LIFO conformity rules violated by giving financial statements using IFRS to lending bank

Legal Advice Issued by Field Attorneys 20114702F
In a Legal Memorandum, IRS has concluded that a corporation's providing financial statements prepared using the International Financial Reporting Standards (IFRS) to a lending bank violated the last-in, first-out (LIFO) conformity requirements under Code Sec. 472(c), Code Sec. 472(e)(2), and Reg. § 1.472-2(e)(1).

Background. Under Code Sec. 472 and Reg. § 1.472-2(e)(1), a taxpayer that elects to use the LIFO inventory method for federal income tax purposes must establish to IRS's satisfaction that it has used no method other than LIFO in inventorying goods specified in its LIFO election to ascertain income, profit, or loss for the first tax year for which the method is to be used, for the purpose of a report or statement covering the tax year to shareholders, partners, or other proprietors, or to beneficiaries, or for credit purposes. In general, IRS may require the taxpayer to discontinue the LIFO method if, in a later tax year, it violates the conformity requirement. (Code Sec. 472(e))

The regs carry detailed rules relating to whether or not a taxpayer is at variance with the Code Sec. 472 LIFO conformity requirement:

• Under Reg. § 1.472-2(e)(1)(i), a taxpayer's use of an inventory method other than LIFO for purposes of ascertaining information reported as a supplement to or explanation of the taxpayer's primary presentation of its income, profit, or loss for a tax year in credit statements or financial reports is not considered at variance with the conformity requirement.
• Under Reg. § 1.472-2(e)(1)(ii), using an inventory method other than LIFO to ascertain the value of the taxpayer's inventory of goods on hand for purposes of reporting the value of such inventories as assets is not considered at variance with the conformity requirement.
• Under Reg. § 1.472-2(e)(4), disclosure of the value of inventories on a balance sheet using a method other than LIFO to identify the inventories will not be considered at variance with the conformity requirement. However, the disclosure of income, profit, or loss for a tax year on a balance sheet issued to creditors, shareholders, partners, other proprietors, or beneficiaries is considered at variance with the conformity requirement if such income information is: (1) ascertained using an inventory method other than LIFO; and (2) is for a tax year for which the LIFO method is used for Federal income tax purposes. Thus, a balance sheet disclosing a taxpayer's net worth, determined as if income had been ascertained using an inventory method other than LIFO, may be at variance with the conformity requirement if the disclosure of net worth is made in a manner that also discloses income, profit, or loss for a tax year. But a disclosure of income, profit, or loss using an inventory method other than LIFO isn't at variance if made in the form of either a footnote to the balance sheet or a parenthetical disclosure on the face of the balance sheet. In addition, an income disclosure isn't considered at variance with the conformity requirement if made on the face of a supplemental balance sheet labelled as a supplement to the taxpayer's primary presentation of financial position, but only if the disclosure is clearly identified as a supplement to or explanation of the taxpayer's primary presentation of financial income as reported on the face of its income statement.

Specific rules relating to the conformity rule exception for supplemental or explanatory information include:

• Information reported on the face of a taxpayer's financial income statement for a tax year isn't considered a supplement to or explanation of its primary presentation of income, profit, or loss for the tax year in credit statements or financial reports. The face of an income statement doesn't include notes to the income statement presented on the same page as the income statement, but only if all notes to the financial income statement are presented together. (Reg. § 1.472-2(e)(3)(i))
• Information reported in an appendix or supplement to a taxpayer's financial income statement is considered a supplement to or explanation of the primary presentation of income, profit, or loss for the period covered by the income statement if it accompanies the income statement in a single report and the information reported in the appendix or supplement is clearly identified as a supplement to or explanation of the primary presentation of income, profit, or loss as reported on the face of the taxpayer's income statement. (Reg. § 1.472-2(e)(3)(iii))

Facts. Taxpayer became a wholly-owned subsidiary of ABC and a member of the ABC Consolidated Group which filed a consolidated federal tax return. ABC was wholly-owned by Foreign Parent, which reported its worldwide consolidated financial statements using the IFRS. Taxpayer had used U.S. Generally Accepted Accounting Principles (GAAP) as its accounting standard, but was required to adopt the IFRS standards by Foreign Parent.

The LIFO inventory method isn't an allowable method under IFRS. Nonetheless, Taxpayer continued to use the LIFO inventory method for accounting for a part of its inventory for both tax and financial reporting purposes. Taxpayer provided financial statements to its foreign parent based upon IFRS standards, including a balance sheet and income statement. Taxpayer also provided the IFRS-only balance sheet and income statement to its lending bank.

In accordance with lending requirements imposed by its bank for a letter of credit, Taxpayer provided the bank with tabulated versions of its balance sheet and income statement under which each was presented on an IFRS and U.S. GAAP standard, along with the IFRS-only balance sheet and income statement. Specifically, the tabulated financial statements made adjustments (including LIFO adjustments) to the IFRS column to arrive at U.S. GAAP. The IFRS version of Taxpayer's profit/income was based on a method that didn't include LIFO principles in inventorying goods. Taxpayer didn't make a distinction between primary or supplemental information within these financial statements related to the change from IFRS to U.S. GAAP reporting standards, nor did it include explanatory footnotes regarding the change.

Use of IFRS violated of conformity rules. In the Memo, IRS concluded that the issuance of the financial statements to the lending bank violated the LIFO conformity requirements. It further concluded that these documents failed to meet the exception for supplemental or explanatory information, and that no other exception applied.

In its analysis, IRS reasoned that Taxpayer would violate the LIFO conformity rules with respect to the financial statements provided to its lending bank if: (1) it used an inventory method other than LIFO to ascertain its income, profit or loss in the financial statements; (2) the financial statements were “for credit purposes”; and (3) the financial statements were not within any of the exceptions to the LIFO conformity requirements.

IRS found that there was no question the IFRS-only versions used a method other than LIFO to ascertain income, profit, or loss. Arguably, the tabulated versions of the financial statements provided to the lending bank could comply with the LIFO conformity requirements—as they used U.S. GAAP to determine income, profit, and loss. However, IRS noted that the LIFO conformity requirements do not merely require the use of a LIFO inventory method. They require that no method other than LIFO be used. (Code Sec. 472(c), Code Sec. 472(e)(2), and Reg. § 1.472-2(e)(1))

In addition, the financial statements were issued to Taxpayer's lending bank under the requirements for a letter of credit (i.e., a debtor-creditor relationship). Taxpayer's continued receipt of credit was dependent upon the provision of these financial statements. Thus, the financial statements were “for credit purposes.”

Finally, IRS concluded that the tabulated financial statements failed to meet the exception for supplemental or explanatory information. While it could be argued that the use of IFRS was for purposes of supplementing or explaining Taxpayer's primary U.S. GAAP position, the provision of information using IFRS wasn't presented as either supplemental or explanatory.

The disclosure of income, profit, and loss using IFRS wasn't made in the form of a footnote to the balance sheet or a parenthetical disclosure on the face of the balance sheet. Even if the disclosure qualified as a parenthetical—despite the lack of parentheses, or other punctuation or formatting to indicate the IFRS information was an aside—the IFRS information was reported on the face of the income statement and not as part of a note to the income statement contrary to Reg. § 1.472-2(e)(3)(i).

Further, even if the tabulated financial statements conformed to the requirements of Code Sec. 472(e) and its regs, Taxpayer also provided the lending bank with the same balance sheet and income statement it provided to Foreign Parent. These documents were prepared based solely on IFRS and weren't identified as supplemental, explanatory, or appendixes. For example, the balance sheet wasn't marked as an appendix or otherwise clearly identified as a supplement to or explanation of Taxpayer's primary presentation.

RIA Research References: For LIFO conformity rule, see FTC 2d/FIN ¶ G-5309; United States Tax Reporter ¶ 4724; TaxDesk ¶ 452,080.