CCA 200004008: Retailer may weight inventory indexes by ending costs

Plain-English summary

A retailer using the inventory price index computation (IPIC) method asked how to combine category indexes for its dollar value LIFO pools. Chief Counsel advised that the retailer could weight the category indexes by current costs in ending inventory using a weighted arithmetic mean. It also said the IRS would not disturb this retailer's continued use of the link chain method to compute pool values on the stated facts. The memo noted that the regulations prefer double extension and that this method can reduce distortions, so its acceptance of link chain did not state a general preference for it.

Ruling snapshot

• Question: May the retailer use ending inventory costs to weight IPIC categories and continue its link chain LIFO calculation?
• Outcome: Advice given: both methods accepted for this retailer on the stated facts.
• Key authorities: IRC §§ 471, 472; Treas. Reg. § 1.472-8(e)(3); Rev. Proc. 84-57; Rev. Proc. 98-49.

Full text (IRS public release)

                            DEPARTMENT OF THE TREASURY
                                I N T E R N AL R E V E N U E S E R V I C E
                                     WASHINGTON, D.C. 20224


                                           October 12, 1999

Number: 200004008
Release Date: 1/28/2000
CC:DOM:FS:IT&A
TL-N-5655-98
UILC: 472.09-00

  INTERNAL REVENUE SERVICE NATIONAL OFFICE FIELD SERVICE ADVICE

MEMORANDUM FOR

FROM:                 Deborah A. Butler
                      Assistant Chief Counsel (Field Service) CC:DOM:FS

SUBJECT:              Inventory Price Index Computation Method

This Field Service Advice responds to your memorandum dated July 14, 1999.
Field Service Advice is not binding on Examination or Appeals and is not a final
case determination. This document is not to be cited as precedent.

LEGEND:

      Taxpayer                  =
      Tax Year 1                =
      X                         =

ISSUES:

       1. Whether Taxpayer may weight its Inventory Price Index Computation
(IPIC) method category indexes (to determine its pool index) using end of the year
inventory value.

      2. Whether under its IPIC method Taxpayer must use a double-extension
method or can use a link-chain method in computing the last-in, first-out (LIFO)
value of its dollar-value pools.

CONCLUSIONS:

       1. Taxpayer may weight its IPIC method category indexes using end of the
year inventory value.

      2. In conjunction with its IPIC method, Taxpayer may continue to use the


link-chain method to compute the LIFO value of its pools.

FACTS:

       Taxpayer is a retailer/grocer which employs an overall accrual method of
accounting. Taxpayer does not qualify as an eligible small business as defined in
I.R.C. § 474. In Tax Year 1, Taxpayer was permitted to change its method of
accounting for its inventories to the IPIC method set forth in Treas. Reg. § 1.472-
8(e)(3). Taxpayer has X categories of inventory items to which it applies the
Consumer Price Index (CPI). Prior to the change, Taxpayer used a dollar-value,
link-chain method pooled by line, type or class of goods under Treas. Reg. § 1.472-
8(c).

        When making calculations under the IPIC method, Taxpayer first computes
inflation by category by dividing the current-year’s CPI (after adjustments) by the
beginning of the year CPI (also after adjustments). Taxpayer then multiplies the
resulting inflation for the category by the dollars in ending inventory for that
category. Taxpayer sums up the result for all X categories. Taxpayer then divides
the total inventory at current costs by the sum of this multiplication to arrive at the
current year’s index for the pool.

       In addition, in determining the current-year and base-year cost of each of its
dollar-value, IPIC inventory pools, Taxpayer uses the link-chain method.

LAW AND ANALYSIS:

      Treas. Reg. 1.471-1 requires, in order to clearly reflect income, that
taxpayers who have merchandise which is an income-producing factor take and
keep inventories. Being a retailer, Taxpayer’s merchandise is a significant income-
producing factor in its business. Accordingly, Taxpayer takes and keeps
inventories.

       Treas. Reg. § 1.472-1(a) permits taxpayers who take inventories pursuant to
the provisions of I.R.C. § 471 to elect to compute its inventory in accordance with
the method provided in I.R.C. § 472, the LIFO method.

       Treas. Reg. § 1.472-8 provides that taxpayers may elect to determine the
cost of their LIFO inventories under the dollar-value LIFO method, provided such
method is used consistently and clearly reflects the taxpayer’s income.

      Treas. Reg. § 1.472-8(e) describes the methods available for computing the
LIFO value of a dollar value pool: (1) the double-extension method, (2) an index
method, (3) the link-chain method. In addition, a taxpayer may use the IPIC
method which relies on external indexes rather than internally-developed indexes.


       Treas. Reg. § 1.472-8(e)(2) provides that, under the double-extension
method, the quantity of each item in the inventory pool at the close of the taxable
year is extended at both base-year unit cost and current-year unit cost. The
respective extensions at the two costs are then each totaled. The first total gives
the amount of inventory in terms of base-year costs and the second total gives the
amount of such inventory in terms of current-year costs. If there is an increment in
terms of base-year cost, that increment is valued by multiplying the increment by
the ratio of total base-year cost to total current-year cost.

       Treas. Reg. § 1.472-8(e)(3) permits taxpayer to elect to use the IPIC method
as a method to determine the inventory price indexes. For taxpayers electing the
IPIC method, the method will be accepted by the Commissioner as an appropriate
method of computing an index, and the use of such method to compute the LIFO
value of a dollar-value inventory pool will be accepted as accurate, reliable and
suitable.

        In general, Treas. Reg. § 1.472-8(e)(3) provides that, under the IPIC method,
inventory price indexes are computed with reference to consumer or producer price
indexes. The inventory items in each pool are classified according to the detailed
listings in the appropriate tables of either the consumer or producer price index.
The inventory items are assigned to various categories, and index categories are
assigned to a pool or pools. Published indexes and weights are used to compute
the appropriate index for an index category, and then an index is computed for the
pool. See Rev. Proc. 84-57, 1984-2 C.B. 496, Section 2.05; Rev. Proc. 98-49,
1998-37 I.R.B. 9 (Sept. 14, 1998), Section 2.

       Treas. Reg. § 1.472-8(e)(3)(ii) provides that an inventory price index
computed under the IPIC method shall be a stated percentage of the percent
change in the selected consumer (or producer) price index or indexes for a specific
category or categories of goods. In computing an index for a pool, the taxpayer will
weight the appropriate indexes for the separate index categories comprising the
pool according to the taxpayer’s actual inventory weights for such separate index
categories. Treas. Reg. § 1. 472-8(e)(3)(iii)(B)(5). Because Taxpayer does not
qualify as an eligible small business as defined in I.R.C. § 474, the stated
percentage for Taxpayer shall be 80 percent of the percent change in the pool
index.

       Sec. 3.01 1 of Rev. Proc. 84-57 restates the requirement that inventory items
have to be categorized into index categories chosen from the published consumer
of producer price indexes (for Taxpayer, it is the consumer price index). Sec. 3.04
1 restates that if it is necessary to select more than one inventory category for an
inventory pool, then the pool index is the weighted average of the indexes for the
index categories in the pool. The weighted average is computed with reference to
the relative weighted amounts of costs in the inventory pool for each index category


of goods. The costs to be used in computing the weighted average must be the
relative current costs in ending inventory.

Issue 1

        When making calculations under the IPIC method, Taxpayer first computes
inflation by category by dividing the current-year’s CPI (after adjustments) by the
beginning of the year CPI (also after adjustments). Taxpayer then multiplies the
resulting inflation for the category by the dollars in ending inventory for that
category. Taxpayer sums up the result for all X categories. Taxpayer then divides
the total inventory at current costs by the sum of this multiplication to arrive at the
current year’s index for the pool. This is computing a weighted arithmetic mean
based on end of the year costs.

       Treas. Reg. § 1.472-8(e)(2), providing the general rules for dollar-value LIFO
calculations, requires double-extension of item categories. Under LIFO methods
that compute an internal index (double-extension of link-chain), the index
computation procedure automatically produces an appropriately weighted pool
index. However, when a taxpayer computes a LIFO pool index using externally
generated inflation rates, as under IPIC, the taxpayer must weight the inflation rates
to compute an appropriate composite pool index. Treas. Reg. § 1.472-8(e)(3)(ii)
requires relative current-year costs be used to weight the applicable index. The
regulation does not state whether to use an arithmetic mean or a harmonic mean to
average the various indexes. Absent a preference expressed in the regulations, we
believe that the regulation permits the use of a weighted arithmetic mean based
upon dollars in ending inventory. The Service’s pronouncements in this area, Rev.
Proc. 84-57 and Rev. Proc. 98-49, are consistent with this interpretation.
Accordingly, Taxpayer’s method of determining its pool index by using weighted
arithmetic mean is permissible.

Issue 2

       Treas. Reg. § 1.472-8(e) states that ordinarily a taxpayer may only use the
double-extension method for computing the base-year and current-year cost of a
dollar-value inventory pool. However, where the double-extension method is
impractical, a taxpayer may use an index method. A third method, the link-chain
method, is also authorized where the taxpayer can demonstrate that the use of the
double-extension or index method is impractical or unsuitable in view of the nature
of the pool. Treas. Reg. § 1.472-8(e)(3) permits the use of the IPIC method as a
type of index method, relying on external indexes rather than internally-developed
indexes.

       Accordingly, although the IPIC method is an additional and simplified method
of using an external index (rather than an internal index), whether the ultimate price


index is determined using the double-extension or link-chain method is still at issue.
The stated preference in the regulations is for the double-extension method.
Furthermore, there are fewer distortions with the double-extension method used
with the IPIC method than there are with the link-chain method.

       Because the base-year and current-year indexes are published monthly by
the Bureau of Labor Statistics, it is relatively simple to double-extend under the
IPIC method. Furthermore, because the indexes are external, base-year cost
reconstruction can invariably be accomplished using the double-extension method.
Finally, distortions from errors in the index or changes in product mix are reduced
by using the double-extension method rather than the link-chain method in
conjunction with the IPIC method.

        On the other hand, although there are arguments favoring using the double-
extension method, there are no Service pronouncements specifically prohibiting
using the link-chain method with the IPIC method. Accordingly, under the facts of
this situation, we would not disturb Taxpayer’s use of the link-chain method to
compute the LIFO value of its pools.

      If you have any further questions, please call 202 622-7900.

                                              Deborah A. Butler
                                              Assistant Chief Counsel (Field
                                              Service)

                                       By:
                                              THOMAS D. MOFFITT
                                              Senior Technician Reviewer
                                              CC:DOM:FS:IT&A