26 CFR § 1.1502-18 - Inventory adjustment.

§ 1.1502-18 Inventory adjustment.

(a) Definition of intercompany profit amount. For purposes of this section, the term “intercompany profit amount” for a taxable year means an amount equal to the profits of a corporation (other than those profits which such corporation has elected not to defer pursuant to § 1.1502- 13(c)(3) or which have been taken into account pursuant to § 1.1502-13(f)(1)(viii)) arising in transactions with other members of the group with respect to goods which are, at the close of such corporation's taxable year, included in the inventories of any member of the group. See § 1.1502-13(c)(2) with respect to the determination of profits. See the last sentence of § 1.1502-13(f)(1)(i) for rules for determining which goods are considered to be disposed of outside the group and therefore not included in inventories of members.

(b) Addition of initial inventory amount to taxable income. If a corporation:

(1) Is a member of a group filing a consolidated return for the taxable year,

(2) Was a member of such group for its immediately preceding taxable year, and

(3) Filed a separate return for such preceding year,

then the intercompany profit amount of such corporation for such separate return year (hereinafter referred to as the “initial inventory amount”) shall be added to the income of such corporation for the consolidated return year (or years) in which the goods to which the initial inventory amount is attributable are disposed of outside the group or such corporation becomes a nonmember. Such amount shall be treated as gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231.

(c) Recovery of initial inventory amount -

(1) Unrecovered inventory amount. The term “unrecovered inventory amount” for any consolidated return year means the lesser of:

(i) The intercompany profit amount for such year, or

(ii) The initial inventory amount.

However, if a corporation ceases to be a member of the group during a consolidated return year, its unrecovered inventory amount for such year shall be considered to be zero.

(2) Recovery during consolidated return years.

(i) To the extent that the unrecovered inventory amount of a corporation for a consolidated return year is less than such amount for its immediately preceding year, such decrease shall be treated for such year by such corporation as a loss from the sale or exchange of property which is neither a capital asset nor property described in section 1231.

(ii) To the extent that the unrecovered inventory amount for a consolidated return year exceeds such amount for the preceding year, such increase shall be treated as gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231.

(3) Recovery during first separate return year. For the first separate return year of a member following a consolidated return year, the unrecovered inventory amount for such consolidated return year (minus any part of the initial inventory amount which has not been added to income pursuant to paragraph (b) of this section) shall be treated as a loss from the sale or exchange of property which is neither a capital asset nor property described in section 1231.

(4) Acquisition of group. For purposes of this section, a member of a group shall not become a nonmember or be considered as filing a separate return solely because of a termination of the group (hereinafter referred to as the “terminating group”) resulting from:

(i) The acquisition by a nonmember corporation of (a) the assets of the common parent in a reorganization described in subparagraph (A), (C), or (D) (but only if the requirements of subparagraphs (A) and (B) of section 354(b)(1) are met) of section 368 (a)(1), or (b) stock of the common parent, or

(ii) The acquisition (in a transaction to which § 1.1502-75(d)(3) applies) by a member of (a) the assets of a nonmember corporation in a reorganization referred to in subdivision (i) of this subparagraph, or (b) stock of a nonmember corporation,

if all the members of the terminating group (other than such common parent if its assets are acquired) immediately before the acquisition are members immediately after the acquisition of another group (hereinafter referred to as the “succeeding group”) which files a consolidated return for the first taxable year ending after the date of acquisition. The members of the succeeding group shall succeed to any initial inventory amount and to any unrecovered inventory amount of members of the terminating group. This subparagraph shall not apply with respect to acquisitions occurring before August 25, 1971.

(d) Examples. The provisions of paragraphs (a), (b), and (c) of this section may be illustrated by the following examples:

Example 1.
Corporations P, S, and T report income on the basis of a calendar year. Such corporations file separate returns for 1965. P manufactures widgets which it sells to both S and T, who act as distributors. The inventories of S and T at the close of 1965 are comprised of widgets which they purchased from P and with respect to which P derived profits of $5,000 and $8,000, respectively. P, S, and T file a consolidated return for 1966. During 1966, P sells widgets to S and T with respect to which it derives profits of $7,000 and $10,000, respectively. The inventories of S and T as of December 31, 1966, are comprised of widgets on which P derived net profits of $4,000 and $8,000, respectively. P's initial inventory amount is $13,000, P's intercompany profit amount for 1965 (such $13,000 amount is the profits of P with respect to goods sold to S and T and included in their inventories at the close of 1965). Assuming that S and T identify their goods on a first-in, first-out basis, the entire opening inventory amount of $13,000 is added to P's income for 1966 as gain from the sale or exchange of property which is neither a capital asset nor properly described in section 1231, since the goods to which the initial inventory amount is attributable were disposed of in 1966 outside the group. However, since P's unrecovered inventory amount for 1966, $12,000 (the intercompany profit amount for the year, which is less than the initial inventory amount), is less than the unrecovered inventory amount for 1965, $13,000, this decrease of $1,000 is treated by P for 1966 as a loss from the sale or exchange of property which is neither a capital asset nor property described in section 1231.
Example 2.
Assume the same facts as in example (1) and that at the close of 1967, a consolidated return year, the inventories of S and T are comprised of widgets on which P derived profits of $5,000 and $3,000, respectively. Since P's unrecovered inventory amount for 1967, $8,000, is less than $12,000, the unrecovered inventory amount for 1966, this decrease of $4,000 is treated by P for 1967 as a loss from the sale or exchange of property which is neither a capital asset nor property described in section 1231.
Example 3.
Assume the same facts as in examples (1) and (2) and that in 1968, a consolidated return year, P's intercompany profit amount is $11,000. P will report $3,000 (the excess of $11,000, P's unrecovered inventory amount for 1968, over $8,000, P's unrecovered inventory amount for 1967) for 1968 as a gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231.
Example 4.
Assume the same facts as in examples (1), (2), and (3) and that in 1969 P, S, and T file separate returns. P will report $11,000 (its unrecovered inventory amount for 1968, $11,000, minus the portion of the initial inventory amount which has not been added to income during 1966, 1967, and 1968, zero) as a loss from the sale or exchange of property which is neither a capital asset nor property described in section 1231.
Example 5.
Corporations P and S file a consolidated return for the first time for the calendar year 1966. P manufactures machines and sells them to S, which sells them to users throughout the country. At the close of 1965, S has on hand 20 machines which it purchased from P and with respect to which P derived profits of $3,500. During 1966, P sells 6 machines to S on which it derives profits of $1,300, and S sells 5 machines which it had on hand at the beginning of the year (S specifically identifies the machines which it sells) and on which P had derived profits of $900. P's initial inventory amount is $3,500, of which $900 is added to P's income in 1966 as gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231, since such $900 amount is attributable to goods disposed of in 1966 outside the group, which goods were included in S's inventory at the close of 1965. If P and S continue to file consolidated returns, the remaining $2,600 of the initial inventory amount will be added to P's income as the machines on which such profits were derived are disposed of outside the group.
Example 6.
Assume that in example (5) S had elected to inventory its goods under section 472 (relating to last-in, first-out inventories). None of P's initial inventory amount of $3,500 would be added to P's income in 1966, since none of the goods to which such amount is attributable would be considered to be disposed of during such year under the last-in, first-out method of identifying inventories.

(e) Section 381 transfer. If a member of the group is a transferor or distributor of assets to another member of the group within the meaning of section 381(a), then the acquiring corporation shall be treated as succeeding to the initial inventory amount of the transferor or distributor corporation to the extent that as of the date of distribution or transfer such amount has not yet been added to income. Such amount shall then be added to the acquiring corporation's income under the provisions of paragraph (b) of this section. For purposes of applying paragraph (c) of this section:

(1) The initial inventory amount of the transferor or distributor corporation shall be added to such amount of the acquiring corporation as of the close of the acquiring corporation's taxable year in which the date of distribution or transfer occurs, and

(2) The unrecovered inventory amount of the transferor or distributor corporation for its taxable year preceding the taxable year of the group in which the date of distribution or transfer occurs shall be added to such amount of the acquiring corporation.

(f) Transitional rules for years before 1966 -

(1) In general. If:

(i) A group filed a consolidated return for the taxable year immediately preceding the first taxable year to which this section applies,

(ii) Any member of such group made an opening adjustment to its inventory pursuant to paragraph (b) of § 1.1502-39A (as contained in the 26 CFR edition revised as of April 1, 1996), and

(iii) Paragraph (c) of § 1.1502-39A (as contained in the 26 CFR edition revised as of April 1, 1996), has not been applicable for any taxable year subsequent to the taxable year for which such adjustment was made,

then subparagraphs (2) and (3) of this paragraph shall apply.

(2) Closing adjustment to inventory.

(i) For the first consolidated return year to which this section applies, the increase in inventory prescribed in paragraph (c) of § 1.1502-39A (as contained in the 26 CFR edition revised as of April 1, 1996), shall be made as if such year were a separate return year.

(ii) For the first separate return year of a member to which this section applies, the adjustment to inventory (whether an increase or a decrease) prescribed in paragraph (c) of § 1.1502-39A (as contained in the 26 CFR edition revised as of April 1, 1996), minus any adjustment already made pursuant to subdivision (i) of this subparagraph, shall be made to the inventory of such member.

(3) Addition and recovery of initial inventory amount. Each selling member shall treat as an initial inventory amount its share of the net amount by which the inventories of all members are increased pursuant to subparagraph (2)(i) of this paragraph for the first taxable year to which this section applies. A member's share shall be such net amount multiplied by a fraction, the numerator of which is its initial inventory amount (computed under paragraph (b) as if such taxable year were its first consolidated return year), and the denominator of which is the sum of such initial inventory amounts of all members. Such initial inventory amount shall be added to the income of such selling member and shall be recovered at the time and in the manner prescribed in paragraphs (b) and (c) of this section.

(4) Example. The provisions of this paragraph may be illustrated by the following example:

Example.
(i) Corporations P, S, and T file consolidated returns for calendar 1966, having filed consolidated returns continuously since 1962. P is a wholesale distributor of groceries selling to chains of supermarkets, including those owned by S and T. The opening inventories of S and T for 1962 were reduced by $40,000 and $80,000, respectively, pursuant to paragraph (b) of § 1.1502-39A (as contained in the 26 CFR edition revised as of April 1, 1996). At the close of 1965, S and T have on hand in their inventories goods on which P derived profits of $80,000 and $90,000, respectively. The inventories of S and T at the close of 1966 include goods which they purchased from P during the year on which P derived profits of $85,000 and $105,000, respectively.

(ii) The opening inventories of S and T for 1966, the first year to which this section applies, are increased by $40,000 and $80,000, respectively, pursuant to the provisions of subparagraph (2)(i) of this paragraph. P will take into account (as provided in paragraphs (b) and (c) of this section) an initial inventory amount of $120,000 as of the beginning of 1966, the net amount by which the inventories of S and T were increased in such year. Since the increases in the inventories of S and T are the maximum allowable under paragraph (c) of § 1.1502-39A (as contained in the 26 CFR edition revised as of April 1, 1996) (i.e., the amount by which such inventories were originally decreased), no further adjustments will be made pursuant to subparagraph (2)(ii) of this paragraph to such inventories in the event that separate returns are subsequently filed.

(5) Election not to eliminate. If a group filed a consolidated return for the taxable year immediately preceding the first taxable year to which this section applies, and for such preceding year the members of the group did not eliminate gain or loss on intercompany inventory transactions pursuant to the adoption under § 1.1502-31A(b)(1) (as contained in the 26 CFR edition revised as of April 1, 1996) of a consistent accounting practice taking into account such gain or loss, then for purposes of this section each member shall be treated as if it had filed a separate return for such immediately preceding year.

(g) Transitional rules for years beginning on or after July 12, 1995. Paragraphs (a) through (f) of this section do not apply for taxable years beginning on or after July 12, 1995. Any remaining unrecovered inventory amount of a member under paragraph (c) of this section is recovered in the first taxable year beginning on or after July 12, 1995, under the principles of paragraph (c)(3) of this section by treating the first taxable year as the first separate return year of the member. The unrecovered inventory amount can be recovered only to the extent it was previously included in taxable income. The principles of this section apply, with appropriate adjustments, to comparable amounts under paragraph (f) of this section.

[T.D. 6894, 31 FR 11794, Sept. 8, 1966, as amended by T.D. 7246, 38 FR 762, Jan. 4, 1973; T.D. 8597, 60 FR 36709, July 18, 1995: T.D. 8677, 61 FR 33323, June 27, 1996]