Rev. Proc. 75-40

Section 1. Purpose

The purpose of this Revenue Procedure is to set forth certain procedures to be used by the Internal Revenue Service with respect to taxpayers who are changing to or who have changed to the full absorption method of inventory costing under section 1.471-11(e) of the Income Tax Regulations. Specifically, the Revenue Procedure requires certain representations to be made for the purpose of determining whether or not the proposed treatment of indirect production costs under section 1.471-11(c)(2)(iii) is inconsistent with generally accepted accounting principles.

Sec. 2. Scope

This Revenue Procedure is applicable to any taxpayer that is changing to or who has changed to the full absorption method of inventory costing who, under its proposed method of full absorption costing, has or will exclude from inventoriable costs any or all of the indirect production costs listed in or subject to section 1.471-11(c)(2)(iii) of the regulations.

Sec. 3. Background

.01 Section 1.471-11(e)(1)(i) of the regulations provides, in part, that a taxpayer not using the full absorption method of inventory costing as prescribed by paragraph (a) of section 1.471-11 must change to that method.

.02 Section 1.471-11(e)(1)(ii) of the regulations provides a special election during the two-year-transition period where a taxpayer may elect on Form 3115 to change to the full absorption method of inventory costing. Such election shall be made during the first 180 days of any taxable year beginning on or after September 19, 1973, and before September 19, 1975.

.03 Announcement 75-42, 1975-19 I.R.B. 138, issued as Technical Information Release 1365, dated April 17, 1975, as amended by Technical Information Release 1375, dated May 7, 1975, announced a proposed revenue procedure wherein the Service invited comments relative to certain representations that may be required from taxpayers changing to the full absorption method of inventory costing.

.04 Rev. Proc. 75-34, page 560, this Bulletin, was announced by Technical Information Release 1389, dated June 25, 1975. Rev. Proc. 75-34 extended the time for filing Form 3115 (Application for Change in Accounting Method) by taxpayers who are changing to the full absorption method of inventory costing and are electing the transition procedures under section 1.471-11(e)(1)(ii) of the regulations. Under Rev. Proc. 75-34 the time for making the election to change to the full absorption method of inventory costing and to use the transition procedures set forth in section 1.471-11(e)(1)(ii) was extended until 60 days after the Service publishes its decision with respect to the proposed Revenue Procedure announced in Announcement 75-42, or as provided in section 1.471-11(e)(1)(ii), whichever is later. This Revenue Procedure is the publication of the Service's decision referred to in Rev. Proc. 75-34. Thus, a taxpayer that desires to make an election for a taxable year with respect to which the first 180 days had not expired on or before April 17, 1975 (the date Announcement 75-42 was issued as Technical Information Release 1365) has until November 28, 1975 or the end of such 180 days, whichever is later, to make the election to change to the full absorption method of inventory costing and to use the transition procedures set forth in section 1.471-11(e)(1)(ii).

.05 Section 1.471-11(a) of the regulations provides, in part, that in order to conform as nearly as may be possible to the best accounting practices and to clearly reflect income (as required by section 471 of the Code), both direct and indirect production costs must be taken into account in the computation of inventoriable cost in accordance with the "full absorption" method of inventory costing. Under the full absorption method of inventory costing production costs must be allocated to goods produced during the taxable year, whether sold during the taxable year or in inventory at the close of the taxable year, determined in accordance with the taxpayer's method of identifying goods in inventory. Thus, the taxpayer must include as inventoriable costs all direct production costs and, to the extent provided by paragraphs (c) and (d) of section 1.471-11, all indirect production costs.

.06 Section 1.471-11(c)(2) of the regulations contains three categories of indirect production costs--(i) those costs that are inventoriable regardless of the taxpayer's treatment of such costs in its financial reports, (ii) those costs that are not required to be considered inventoriable regardless of the taxpayer's treatment of such costs in its financial reports, and (iii) those costs that are to be included or excluded as inventoriable costs in accordance with the taxpayer's treatment of such costs in its financial reports and generally accepted accounting principles.

.07 Section 1.471-11(c)(2)(iii) of the regulations provides, in part, that the inclusion or exclusion of such costs (listed in the subdivision) from the amount of inventoriable costs for purpose of a taxpayer's financial reports shall determine whether such costs must be included in or excluded from the computation of inventoriable costs for Federal income tax purposes, but only if such treatment is not inconsistent with generally accepted accounting principles.

Sec. 4. Application

.01 Section 1.471-11(c)(2)(i) and (ii) of the regulations establish definitive treatment of certain production costs for Federal income tax purposes irrespective of the treatment of such costs in the taxpayer's financial reports. Section 1.471-11(c)(2)(iii) establishes the tax treatment of certain indirect production costs on a two-step basis. The first step is to determine the tax treatment of the item of cost on the basis of an objective test that is, whether the item has been and/or will be included as an inventoriable cost in the taxpayer's financial reports. The second step is to determine the tax treatment of an item of cost on the basis of a more independent test that is, whether under the standards of generally accepted accounting principles it is appropriate to either include or exclude the item as an inventoriable cost.

.02 In setting forth a "three category" approach to the treatment of indirect production costs for Federal income tax purposes, section 1.471-11(c)(2) of the regulations is intended to establish fixed rules with respect to certain indirect production costs, and flexible rules with respect to certain other indirect production costs. The flexible rules are intended to take into account varying industry and trade or business practices with respect to such costs that come within the scope of generally accepted accounting principles.

.03 With respect to the flexible rules set forth in section 1.471-11(c)(2)(iii) of the regulations, the two-step approach provided therein applies a financial reports test as an objective measure of the appropriateness of either including or excluding certain indirect production costs, and further applies a generally accepted accounting principles test as an independent measure to insure, to the extent possible, that the appropriateness of either including or excluding such indirect production costs in such financial statements reflects generally accepted accounting principles within the taxpayer's industry or trade or business.

.04 The Service notes that some taxpayers have attempted to justify the exclusion of some or all costs listed in section 1.471-11(c)(2)(iii) of the regulations from inventoriable costs for income tax purposes as not inconsistent with generally accepted accounting principles on the basis of offsetting of costs included in inventoriable costs under section 1.471-11(b)(2), (c)(2)(i), or (c)(2)(ii) against costs to be excluded under section 1.471-11(c)(2)(iii). For example, certain taxpayers required to include costs listed in sections 1.471-11(b)(2) or (c)(2)(i) in inventoriable costs for Federal income tax purposes have sought to include such costs in inventoriable costs for financial reporting purposes and to exclude costs listed in section 1.471-11(c)(2)(iii) for tax and financial reporting purposes as an offset. In some cases, where the net overall change in inventiorable costs for financial reporting purposes resulted in a greater amount of costs being removed from inventory, taxpayers have sought to justify such change in treatment of costs under section 1.471-11(c)(2)(iii) for Federal income tax purposes as being not inconsistent with generally accepted accounting principles because the net reduction in inventoriable costs was immaterial in amount, in a financial reporting sense. In other cases, where the net overall change in inventoriable costs for financial reporting purposes resulted in a greater amount of cost being included in inventory, taxpayers have sought to justify such change as being not inconsistent with generally accepted accounting principles because the change resulted in a net increase in inventoriable costs. In such cases, the Service does not believe that taxpayers are properly complying with the intent of the regulations. It is the position of the Service that the items of cost listed in section 1.471-11(c)(2)(iii), taken as a whole, must be tested as to includibility or excludibility from inventoriable costs under the merits of generally accepted accounting principles as applied to the taxpayer's industry or trade or business without regard to either the materiality of such costs or the financial reporting treatment of costs listed in sections 1.471-11(b)(2), (c)(2)(i), or (c)(2)(ii).

.05 The Service will not recognize immateriality, in a financial reporting sense, as justification for the exclusion of costs listed in section 1.471-11(c)(2)(iii) of the regulations from inventoriable costs for Federal income tax purposes.

.06 It was not the intent of section 1.471-11(c)(2)(iii) of the regulations to encourage taxpayers to change their financial reporting treatment of costs listed in such section in order to obtain a tax advantage. Thus, the Service will not ordinarily permit taxpayers to exclude costs listed in section 1.471-11(c)(2)(iii) from inventoriable costs if the taxpayer had included such costs in inventoriable costs in financial reports issued on or before September 19, 1973, the beginning of the two-year transition period referred to in section 1.471-11(e)(1)(ii). An exception to this rule will generally be permitted only where the taxpayer satisfies the conditions of section 5.03 of this Revenue Procedure.

Sec. 5. Procedure

.01 Taxpayers who have not yet received permission to change to the full absorption method for Federal income tax purposes must provide the information specified in section 5.02 or 5.03 below. The Service may also require in certain circumstances information in addition to that requested in section 5.02 or 5.03 below. In the case of taxpayers who have already received permission to change to the full absorption method for Federal income tax purposes, see sections 5.04 and 5.05 below.

.02 Taxpayers changing to the full absorption method for Federal income tax purposes and who propose to exclude from their computation of inventoriable costs some or all of the indirect production costs listed in or subject to section 1.471-11(c)(2)(iii) of the regulations, but not changing the treatment of such costs with respect to financial reports issued on or after September 19, 1973, must represent to the Service that:

"The treatment of all costs listed in or subject to section 1.471-11(c)(2)(iii) of the regulations in the financial reports issued on or after September 19, 1973, of [insert taxpayer's name] are not inconsistent with generally accepted accounting principles. Furthermore, immateriality of inventory costs, in a financial reporting sense, was not relied on as a basis for making the representation in the preceding sentence."

The taxpayer, at its option, may also provide for the Service's consideration a representation or concurrence from its independent public accountant to the effect that:

"The principles applied to the financial statements of [insert taxpayer's name] for [insert taxable year for which the change to full absorption is requested], with respect to the valuation of inventories taken as a whole, are not inconsistent with generally accepted accounting principles."

.03 Taxpayers changing to full absorption for Federal income tax purposes and changing the treatment of any or all costs listed in or subject to section 1.471-11(c)(2)(iii) of the regulations for financial report purposes with respect to financial reports issued on or after September 19, 1973, must represent to the Service that:

"The net effect of changes in the financial reporting treatment of costs listed in or subject to section 1.471-11(c)(2)(iii) of the regulations is a change to a preferable method of accounting for the taxpayer's industry or trade or business, without regard to either the immateriality of such costs in a financial reporting sense or the treatment of costs listed in section 1.471-11(b)(2), (c)(2)(i) or (c)(2)(ii)."

In addition, the taxpayer must provide a written explanation justifying the preferability of the net effect of the changes in the financial reporting treatment of costs listed in or subject to section 1.471-11(c)(2)(iii) of the regulations. Absent a clear justification of the preferability of such changes, the Service will deny the taxpayer's request to exclude such costs from inventoriable costs for Federal income tax purposes. See section 4.06 of this Revenue Procedure.

The taxpayer, at its option, may also provide for the Service's consideration a representation or concurrence from its independent public accountant to the effect that:

"The principles to be applied to the financial statements of [insert taxpayer's name] for [insert taxable year for which the change to full absorption is requested] with respect to the valuation of inventories taken as a whole, are not inconsistent with generally accepted accounting principles. For purposes of the representation in the preceding sentence, the net effect of changes listed in or subject to section 1.471-11(c)(2)(iii) of the regulations in financial reports issued on or after September 19, 1973, is not inconsistent with generally accepted accounting principles, irrespective of the treatment of costs listed in sections 1.471-11(b)(2), (c)(2)(i) or (c)(2)(ii)."

.04 Prior to the publication of Announcement 75-42 and the amplification of section 1.471-11(e) of the regulations by this Revenue Procedure the Service issued letters of consent to certain taxpayers who timely elected to change to the full absorption method of inventory costing during the transition period prescribed in section 1.471-11(e)(1)(ii). In considering applications filed by such taxpayers, representations of the types specified in sections 5.02 and 5.03 above, were, in general, neither requested by the Service nor supplied by the taxpayers. Under the authority contained in section 7805(b) of the Code, the Service will not retroactively amend or modify, except as provided in section 5.05 below, any consent letter issued to a taxpayer prior to the publication of this Revenue Procedure. However, any taxpayer whose situation is described in sections 5.02 or 5.03, above, and who had previously received a letter of consent as referred to in this section, must provide the Service the representation required by sections 5.02 and 5.03, whichever is appropriate, within the first 180 days of the first taxable year beginning on or after September 29, 1975, the date this Revenue Procedure is published in the Internal Revenue Bulletin. If the Service determines that an additional adjustment is required because such representation is unacceptable, in whole or in part, or a taxpayer advises the Service, in writing within such 180 day period, that it cannot make the required representation, any additional costs to be included in or excluded from inventoriable costs by virtue of the application of this Revenue Procedure will be considered a change in accounting method for the first taxable year beginning on or after September 29, 1975, the date this Revenue Procedure is published in the Internal Revenue Bulletin. The adjustment required under section 481(a) will be taken into account pursuant to the transition rules contained in section 1.471-11(e) of the regulations without regard to the effective dates contained therein.

.05 Within the first 180 days of the first taxable year beginning on or after September 29, 1975, the date this Revenue Procedure is published in the Internal Revenue Bulletin, a taxpayer, at its option, may request to have its original letter of consent for the taxable year for which permission to change to the full absorption method was granted, modified to incorporate any additional adjustments required by section 5.04 above.

.06 Taxpayers described in section 5.04, above, who fail to comply with the requirements contained therein, may be subject to appropriate adjustments under section 481(a) of the Code when their returns are examined. Such taxpayers will not receive the benefits contained in Rev. Proc. 70-27, 1970-2 C.B. 509, as clarified by Rev. Proc. 75-18, 1975-1 C.B. 687. See Rev. Proc. 74-51, 1974-2 C.B. 507, for comparable treatment for taxpayers failing to comply with section 1.471-11 of the regulations.

Sec. 6. Inquiries

Inquiries in regard to this Revenue Procedure should refer to its number and be addressed to the Commissioner of Internal Revenue, Attention T:C:C, 1111 Constitution Avenue, N.W., Washington, D.C. 20224.

Sec. 7. Miscellaneous

Prior to processing an election to change to the full absorption method of inventory costing the Service may need to request other information in addition to the requirements of section 5.02 or 5.03 of this Revenue Procedure.

¹ Also released as TIR-1402, dated 9/9/75.