost flow assumption. The proposed regulations required that taxpayers reduce cost of goods sold for the allowances and not reduce ending inventory cost or the value of goods on hand at the end of the tax year.

The final regulations, however, specifically identified one type of sales-based vendor allowance, referred to as sales-based vendor chargebacks, that reduces cost of goods sold and does not reduce the cost of goods on hand at the end of the tax year. A sales-based vendor chargeback is defined as an allowance, discount, or price rebate that a taxpayer becomes unconditionally entitled to by selling a vendor's merchandise to specific customers identified by the vendor at a price determined by the vendor. Sales-based vendor chargebacks protect a taxpayer from realizing a loss or a reduced profit on the sale of specific merchandise when the taxpayer is obligated by contract with the vendor of the merchandise to resell the merchandise at a specific price (in some cases below the taxpayer's cost). Under the terms and conditions of the agreement between the vendor and the taxpayer and the economics of the transaction, the IRS said it was inappropriate to treat the allowance as an adjustment to the cost of goods in ending inventory. A sales-based vendor chargeback properly reduces only cost of goods sold because it arises from and relates only to merchandise sold. Thus, the final regulations provide that sales-based vendor chargebacks reduce cost of goods sold.

Taxpayers Eligible for Automatic Consent Procedures under Rev. Proc. 2014-33

The IRS has issued a number of automatic consent revenue procedures under which a taxpayer automatically receives IRS consent to change to a particular accounting method from another method as long as the requirements of the revenue procedure are satisfied. The primary automatic consent procedure is Rev. Proc. 2011-14. Subsequent automatic change procedures are added to the appendix of Rev. Proc. 2011-14. If the taxpayer doesn't meet the requirements for automatic consent, a ruling request must be filed and a user fee paid.

Changes Relating to Sales-Based Royalties

While certain limitations apply, Rev. Proc. 2014-33 generally applies to a taxpayer that wants to change its method of accounting for sales-based royalties that are properly allocable to inventory property:

1. from not capitalizing sales-based royalties to capitalizing these costs and allocating them entirely to cost of goods sold under the taxpayer's method of accounting; from not capitalizing sales-based royalties to capitalizing these costs and allocating them to inventory property under the taxpayer's method of accounting;

2. from capitalizing sales-based royalties and allocating these costs to inventory property to allocating them entirely to cost of goods sold; or

3. from capitalizing sales-based royalties and allocating these costs entirely to cost of goods sold to allocating them to inventory property.

Changes Relating to Sales-Based Vendor Chargebacks under a Simplified Method

Again, while certain limitations apply, Rev. Proc. 2014-33 generally applies to a taxpayer that wants to change its method of accounting to no longer include cost adjustments for sales-based vendor chargebacks in the formulas used to allocate additional Code Sec. 263A costs to ending inventory under a simplified method. A taxpayer making a change in method of accounting under this provision that uses a simplified method with an historic absorption ratio election and currently includes sales-based vendor chargebacks in any part of its historic absorption ratio must revise its previous and current historic absorption ratio(s).

Changes Relating to Sales-Based Vendor Chargebacks

Subject to certain limitations, Rev. Proc. 2014-33 applies to a taxpayer that wants to change its method of accounting to treat sales-based vendor chargebacks as a reduction in cost of goods sold.

Waiver of Scope Limitations

One of the favorable features of Rev. Proc. 2014-33 is that it waives certain scope limitations that might otherwise prevent a taxpayer from taking advantage of the procedure. For example, the automatic consent procedures do not normally apply to a taxpayer under examination, a partnership or S corporation where the entity's accounting method to be changed is an issue under consideration in an examination of a partner, member, or shareholder's federal income tax return, or where during any of the five tax years ending with the year of change, a taxpayer changed its overall method of accounting, or applied for consent to change its overall method of accounting, regardless of whether it implemented that change. Under Rev. Proc. 2014-33, these limitations do not apply to a change for a taxpayer's first and second tax years ending on or after January 13, 2014.

Filing of Form 3115

Generally, a taxpayer changing its method of accounting under Rev. Proc. 2014-33 must file a signed copy of its completed Form 3115 with the IRS in Ogden, UT in lieu of filing a copy with the IRS National Office no earlier than the first day of the year of change and no later than the date the taxpayer files the original Form 3115 with its federal income tax return for the year of change. A taxpayer that makes both this change and a concurrent automatic change under Code Sec. 263A on a single Form 3115 for the same year of change must file a signed copy of the completed Form 3115 with the IRS in Ogden, UT in lieu of filing the National Office copy no earlier than the first day of the year of change and no later than the date the taxpayer files the original Form 3115 with its federal income tax return for the year of change. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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