70 Tax Notes 111

Tax Notes

JANUARY 1, 1996

LENGTH: 3267 words

DEPARTMENT: Viewpoint (VWP)

CITE: 70 Tax Notes 111

HEADLINE: 70 Tax Notes 111 - FEDERAL CIRCUIT PLAYS DIRTY POOL WITH INVENTORY ACCOUNTING. (Section 446 -- Methods of Accounting)

AUTHOR: Johnson, Calvin H.

University of Texas School of Law

CODE: Section 446 -- Methods of Accounting

SUMMARY:

Calvin H. Johnson is Andrews & Kurth Centennial Professor of Law at the University of Texas. Professor Johnson was considered, but not used as, an expert for the government in the trial court case, Apollo

INDEX: accounting methods; inventories

REFERENCES:

Subject Area:

Accounting

Business Tax Issues

TEXT: 01 JAN 95

In Hewlett-Packard Co., et al. v. United States, 76 AFTR2d Par. 95-5715, 95 TNT 240-9 (Fed. Cir. 1995), the Court of Appeals for the Federal Circuit has reversed the Court of Federal Claims, overruled the IRS, and allowed the taxpayer to have both ITC and ACRS depreciation on its pool or inventory of repair parts. The IRS, quite reasonably, treated the pool of repair parts on hand at the end of the year as closing inventory, which is nondepreciable. The Federal Circuit, however, said that the parts were not inventory because the taxpayer was just providing a repair service for its computers and not selling parts. Ironically, the statute, reading its words in English, delegates the authority to require inventory accounting and to judge accounting methods to the IRS and, here, the IRS disposition would have been perfectly fine accounting. The Federal Circuit is showing a hostility to the IRS on accounting issues that is highly inappropriate to an issue delegated to the IRS, especially when as here, the IRS is right and the Federal Circuit is so terribly wrong on the ultimate merits of the accounting.

'Rotating' Repair Parts

The taxpayer in the years at issue was a computer company, called Apollo Computer. Hewlett-Packard is the named party in the case only because it took over Apollo during the course of the appeal. The parts at issue were a pool of 'rotating' computer circuit boards and other spare parts used by Apollo to repair computers that Apollo had sold to customers. Apollo did most of its repairs under its initial warranty of the computers or under contracts for extended service. Commonly, an Apollo technician would go to the customer's office to repair the computer and, for speed and ease, the technician would fix the computer on site just by swapping out suspect or defective circuit boards. The customer's old circuit boards were then brought back to Apollo premises for inspection and testing. Some boards were repaired, sometimes easily and sometimes with effort. Once repaired, the boards were put back into the pool or inventory for further use. Some boards were put back into the pool 'as is.' Some boards were thrown out as defective and not worth repairing. The boards are called 'rotating' because boards pulled out of customer machines could go back into the pool. Circuit boards put back into the pool, whether or not repaired, were indistinguishable from newly manufactured circuit boards, which were also being added to the pool.

The Rationale of Inventory Accounting

The IRS, quite reasonably, treated the circuit boards and other parts Apollo had on hand at the end of the year as closing inventory. Closing inventory is not deductible. The taxpayer's costs are still found in the parts on hand in the pool. Given the lower of cost or market method of inventory accounting, we can reasonably presume the inventory parts were worth at least what they originally cost to make. The taxpayer has not lost anything economically. Costs in closing inventory are capitalized and become basis and do not qualify as immediate deductions. A taxpayer gets to recover its costs for inventory parts on hand when the parts are ultimately sold or discarded or when the parts provably decline in value.

Closing inventory is also not depreciable because inventory is being constantly refreshed. Inventory costs do not exhaust or expire for tax accounting purposes because the inventory items are a pool that is always turning over. Circuit boards were continuously leaving the pool to move to customers or because they were found to be defective. Newly manufactured or newly inspected parts were continuously being added to the pool. Especially given the changes in the computer industry, none of the computer boards was physically very old. The circuit boards remained in the pool only because Apollo itself on inspection considered the parts to be as good as new. In short, inventory is a pool, like a fountain of youth, that never grows old because it is constantly being renewed.

The Economic Harm From Deducting Closing Inventory

Deducting or depreciating inventory costs that are still on hand and still valuable is a violation of the fundamental norms of an income tax. Under an income tax, costs that remain part of wealth cannot be deducted, even when the costs are profit-related. Investments, in an income tax, are made and continued with cash that has not been deducted. Costs that remain part of the taxpayer's wealth and investment must not be deducted, but must remain part of basis.

The ability to deduct unexpired costs that remain part of wealth and investment is an extraordinary privilege within an income tax. Deducting unexpired costs is like exempting subsequent income generated by the costs from tax: The ability to make an investment with deducted or untaxed 'soft money' can ordinarily be expected to be as valuable as not having to pay tax on the subsequent income. The effective tax rate on the income generated by the investment is zero.

How valuable a zero effective tax rate is also depends upon what tax rate the investor could expect on normally taxed investments. The zero rate is not all that valuable to investors and bidders who would pay low tax anyway, but it is worth a great deal to investors and bidders who would otherwise face high rates on their business investments. When zero effective tax rate investments are selectively available, then high-bracket investors bid up the price of the good or investment and drive out lower-tax-bracket competitors. Tax then upsets the level playing field in the competition for investment. Tax then also distorts the competition between investments and makes investments that are losing investments on their real pretax appeal become the winning investment after tax.

Thus, within an income tax, there is a 'prime directive' by which to judge how well an accounting method reflects income. The prime directive is to maintain adjusted basis at the level where it is equal to the real remaining investment value of the costs. Closing inventory that still has value should not be deducted or depreciated to drop the adjusted basis below its real investment value. Only by maintaining the prime directive is it possible to identify capital, to identify the income from the capital and to subject the income to tax at the general statutory tax rate. Only by maintaining costs as nondeductible closing inventory is it possible to make tax a level playing field in the competition among investors in different tax brackets and among investments of different kinds. /1/

Materiality

The issue in Apollo was material, that is, the amount at stake was large enough to be worth accounting for correctly. /2/ Apollo listed the circuit boards as available for sale, for prices varying from $200 to $10,000 a board. Between 1983 and 1985, the taxpayer's closing inventory for the pool expanded dramatically from $500,000 to $21 million, which is not a trivial cost.

ACRS

Treating the repair parts as inventory would have been a sound and perfectly acceptable accounting method, except that in 1981 Congress adopted a more advantageous tax treatment that Apollo wanted to fit into. In the years at issue, depreciable property got both a rapid write-off of basis under the accelerated cost recovery system ('ACRS') and also an investment tax credit ('ITC') at 10 percent of basis. Depending on the discount rate used to calculate present values, the tax savings generated by the combination of ACRS and ITC were commonly more valuable than the tax that the business would have to pay on the income generated by the costs invested: on net, depreciable property would then benefit from less than zero tax, that is, a negative tax rate. /3/ Even when depreciable property bore some positive tax on net, ITC and ACRS were still valuable enough to mean that the effective tax on depreciable property was very close to zero. Even now, depreciation is accelerated, so that closing inventory does better than modified ACRS in keeping adjusted basis up to the real investment value. Inventory accounting, with closing inventory accounts kept equal to the unexpired or investment value of the costs makes the real or effective tax rate equal to the statutory tax rate. ACRS and ITC made the real tax rate negative or near zero. Apollo went for the negative or near zero tax rate.

Dirty 'Pool'

While 'inventory' identified as such is not depreciable and not eligible for either ITC or ACRS, Apollo described the circuit boards held for repairs as a 'pool' and claimed both ACRS and ITC. In reasonable usage, the term 'inventory' and the term 'pool' are synonyms. Inventory is nondepreciable precisely because it is a pool, constantly rotating out old costs and being refreshed by new costs. But 'pool' is a word not necessarily contaminated by the unwanted conclusion adhering to 'inventory' that the costs on hand must remain undepreciable. The taxpayer reported the costs of the 'pool' as eligible for ACRS and ITC, although by its other name, 'inventory,' the tax treatment of the costs would not have smelled so sweet.

Vested in the Discretion of the Commissioner

On audit the IRS determined that the circuit boards were inventory, subject to the capitalization requirement applied to closing inventory and were not depreciable. According to the Supreme Court, the statute vests with the commissioner of Internal Revenue's wide discretion to determine whether a particular method of accounting clearly reflects income. /4/ Section 471 provides that inventory accounting must be used by the taxpayer 'whenever in the opinion of the Secretary the use of inventories is necessary in order clearly to determine the income of any taxpayer' and that inventory 'shall be taken by such taxpayer on such basis as the Secretary may prescribe.' Section 446(b) backs up the inventory requirement and provides that no general method of accounting shall be acceptable for tax purposes, unless in the opinion of the Secretary of the Treasury or his delegate, the method clearly reflects income. '[N]o method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income.' /5/

These are pretty strong words, apparently giving the IRS the final authority to make accounting decisions. If the IRS is given a choice between closing inventory that would maintain statutory tax rate as the real or effective tax rate, and a method of accounting for the pool that generated a negative or near negative tax, it would seem reasonable that the IRS should choose the former method, that is, inventory accounting. It is inventory accounting and not treatment as depreciable property that as a matter of economics, 'clearly reflects income,' because at least under ACRS the depreciation means there is no net tax on the income. Sections 446(b) and 471 imply that the commissioner should be insisting on inventory accounts such that the adjusted basis of the pool comes up to the investment value of the taxpayer's costs.

The discretion delegated to the IRS on the face of the statute, however, is commonly met by a counter-argument that the commissioner may not abuse her discretion. The court then proceeds to determine whether the commissioner has abused her discretion by deciding the accounting issue of 'clear reflection' on its own de novo and as a matter of law. There is a recurring pattern in which a court takes the accounting issue out of the hands of the commissioner under the abuse-of-discretion rubric and then proceeds to get the issue wrong, upholding bad accounting for the benefit of the taxpayer. /6/ In Hewlett-Packard, the Court of Appeals for the Federal Circuit reversed the trial-level Court of Federal Claims, to allow the taxpayer its accounting method. Hewlett-Packard is yet another example of of a court rejecting the commissioner's discretion so as to get the issue exactly wrong, on its own.

The Court of Appeals held the circuit boards were not inventory because Apollo was not selling merchandise by putting new circuit boards into customer computers. Rather, Apollo just provided a business or service of maintaining its computers. Apollo commonly did not bill for the new boards separately. It usually provided the boards under its initial warranty of its computers or under a service contract for extended maintenance. The price for warranty or extended service did not vary according to the number or list price of parts that were used. /7/ The parts were just on hand, the court held, to allow Apollo to provide faster, better maintenance to the customer. Apollo was not 'selling' its parts. The parts were just incidental to Apollo's repair service business.

Ordinarily, a finding that the taxpayer is just providing a service entails that the taxpayer may then deduct the costs under the cash method as soon as they are incurred. Lawyers, for instance, get to deduct their costs of producing future income as soon as the costs are paid and they have heretofore been immune from the normal rules of capitalization. /8/ That is about as bad accounting as you can find in the world. Under an income tax, investments are supposed to be capitalized, but lawyers and other service providers get to deduct costs, even though they are investments and even though they are matched against income billed to the client only in the future. The finding that Apollo's parts were just part of a service contract was a way station toward finding that a terrible method of accounting was acceptable, a method that in no way reflects income.

Even if we assume, arguendo, that the parts were not for sale to customers in the ordinary course of Apollo's business, it is difficult to see why the court would not still have held that parts still on hand were not lost or expired costs. The pool was constantly being renewed and refreshed. Inventory accounting was a reasonable way to describe the pool. If inventory accounting was a reasonable description, that should have been enough within a statutory framework that on its face says that is for the commissioner and not the court to call.

Here the taxpayer got something better than expensing of costs that still had future value: ACRS and ITC. ACRS and ITC in combination were better than mere expensing of the costs. The decision does not depend upon the intended scope of ACRS and ITC. The rationale instead is the court may impose bad accounting on the commissioner, notwithstanding the delegation to the commissioner in the statute.

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FOOTNOTES.

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/1/ Calvin Johnson, 'Capitalization After the Government's Big Win in INDOPCO,' Tax Notes, June 6, 1994, p. 1323, expands the argument and gives sources.

/2/ See section 132(e)(1) ('de minimis fringe benefits' are those so small as to make accounting for them unreasonable or administratively impracticable).

/3/ Calvin Johnson, 'Tax Shelter Gain Under the Income Tax,' 61 Texas L. Rev., 1013, 1022-1024 (1983), shows the discount rates under which ACRS, ITC, and tax on income in combination yielded net negative, net zero, or net positive tax burdens.

/4/ Thor Power Tool Co. v. Power, 439 U.S. 522, 532 (1979).

/5/ Treas. reg. section 1.446-1(a)(2) (1993).

/6/ The courts commonly reject the commissioner's authority:

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(1) to capitalize costs that have not expired but

remain as investments producing future value. See, e.g.,

Van Raden v. Commissioner, 650 F..2d 1046, 1049 (9th Cir.

1981) (preventing the commissioner from capitalizing

material prepaid feed in a tax shelter under the Circuit

rule that one-year costs are always expensed), result

criticized, e.g., by Calvin Johnson, 'Soft Money Investing

Under the Income Tax,' 1989 U. Ill. L. Rev. 1071,1079-

1086; Fort Howard Paper Co. v. Commissioner, 49 T.C. 275,

284 (1967) (in court's opinion, failure to capitalize

overhead costs of self-constructed assets clearly

reflected income), results reversed by section 263A(a) and

Treas. reg. section 1.263A-1(e)(3) (indirect labor costs

of self-produced asset capitalized); Heavenly Hill

Distilleries Inc. v. United States, 476 F.2d 1327, 1336

(1973) (reading statute as giving taxpayer flexibility not

to capitalize cost of storage of aging whiskey); and Van

Pickerel & Sons, Inc. v. United States, 445 F.2d 918 (7th

Cir. 1971) (accord) result reversed by Treas. reg. section

1.263A-1(e)(3)(ii)(H),(M) (storage costs and insurance

must be capitalized); NCNB v. Commissioner, 684 F.2d 285,

292-293 (4th Cir. 1982) (presumption that controller

mandated accounting clearly reflected income overcame

commissioner's attempt to capitalize business expansion

costs), results questioned in Calvin Johnson,

'Capitalization After the Government's Big Win in

INDOPCO,' Tax Notes, June 6, 1994, p. 1334 (NCNB relied on

defunct 'separate asset' test); Hadley v. Commissioner,

819 F.2d 359 (2d Cir. 1987) (commissioner could not

consider author's costs of writing a book 'investments')

(query how they can be related to profit at all if they

are not investments, since the author had no current

revenue).

(2) to defer cash in hand that taxpayer may invest or

consume because the wealth is not yet earned. Artnell v.

Commissioner, 400 F.2d 981, 985 (7th Cir. 1968) (failure

to defer prepaid baseball tickets at least arguably an

abuse of discretion), on remand 29 T.C.M. 403 (1970)

(finding deferral more clearly reflects income than

immediate tax on prepayments), and Boise Cascade Corp. v.

United States, 530 F.2d 136, 1373 (Ct. Cl.), cert. denied

429 U.S. 867 (1976) (deferring prepaid income for

engineering services), criticized by Calvin Johnson, 'The

Illegitimate Earned Requirement in Tax and Nontax

Accounting,' -- Tax L. Rev.-- (forthcoming 1996) (deferral

of unearned service income is bad economic description).

(3) to unmatch income, with deductions first and

revenue later. Public Service of New Hampshire, 78 T.C.

446, 457 (1982) (utility may deduct costs of electricity

as provided while deferring revenue from electricity until

billed in the following year).

(4) as in Hewlett-Packard, to allow a constantly

refreshed pool of inventory in the pipeline on the way to

customers as depreciable property rather than inventory.

Transwestern Pipeline v. United States, 639 F.679, 688

(Ct. Cl. 1980) (notwithstanding the authority in section

471 to proscribe inventory accounting, oil in pipeline was

depreciable property).

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/7/ Hewlett-Packard, presumably, is readily distinguished in other cases in which the cost of parts is stated separately or in which a court can find on its own that the parts have an allocable or identifiable cost and are not a free lunch for customers. The best thing about Hewlett-Packard may well be that it sets itself up to be readily distinguished.

/8/ Cf. section 448(b)(2),(d)(1) (lawyers may continue to use cash method, notwithstanding anti-shelter rules putting taxpayers on accrual method).

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