Rev. Rul. 70-565

Advice has been requested whether, in a nontaxable exchange under section 351(a) of the Internal Revenue Code of 1954, the cost of the LIFO inventory received by the transferee from the transferor may be determined by the average cost method or must be retained and integrated into the transferee's own corresponding LIFO costs and layers.

X corporation transferred LIFO inventories to corporation Y, in a transaction in which no gain or loss was recognized by reason of section 351 of the Internal Revenue Code of 1954. Under section 362(a)(1) of the Code, the inventory retained the same basis in the hands of Y as it had in the hands of X. Both X and Y had been in existence for many years prior to the transfer and each had properly adopted the last-in, first-out (LIFO) method of valuing inventories prior to the transfer. Transactions under section 351 of the Code do not meet the requirements of section 381(a) of the Code. Therefore, the provisions of section 381(c)(5) of the Code, relating to carryovers of inventories in certain acquisitions, are not applicable.

Section 472(a) of the Code, provides that a taxpayer may adopt the LIFO method of inventorying goods provided certain conditions are satisfied. One of the conditions is that an application to use such method must be filed in such manner as the Secretary or his delegate may prescribe. Section 472(b) of the Code provides that in inventorying the goods specified in the application the taxpayer shall (1) treat those goods remaining on hand at the close of the taxable year as being: First, those included in the opening inventory of the taxable year (in the order of acquisition) to the extent thereof; and second, those acquired during the taxable year; (2) inventory them at cost; and (3) treat those included in the opening inventory of the taxable year in which such method is first used as having been acquired at the same time and determined their cost by the average cost method.

In Commissioner v. Joseph E. Seagram & Sons, Inc., 394 F. 2d 738 (1968) reversing 46 T.C. 698 (1966), the court held that a subsidiary, which receives liquor inventories from its parent as a contribution to capital in a tax-free transaction is required to retain its parent's LIFO layers in its own inventory records and integrate them into its own corresponding monthly layers.

In Seagram both transferor and transferee were using LIFO and the bases of the inventory transferred was, under section 362(a) of the Code, the same as in the hands of the transferor. The court stated that neither section 362(a) of the Code nor section 472(b)(1) of the Code are controlling because they do not specifically or impliedly cover a tax-free capital contribution from a parent to its subsidiary. Instead, the court stated that those sections must be read together with sections 471 and 472(a) of the Code and sections 1.471-2(b) and 1.472-4 of the Income Tax Regulations requiring that the taking of inventory must accord with the best accounting practice for the purpose of clearly and consistently reflecting income.

The court then reasoned that, since the underlying purpose of the LIFO method of inventory accounting was to match current income with current costs, the inventory received through a tax-free contribution to capital does not represent current costs to the transferee and the use of the date of transfer as the acquisition cost date undercuts the underlying assumption of the LIFO method.

In the instant case, the essential facts are the same as those in the Seagram case, that is, a transfer of assets in a section 351 transaction with both the transferor and the transferee using the LIFO method of valuing inventories.

Accordingly, in the instant case, it is held that Y may not value the LIFO inventories acquired from X by the average cost method using the date of transfer as the acquisition date but must integrate the acquired LIFO inventories into its own monthly LIFO layers retaining the original acquisition dates and costs of X.

For a situation where the transferor uses LIFO and the transferee is a new corporation or an existing corporation not using LIFO, see Revenue Ruling 70-564, page 109.