Rev. Rul. 83-59

1983-1 C.B. 103.

                       Internal Revenue Service
                                 Revenue Ruling

              METHODS OF ACCOUNTING;  GENERAL RULE FOR INVENTORIES

                            Published: April 4, 1983

SECTION 471. - -GENERAL RULE FOR INVENTORIES, 26 CFR 1.471-4: Inventories at cost or market whichever is lower

(Also Sections 61, 446; 1.61-3, 1.446-1.)

  Methods of accounting;  general rule for inventories.  A manufacturer may not reduce its ending inventory based on purported sales of "excess" inventory at scrap value, when under the sales arrangement the manufacturer continues to possess, as a matter of fact, the benefits and burdens of ownership with respect to the "excess" inventory.  This type of transaction is not a bona fide sale for federal income tax purposes.

ISSUE

  Under the circumstances described below, are the purported sales of "excess" inventory bona fide sales for federal income tax purposes?

FACTS

  X is a corporation engaged in the manufacture and sale of equipment.  X values its inventories for both financial accounting and income tax purposes using the "lower of cost or market" method.

  A portion of X's finished goods inventory includes replacement parts for its manufactured equipment.  Generally, the sales life of X's replacement parts corresponds with the period of customer usage of the underlying equipment, which is approximately 15 years.  X's practice has been to manufacture the replacement parts at the time a new or revised equipment model is produced and to carry the parts in its inventory for their entire sales life.

  X characterized many of these replacement parts as "excess" inventory.  X uses the term "excess" inventory to refer to the portion of its finished goods inventory held in excess of what X concludes is the product's foreseeable future sales demand.  The term "foreseeable future sales demand" refers to the quantity of each replacement part that X estimates will be sold in the following one-year period.  Although X estimated that the "excess" inventory will not be sold in the year following its manufacture, X was of the opinion that most, if not all, of its "excess" inventory will be sold to its customers at regular prices in periods beyond one year.  Another reason that X continued to carry, as opposed to scrapping, the "excess" inventory was the necessity of retaining customer good-will through the assured availability of replacement parts for X's products.

  Prior to its 1972 tax year, X valued its "excess" inventory for federal income tax purposes at the lower of its cost (actual cost) or market (replacement cost).  X was unable to value its "excess" inventory below actual or replacement cost.  This was so because X was unable to establish a lower value, since X did not scrap or sell or offer for sale the "excess" inventory at reduced prices, but rather continued to offer for sale and, in fact, sold these goods at regular prices.

  In 1972 X was contacted by Y, a corporation holding itself out as a company in the business of buying and selling slow-moving inventory items.  Y offered to buy any portion of X's inventory that X considered to be excess under the following terms as specified in the sales offer:

    (1) the purchase price of the inventory will be its scrap value as determined by the mixed scrap prices prevailing in X's locale;

    (2) the inventory will be stored in Y's warehouse;

    (3) X may repurchase any portion of the inventory at a price equal to 8x percent of X's original standard cost in manufacturing the repurchased items, plus an additional negotiated amount for each year that Y owns the inventory;

    (4) if X's repurchases for a year exceed y percent of the inventory Y purchased from X, Y will reduce its selling price on the excess to 1x percent of X's standard cost at the time of manufacture, plus an additional negotiated amount per year;  and

    (5) the agreement may be cancelled by either party providing written notice and upon cancellation Y will sell to X whatever portion of the inventory X wishes to repurchase under the terms described in (3) and (4) above.

  Accompanying the proposed purchase agreement sent to X was a brochure advertising the services of Y.  The brochure indicates that the benefits to the manufacturer of using Y's system are the substantial tax benefits derived from reducing the value of the inventory, relief from the responsibility for storing and managing the parts, and continued access to the inventory to meet future needs.  The brochure also indicates that, unlike scrap dealers, Y does not find or develop markets for the parts it purchases. Further, the brochure states that it is Y's policy to retain the inventory it purchases for a reasonable length of time, taking into consideration the anticipated demand for such inventory.  It is also Y's policy to destroy and scrap those inventory items that the manufacturer requests be scrapped.  Each manufacturer will receive periodic computer printouts of its manufactured inventory that Y has on hand and, upon a manufacturer's repurchase request, Y states that the inventory will be shipped to the manufacturer or the manufacturer's customer promptly.

  During its 1972 tax year, X agreed to Y's offer to buy a portion of its  "excess" inventory as outlined above.  This "excess" inventory was comprised of metal equipment parts that were not damaged or defective.  Upon transfer of the parts, Y paid X an

amount equal to the inventory's scrap value, which represented approximately three percent of the cost of manufacturing the inventory items.  Subsequent to this agreement with Y, X in 1972 continued to offer for sale and sell to its customers at the regular prices parts of the kind transferred to Y.  Upon a customer request for a part (after X had used up its remaining supply of the part), X would then repurchase the appropriate part from Y under the repurchase terms of their agreement and sell the part to the customer for an amount that exceeded twice X's cost in manufacturing that part.

  At the time X's "excess" inventory was delivered to Y's warehouse, Y insured the inventory against casualty loss.  Y paid any property taxes imposed by the state in which Y stores the inventory transferred from X.

  On X's 1972 tax return, X included in gross sales income the scrap value amount of the "excess" inventory received from Y and included in the cost of goods sold the cost of producing the "excess" inventory that was transferred to Y.  The parts repurchased by X from Y during 1972 were recorded by X as purchases and were added to X's inventories.  Upon their sales to customers in 1972, X included the sales amounts in gross sales income and included in the cost of goods sold the repurchase amounts paid to Y.  Repurchased items remaining on hand at the end of the year were included in inventory at the repurchase price.  In each subsequent year X treated these transactions with Y in the same manner for income tax purposes.

LAW AND ANALYSIS

  Section 1.61-3 of the Income Tax Regulations provides that in a manufacturing, merchandising, or mining business, "gross income" means the total sales less the cost of goods sold.

  Section 446(b) of the Internal Revenue Code provides that if no method of accounting has been regularly used by the taxpayer, or if the method used does not clearly reflect income, the computation of taxable income shall be made under such method, as in the opinion of the Secretary, does clearly reflect income.

  Section 471 of the Code provides that whenever in the opinion of the Secretary the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income.

  Section 1.471-1 of the regulations provides that a taxpayer should exclude from its inventory goods that have been sold.

  Section 1.471-2(c) of the regulations provides that the bases of valuation most commonly used by business concerns and which meet the requirements of section 471 are (1) cost and (2) cost or market, whichever is lower.  Any goods in an inventory that are unsalable at normal prices or unusable in the normal way because of damage, imperfections, shop wear, or other similar causes, should be valued at bona fide selling prices less direct cost of disposition whether the cost or the lower of cost or market basis is used.  The burden of proof will rest upon the taxpayer to show that its goods valued upon this basis come within the above classifications.

  Section 1.471-4(a) of the regulations provides that, under ordinary circumstances and for normal goods in an inventory, "market" means the current bid price prevailing at the date of the inventory for the particular merchandise in the volume in which usually purchased by the taxpayer.

  Section 1.471-4(b) of the regulations provides that, if there is no open market or an inactive market, the taxpayer must use the available evidence of a fair market price, such as specific purchases or sales by the taxpayer in reasonable volume and made in good faith.  If the taxpayer, in the regular course of business, has offered the merchandise for sale at prices lower than the current price as previously defined, the inventory may be valued at the lower prices less direct cost of disposition.  The correctness of the lower prices will be determined by reference to the taxpayer's actual sales for a reasonable period before and after the date of the inventory.  Prices which vary materially from the actual prices will not be accepted as reflecting the market.

  In Thor Power Tool Co. v. Commissioner, 439 U.S. 522 (1979), 1979-1 C.B. 167, the taxpayer, who used the "lower of cost or market" method of valuing inventories, wrote down what it regarded as "excess" inventory to its net realizable value, which in most cases was determined to be scrap value. The taxpayer determined that this inventory, mostly spare parts, was "excess" inventory because it was held in excess of any reasonably foreseeable future demand, although this inventory was not scrapped or sold at reduced prices. The taxpayer physically retained the excess items in inventory and continued to sell them at original prices.  The Supreme Court, in disallowing the taxpayer's writedown, held that because the taxpayer provided no objective evidence of the reduced market of its excess inventory, its write-down was plainly inconsistent with the regulations and was properly disallowed by the Commissioner.  The taxpayer could not have properly taken advantage of any permitted write-down because it did not scrap its "excess" inventory nor sell or offer it for sale at prices below market (replacement cost).

  Although, in the present situation, X appears to have complied with section 471 of the Code and the regulations thereunder by eliminating from inventory the cost of the goods transferred to Y, the issue presented is actually no different than the issue presented in Thor Power.  In Thor Power the Court held that the taxpayer did not comply with section 1.471-2(c) and 1.471-4(b) of the regulations, as the write-down was not substantiated by objective evidence of scrapping the "excess" inventory or actual offerings or sales of the "excess" inventory below the lower of actual or replacement cost.  In the present situation, X purports to comply with section 1.471-1 of the regulations, at least in form, by eliminating the value of the "excess" inventory from its ending inventory based on the sales of the "excess" inventory to Y.  However, there is no difference between X's situation and Thor Power unless X can demonstrate that its sales of the "excess" inventory to Y are bona fide sales for federal income tax purposes.

  The clear reflection of income standard of sections 446(b) and 471 of the Code invests the Commissioner with broad discretion in determining matters involving accounting methods and imposes a heavy burden of proof on taxpayers challenging the Commissioner's determinations.  See Lucas v. Structual Steel Co., 281 U.S. 246 (1930);  All-Steel Equipment Co. v. Commissioner, 54 T.C. 1974 (1970), aff'd on this issue, 467 F.2d 1184 (7th Cir. 1972); Dearborn Gage Co. v. Commissioner, 48 T.C. 190 (1967);  and Photo-Sonics, Inc. v. Commissioner, 42 T.C. 926 (1964), aff'd, 357 F.2d 656 (9th Cir. 1966).  The Supreme Court in Thor Power, in considering whether the Commissioner acted within this broad discretion, stated at page 538:

    In light of the well-known potential for tax avoidance that is inherent in inventory accounting, the Commissioner in his discretion may insist on a high evidentiary standard before allowing write-downs of inventory to "market" [below actual or replacement cost].

This "high evidentiary standard" regarding inventory write-downs is embodied in section 1.471-2(c) and 1.471-4(b) of the regulations, which requires a taxpayer, in seeking to depart from the lower of actual or replacement cost, to present objective evidence of reduced inventory valuation through bona fide sales offers in the regular course of its business.  Because a potential for tax avoidance exists not only with respect to sale offers but also with respect to purported sales of inventory that are sales in form but not in fact, this same high evidentiary standard acknowledged by the Supreme Court in Thor Power is equally applicable in examining X's transactions with Y.

  In determining whether X's sales of its "excess" inventory to Y are bona fide arm's-length sales for federal income tax purposes, it is well settled that the economic substance of transactions, rather than their form, governs for tax purposes. Cf. Gregory v. Helvering, 293 U.S. 465 (1935), XIV-1 C.B. 193. Recently, in Frank Lyon Co. v. United States, 435 U.S. 561, 572-573 (1978), 1978-1 C.B. 46, 50, the Supreme Court summarized the principles underlying the substance over form doctrine:

    This Court, almost 50 years ago, observed that "taxation is not so much concerned with the refinements of title as it is with actual command over the property taxed-the actual benefit for which the tax is paid."  Corliss v. Bowers, 281 U.S. 376, 378 (1930).  In a number of cases, the Court has refused to permit the transfer of formal legal title to shift the incidence of taxation attributable to ownership of property where the transferor continues to retain significant control over the property transferred.  E.g., Commissioner v. Sunnen, 333 U.S. 591 (1948);  Helvering v. Clifford, 309 U.S. 331 (1940).  In applying this doctrine of substance over form, the Court has looked to the objective economic realities of a transaction rather than to the particular form the parties employed.  The Court has never regarded "the simple expedient of drawing up papers," Commissioner v. Tower, 327 U.S. 280, 291 (1946), as controlling for tax purposes when the objective economic realities are to the contrary.  "In the field of taxation, administrators of the laws, and the courts, are concerned with substance and realities, and formal written documents are not rigidly binding."  Helvering v. Lazarus & Co., 308 U.S. 252, 255 (1939).

    In considering whether a transferor has relinquished its rights of ownership or has retained significant control over the property, it is necessary to establish what the ownership of property entails.  The ownership of property consists of a "bundle of rights" including its free use and enjoyment, the control over it, and the right to dispose of it in any manner not contrary to existing regulatory laws.  Black v. Commissioner, 38 T.C. 673, 676 (1962).

  In this situation X has not relinquished, but has retained, these rights of ownership in the "excess" inventory.  X has retained use and enjoyment, control, and disposition through:

    (1) the agreement with Yproviding for Y's storage of the "excess" inventory with Y possessing no right to use and enjoy the goods in any way. See Resthaven Memorial Cemetery, Inc. v. Commissioner, 43 B.T.A. 683 (1941), involving a sale, a repurchase option, and an obligation on seller to repurchase under certain conditions, cemetery lots, in which the Board of Tax Appeals, in concluding that the transactions were bona fide sales for federal income tax purposes, relied on the fact that it was outside the control of the seller how the buyer used the purchased lots and the buyer's use would terminate both the seller's option and obligation to repurchase;  and

    (2) the tacit understanding of the parties, based on Y's representations, that Y will not find or develop markets for the parts it purchases and thus Y will not sell or dispose of any of the "excess" inventory to anyone other than X.  See Comtel Corporation v. Commissioner, 376 F.2d 791 (2nd Cir. 1967), in which the Second Circuit, in concluding that a transaction in the form of a stock sale with an exclusive option to repurchase was in substance a financial arrangement, relied, in part, on the buyer having no right to sell, dispose, or pledge the stock;  and Fender v. United States, 577 F.2d 934 (5th Cir. 1978), nullifying loss deduction on the sale of unrated bonds with limited marketability on the basis, in part, of the difficulty the buyer would have in selling bonds to someone other than the seller.

  The extent of X's dominion and control over the "excess" inventory subsequent to its agreements with Y is best illustrated by X continuing to offer for sale to its customers at the regular prices the parts that comprised the subject matter of the "excess" inventory agreements.  See Higgins v. Smith, 308 U.S. 473, 476 (1940), 1940-1 C.B. 127, 128, in which the Supreme Court, in disallowing a loss deduction arising from a taxpayer's sale of securities to a corporation wholly owned by the taxpayer, relied on evidence of the taxpayer's continued dominion and control of the securities subsequent to the sale.  See also American National Bank of Austin v. United States, 421 F.2d 442 (5th Cir. 1970), and Union Planters National Bank of Memphis v. United States, 426 F.2d 115 (6th Cir. 1970), cert. denied, 400 U.S. 827 (1970), in which the respective Circuit Courts, in concluding that "sale and repurchase" transactions involving municipal bonds were in substance loans arrangements, relied, in part, on the continued dominion exercised by the purported seller prior to its "repurchase" of the bonds through offers to sell and sales of the bonds to its customers.

  In addition to the fact that X has retained the use, control and disposition rights over the "excess" inventory, the risk of loss in the inventory has not realistically passed from X to Y under their agreements.  The only risk that Y assumes in not recovering the amounts paid to X is that upon cancellation X will not repurchase any of the "excess" inventory and that the scrap value prices will have declined since Y's payments to X.  The history of the X-Y relationship reflects periodic repurchases by X.  Moreover, X is compelled to repurchase most, if not all, of the "excess" inventory because X needs a supply of parts to sell its customers and because X can repurchase large quantities from Y at less than X's original production cost.  See Comtel Corporation v. Commissioner, supra, in which the Second Circuit, in recharacterizing a sale of stock with an option to repurchase as a financing arrangement, placed substantial emphasis on the lower court's finding that the seller was realistically compelled to repurchase the stock.  In light of the necessity of X having an assured supply of replacement parts for its customers and the disparity between the scrap value prices paid by Y and the repurchase price amounts, the chances of Y suffering any economic loss are practically eliminated.

  In light of X's continued use, control, disposition rights and compulsion to repurchase, the arrangements between X and Y are not bona fide arms-length sales for federal income tax purposes.  Moreover, taking into account Y's lack of ownership rights and lack of any realistic risk of loss, the objective economic realities of the arrangements between X and Y reveal that in substance X has merely entered into a warehousing and inventory management service arrangement with Y receiving a contingent right to scrap the warehoused goods. Y's compensation for these storage and management services is the difference between the scrap value of the "excess" inventory and the amount to be derived from the repurchase by X of some, if not all, of the "excess" inventory.

  Lastly, it is evident from examining the entire transaction that the only significant purpose of these arrangements between X and Y was to create a substantial decrease in X's taxable income, without any real change in position.  See Horne v. Commissioner, 5 T.C. 250 (1945);  Shoenberg v. Commissioner, 77 F.2d 446 (8th Cir. 1935);  and Estate of Esperson v. Commissioner, 13 B.T.A. 596 (1928), aff'd, 49 F.2d 259 (5th Cir. 1931), cert. denied, 284 U.S. 658 (1931), for the proposition that a purported sale of property for the purpose of establishing a loss for income tax purposes is not a bona fide sale.  See also Rev. Rul. 67-178, 1967-1 C.B. 64, which disregards a transfer and repurchase of stock arranged for the purpose of obtaining for the transferor a stepped-up basis in the stock;  and Rev. Rul. 79-188, 1979-1 C.B. 191, which negated the purchase and sale of gold arranged for the purpose of avoiding penetration of the taxpayer's LIFO layers.

HOLDING

  Under the circumstances described above, the purported sales of "excess" inventory are not bona fide sales and will not be recognized for federal income tax purposes.  It is only when items of "excess" inventory are scrapped that X has relinquished its rights of ownership and a bona fide sale of those "excess" inventory items arises for federal income tax purposes.

Rev. Rul. 83-59, 1983-1 C.B. 103.