Treatment of defective merchandise allowances may provide guidance for other trade discounts.

• Author: Newell, Christine J.

The Office of Chief Counsel issued the taxpayer-favorable Chief Counsel Advice (CCA) 200945034, which provides guidance on the proper tax accounting for defective merchandise vendor allowances. Although this advice is not a definitive statement of the IRS's position and cannot be used or cited as precedent under Sec. 6110(k)(3), it might provide insight into the proper treatment of other types of vendor allowances.

Background

Buyers of merchandise often receive discounts if they purchase a certain quantity or volume of goods. A vendor may also offer a discount for other reasons--for example, increasing sales on end-of-season merchandise or on merchandise with a pending removal (because the vendor has replaced it with a new product) or expiration date. To a buyer of merchandise, vendor allowances are simply adjustments to the purchase price. The allowances are meant to lower the price to help the buyer maintain its profit margin on the products sold as well as to help the products move to the end users by allowing competitive pricing in the marketplace. Unless the vendor expects or requires a service or the payment is a reimbursement of an expense, the intent of the discount is always to reduce the purchase price. Thus, the true cost of a purchase is always the net price (invoice price minus any trade discounts).

Regs. Sec. 1.471-3(b) treats trade or other discounts as a reduction in the purchase price of the inventory to which they relate, rather than as gross income. The result of treating discounts this way is generally a net deferral of taxable income to the extent goods to which the discounts relate remain on hand at the end of the year. This deferral occurs because the discount is not an item of income when the merchandise is purchased but instead remains as an adjustment to inventory cost on the balance sheet and is therefore taken into income only when the merchandise is sold. This deferral, in effect, becomes permanent as long as the inventory (under the taxpayer's method of accounting) continues to contain discounts.

The regulations do not define the term "trade or other discount," so taxpayers must look elsewhere for guidance. Rev. Rul. 84-41 describes a trade discount as a vendor reduction to the purchase price, which varies depending on the volume or quantity purchased or other factors established by the vendor. If a discount is always allowed regardless of time of payment, it is deemed a trade discount. (See also Thomas Shoe...