Thor Hammers Home Tax Lessons for a Recession

A 30-year-old Supreme Court case involving inventory write-downs pits financial accounting against tax accounting — and continues to serve as a warning to companies in a slumping economy.

Clear Reflection of Income

The Court noted that under Section 446(a) of the tax code, taxable income is computed under the method of accounting that the taxpayer regularly computes his income. However, Section 446(b) provides that if the method used does not clearly reflect income, the computation of taxable income is then made using a method that, in the opinion of the Commissioner, clearly reflects income.

Moreover, Regulation Section 1.446-1(a)(2) provides that no method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income. Section 471 of the code, which deals specifically with the accounting for inventory, establishes two tests to which an inventory method must adhere. The start, the method must be acceptable and conform to GAAP. Perhaps more important, the method must clearly reflect income. (See Regulation Section 1.471-2(a).)

As a result, the Supreme Court noted that it is apparent that Section 446 and Section 471 vest the U.S. Tax Commissioner with “wide discretion” in determining whether a particular method of inventory accounting should be disallowed as not clearly reflecting income. In this case, the commissioner readily conceded that Thor had satisfied the first part of the two-pronged test: Thor’s method of inventory accounting conformed with GAAP. But did its inventory accounting clearly reflect income? The answer was an unequivocal no.

Thor used, at all times, the lower of cost or market method of inventory accounting. For this purpose, the regulations — as they then existed — defined market as the “current bid price” of the item in the volume in which usually purchased by the taxpayer.1 In turn, current bid price means the “replacement” (or reproduction) cost with respect to the item — essentially the price the taxpayer would have to pay on the open market for the item.

If no such open market exists, the regulations required the taxpayer to ascertain a bid price based upon other objective evidence. Further, the regulations described two situations in which a taxpayer is permitted to value inventory below market. The first is the case in which the taxpayer has actually offered merchandise for sale at prices below replacement cost. The second is the instance in which the merchandise to be valued is “damaged.”

Here, the high court found that Thor’s procedure for writing down excess inventory was patently inconsistent with the “regulatory scheme.” In fact, Thor made no effort to determine the replacement (or reproduction) cost of the excess inventory and, therefore, failed to ascertain the “market” for such inventory.

The court concluded that in seeking to depart from replacement cost, Thor failed to bring itself within either of the authorized exceptions. Most notably, the corporation failed to sell its excess inventory, or even offer it for sale, at prices below replacement cost. Instead, it continued to sell such excess inventory at the original price.

Indeed, Thor failed to prove that its excess inventory came within the statutory conditions. As a result, the court was forced to conclude that Thor’s write-down failed — abjectly — to reflect income clearly and, therefore, the write-down was ignored for tax purposes.


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