Rev. Rul. 89-41

1989-1 C.B. 167, 1989-14 I.R.B. 7.

                       Internal Revenue Service

                                 Revenue Ruling

     INVENTORIES; LIFO; FINANCIAL CONFORMITY REQUIREMENTS; AFFILIATED GROUP

                              WITH FOREIGN PARENT

                            Published: April 3, 1989

26 CFR 1.472-2: Requirements incident to adoption and use of LIFO inventory method.

  Inventories; LIFO; financial conformity requirements; affiliated group with foreign parent. Rev. Rul. 78-246 continues to be a valid exception to the LIFO conformity requirement for certain foreign parent-subsidiary groups of corporations. The exception is also applicable to the combined financial statements of certain foreign controlled brother-sister groups of corporations, but does not apply to U.S. owned groups of corporations. Rev. Rul. 78-246 amplified.

  The last-in, first-out (LIFO) method of inventory valuation has conformity requirements as a condition for its use. The LIFO method of inventory valuation must be used for all financial reports of all corporations in which the LIFO taxpayer's inventory is included. Under Code section 472(g), the LIFO conformity requirements apply to a parent corporation that issues financial statements to its shareholders on a consolidated basis with a subsidiary (or on a combined basis with an affiliated company) that uses the LIFO method of accounting for tax purposes or with a parent that uses the equity method of financial accounting to include the results of operations of a financially related corporation that uses the LIFO method of accounting for tax purposes.

  However, when section 472(g) was added to the Code by the Tax Reform Act of 1984, 1984-3 C.B. (Vol.1) 124, Congress made clear that the limited exception in Rev. Rul. 78-246, 1978-1 C.B. 146, to the LIFO conformity requirement for certain foreign parent-subsidiary groups of corporations was to continue to be allowed. The Service has ruled on whether the LIFO method of inventory valuation must be used in three situations involving foreign-owned groups of financially related corporations where one or more of the related corporations use the LIFO method of valuing inventories for Federal income tax purposes.

  In situation 1, a foreign corporation owns all of the outstanding stock of one domestic subsidiary and three foreign subsidiaries. The inventories of all the subsidiaries are included in the consolidated financial statement of the foreign parent. The group engages in substantial foreign operations. The domestic subsidiary is the only corporation in the group that uses the LIFO.

  In situation 2, three nonresident alien individuals together own all of the stock of a domestic corporation and three foreign corporations. The four corporations issue a combined financial statement in which their inventories are included. The foreign operating assets of the three foreign corporations are of substantial value, consisting of 30 percent or more of the total operating assets of the combined group. Only the domestic corporation uses the LIFO inventory method.

  In situation 3, a domestic parent owns all of the stock of a foreign subsidiary and three domestic subsidiaries. Only the foreign subsidiary uses the LIFO method. All of the subsidiaries' inventories are included in the consolidated financial statement of the parent. The foreign subsidiary is engaged in a business outside the U.S. The group engages in substantial foreign operations as a result of the foreign operations of one domestic subsidiary.

  ISSUE. At issue is whether the LIFO method of inventory valuation must be used in the consolidated financial statements of each group of financially related corporations because one member of the group uses the LIFO method of valuing inventories for Federal income tax purposes.

  HOLDING. The Service has ruled that the LIFO method of inventory valuation need not be used for the inventories included in the consolidated financial statement of the foreign parent in situation 1 or for the inventories of the domestic corporation included in the combined financial statement in situation 2. However, in situation 3, where there is a U.S. parent, the Service ruled that the LIFO method of inventory valuation must be used for the inventories of the foreign subsidiary when they are included in the consolidated financial statement of the U.S. parent and its subsidiaries.

  ANALYSIS. The Service concluded that it should continue to adhere to the position set forth in Rev. Rul. 78-246 regarding exceptions to the LIFO conformity rules. Furthermore, the Service determined that it was appropriate to apply the rule of Rev. Rul. 78-246 to foreign owned groups of affiliated corporations that issue financial statements on a combined basis, for the reasons stated in Rev. Rul. 78-246. However, the position in Rev. Rul. 78-246 does not apply to United States-owned groups of affiliated corporations, the Service noted. Thus, the rationale of Rev. Rul. 78-246 does not extend to the foreign subsidiary of a domestic parent, the Service said.

ISSUE

  Must the last-in, first-out (LIFO) method of inventory valuation be used in the consolidated financial statements of certain foreign-owned groups of financially related corporations when one or more of the related corporations use the LIFO method of valuing inventories for federal income tax purposes?

FACTS

  SITUATION 1: FP, a foreign corporation, owns all of the outstanding stock of S1, a domestic corporation, and of FS1, FS2, and FS3, foreign corporations. S1 uses the LIFO method of inventory valuation for federal income tax purposes. FP, FS1, FS2, and FS3 do no use the LIFO method of accounting for federal income tax purposes and are each engaged in a business outside the United States. The inventories of S1, FS1, FS2, and FS3 are included in the consolidated financial statement of FP. FP owns, through FS1, FS2, and FS3, operating assets of substantial value that are used in the foreign operations of FS1, FS2, and FS3. These assets constitute 30% or more of the total operating assets of the consolidated group.

  SITUATION 2: A, B, and C, nonresident alien individuals, together own all of the outstanding stock of X, a domestic corporation, and of F1, F2, and F3, foreign corporations. X uses the LIFO method of inventory valuation for federal income tax purposes. F1, F2, and F3 do not use the LIFO method of accounting for federal tax purposes and are each engaged in a business outside the United States. X, F1, F2, and F3 issue a combined financial statement. The inventories of X, F1, F2, and F3 are included in this combined financial statement. F1, F2, and F3 own operating assets of substantial value that are used in foreign operations. These assets constitute 30% or more of the total operating assets of the combined group.

  SITUATION 3: P, a domestic corporation, owns all of the outstanding stock of FS1, a foreign corporation, and of S1, S2, and S3, domestic corporations. FS1 uses the LIFO method of inventory valuation for federal income tax purposes. P, S1, S2, and S3 do not use the LIFO method of accounting for federal income tax purposes. The inventories of FS1, S1, S2, and S3 are included in the consolidated financial statement of P. FS1 is engaged in a business outside the United States. P owns, through S1, operating assets of substantial value that are used in the foreign operations of S1. These assets constitute 30% or more of the total operating assets of the consolidated group.

ANALYSIS

  Section 472(a) of the Internal Revenue Code of 1986 authorizes the use of the LIFO inventory method for federal income tax purposes. Section 472(c) of the Code requires that for the first year the method is used, the method must also be used in computing income for purposes of reports to shareholders, partners, other proprietors, or beneficiaries, and reports used for credit purposes. Thereafter, the Commissioner may terminate the taxpayer's use of the LIFO method if the taxpayer uses any method other than LIFO in computing income for these purposes. Section 472(e)(2).

  Rev. Rul. 78-246, 1978-1 C.B. 146, holds that the LIFO method of inventory valuation need not be used in the consolidated financial statements of the foreign parent of a consolidated group that engages in substantial foreign operations, even though one or more of its subsidiaries use the LIFO method of valuing inventories for federal tax purposes. A group engages in substantial foreign operations if the parent owns, either directly or through members of the group, operating assets of substantial value (for this purpose, 30 percent or more of the group's total operating assets) that are used in foreign operations. Rev. Rul. 78-246 revokes Rev. Rul. 73-57, 1973-1 C.B. 218, which had reached a contrary conclusion.

  Rev. Rul. 78-246 relies on the legislative history of the conformity requirements in sections 472(c) and (e)(2). The sections were enacted to ensure that the LIFO method will conform as nearly as possible to the best accounting practice in the trade or business, determined on the basis of the United States standards of accounting practice (see H. Rep. No. 2330, 75th Cong., 3d Sess. 34 (1938)). Because Congress was specifically concerned with domestic accounting practice, the conformity requirements of section 472 were not intended to determine what would be the best accounting practice in a foreign country. Accordingly, Rev. Rul. 78-246 concludes that it is inappropriate to impose the LIFO method of inventory valuation upon a foreign parent corporation with respect to the inventory of any subsidiary that uses the LIFO method of inventory valuation for federal income tax purposes when the group is engaged in substantial foreign operations.

  In Insilco Corp. v. Commissioner, 73 T.C. 589 (1980), affd. mem., 659 F.2d 1059 (2d Cir. 1981), the Tax Court held that the LIFO conformity rules were met by a domestic subsidiary using the LIFO method for federal income tax purposes where the subsidiary used the LIFO method to compute its income in its financial reports issued to its domestic parent company, even though the parent company converted the subsidiary's earnings to a non-LIFO basis in the parent's consolidated financial statements. In response to this decision, Congress enacted section 472(g) of the Code.

  Section 472(g)(l) provides that all members of the same group of financially related corporations are treated as one taxpayer for purposes of the conformity requirements of sections 472(c) and (e)(2). Section 472(g)(2) defines a 'group of financially related corporations' as any affiliated group as defined in section 1504, determined by substituting '50%' for '80%' each place it appears in section 1504(a) and without regard to section 1504(b), and any other group of corporations that consolidate or combine for purposes of financial statements. Section 472(g) of the Code was added to the Code by section 95 of the Tax Reform Act of 1984, 1984-3 C.B. (Vol. 1) 124.

  Section 472(g) of the Code was enacted because Congress was concerned that taxpayers could 'avoid the effect of the LIFO conformity rule under the Insilco decision through the creation of holding companies or subsidiaries'. (H.R. 98- 432, part 2, 98th Cong. 2d Sess. 1380 (1984); S. Rep. 98-169, vol. 1, 98th Cong. 2d Sess. 486 (1984)). Congress believed that the LIFO conformity rule should be applied to all financial reports of all corporations in which the taxpayer's inventory is included. Thus, under section 472(g), it was intended that the conformity requirement generally apply to a parent corporation that issues financial statements to its shareholders on a consolidated basis with a subsidiary (or on a combined basis with an affiliated company) that uses the LIFO method of accounting for tax purposes, or a parent that uses the equity method of financial accounting to include the results of operations of a financially related corporation that uses the LIFO method of accounting for tax purposes. However, Congress made it clear that the 'limited exceptions to the conformity requirement provided under present law (or the similar limited exceptions provided by the Treasury, if appropriate, in the future) should be allowed.' The legislative history identifies Rev. Rul. 78-246 as one of those limited exceptions to the conformity requirement which were to continue to be allowed.

  Therefore, the Internal Revenue Service will continue to adhere to the position set forth in Rev. Rul. 78-246. Furthermore the Service has determined that it is appropriate to apply the rule of Rev. Rul. 78-246 to corporations that issue financial statements on a combined basis with affiliated corporations, for the reasons stated in Rev. Rul. 78-246. However, the position set forth in Rev. Rul. 78-246 applies only to certain foreign owned groups of affiliated corporations; it does not apply to United States owned groups of affiliated corporations. The rationale of Rev. Rul. 78-246 does not extend to the foreign subsidiary of a domestic parent. Such a broad application of that rationale is not consistent with section 472(c) and is excluded by the enactment of section 472(g)(2), which includes foreign corporations in the definition of a 'group of financially related corporations,' and the legislative history to section 472(g).

  In situation 1, FP, S1, FS1, FS2, and FS3 are a group of financially related corporations as defined in section 472(g)(2)(A). Under section 472(g)(1), they are treated as one taxpayer for purposes of the conformity requirement of subsections (c) and (e)(2) of section 472. However, the group is engaged in substantial foreign operations within the meaning of Rev. Rul. 78- 246. Accordingly, although S1 uses the LIFO method of inventory valuation for federal income tax purposes, that method need not be used for its inventories when they are included in the consolidated financial statements of the group. S1 must otherwise comply, however, with the conformity requirements of sections 472(c) and (e)(2) of the Code in inventorying its goods to ascertain income, profit, or loss for the purposes of a report or statement (covering the taxable year for which the LIFO method is used) to shareholders, partners, other proprietors, or beneficiaries, or one used for credit purposes.

  In situation 2, X, F1, F2, and F3 are a group of financially related corporations as defined in section 472(g)(2)(B). Under section 472(g)( 1), the group is treated as one taxpayer for purposes of the conformity requirement of subsections (c) and (e)(2) of section 472. However, the group is engaged in substantial foreign operations as defined in Rev. Rul. 78-246. Therefore, although X uses the LIFO method of inventory valuation for federal income tax purposes, that method need not also be used for its inventories when they are included in the combined financial statements of the group. X must otherwise comply, however, with the conformity requirements of section 472(c) and (e)(2) of the Code in inventorying its goods to ascertain income, profit, or loss for the purposes of a report or statement (covering the taxable year for which the LIFO method is used) to shareholders, partners, other proprietors, or beneficiaries, or one used for credit purposes.

  In situation 3, P, FS1, S1, S2, and S3 are a group of financially related corporations as defined in section 472(g)(2)(A). Under section 472(g)(1), they are treated as one taxpayer for purposes of the conformity requirements of subsections (c) and (e)(2) of section 472. Although the group is engaged in substantial foreign operations within the meaning of Rev. Rul. 78-246, that revenue ruling does not apply to United States owned groups of financially related corporations. Accordingly, because FS1 uses the LIFO method of inventory valuation for federal income tax purposes, that method must be used for its inventories when they are included in the consolidated financial statements of the group.

HOLDINGS

  SITUATION 1. The LIFO method of inventory valuation need not be used for the inventories of S1 when they are included in the consolidated financial statement of FP, S1, FS1, FS2, and FS3.

  SITUATION 2. The LIFO method of inventory valuation need not be used for the inventories of X when they are included in the combined financial statement of X, F1, F2, and F3.

  SITUATION 3. The LIFO method of inventory valuation must be used for the inventories of FS1 when they are included in the consolidated financial statement of P, FS1, S1, S2, and S3.

EFFECT ON OTHER REVENUE RULINGS

  Rev. Rul. 78-246 is amplified.

DRAFTING INFORMATION

  The principal author of this Revenue Ruling is Carl Cooper of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and Treasury Department participated in developing this Revenue Ruling, in matters of both substance and style.

Rev. Rul. 89-41, 1989-1 C.B. 167, 1989-14 I.R.B. 7.