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Two recent developments have ameliorated the adverse financial statement impact of the conformity requirement. First, final Treasury regulations have been issued that allow taxpayers using LIFO to disclose in their financial statements the amount of earnings they would have had on a non-LIFO basis. However, although the regulations allow the taxpayer to prepare a supplemental income statement on a non-LIFO basis, the taxpayer must prepare its primary financial statements using LIFO (Reg. § 1.472-2(e)).

The second event was the decision of the Second Circuit in Insilco Corporation v. Commissioner (unpublished opinion dated April 17, 1981), affirming a decision of the U.S. Tax Court that the conformity requirement applicable to a subsidiary using LIFO does not extend to the subsidiary's parent company which is not using LIFO. Thus, the parent company can incorporate the non-LIFO financial statements of the subsidiary in its consolidated financial statement.

Another requirement of the LIFO method is that the inventory must be accounted for only at cost, while under FIFO, the taxpayer can elect to value inventory at the lower of cost or market. Thus, when the value of an item of inventory declines below cost, a taxpayer using FIFO may write off the decline in value ("market writedowns") and carry the inventory at its new lower value. Under LIFO, the taxpayer may not take such a writedown. Moreover, if the ending inventory of the year immediately preceding the year of change to LIFO contains any items that have had market writedowns, the taxpayer must write the inventory back up to cost and include the entire write-up in income in such preceding year. Thus, in the year of change to LIFO all items of beginning inventory will be carried at cost.

In the Economic Recovery Tax Act of 1981 (P.L. 97-34), the Congress amended the rules relating to the recapture of market writedowns (sec 472(d)). For taxpayers adopting LIFO for taxable years beginning after December 31, 1981, market writedowns will be included in income ratably over a three-year period beginning with the year of change to LIFO. Thus, the taxpayer no longer will have to amend the return of the year preceding the year of the LIFO election and include the entire amount of market writedowns in income in that year.


The issues are whether to eliminate the LIFO conformity requirement, and whether to allow taxpayers to spread the recapture of inventory writedowns over a ten-year period.

Explanation of provisions

Section 2 of the bill would eliminate the conformity requirement, so that taxpayers could use LIFO for tax purposes regardless of the method used for financial statement purposes. Section 3 of the bill would allow taxpayers to spread the recapture of inventory writedowns equally over ten years, beginning with the year of change, rather than spreading it over three years as was recently provided in the Economic Recovery Tax Act of 1981 (P.L. 97–34).

Effective date

The provisions of sections 2 and 3 of S. 578 would be effective for taxable years beginning after the date of enactment of the bill.

2. S. 768-Senator Moynihan, and S. 1472—Senator Denton

Exclusion of Research Expenses from Capital Expenditure Limitation on Interest Exemption for Small Issue Industrial Development Bonds

Present law

In general

Interest on State and local government obligations generally is exempt from Federal income tax (Code sec. 103(a)). However, subject to certain exceptions, interest on State and local issues of industrial development bonds is taxable (sec. 103(b)). An obligation constitutes an industrial development bond if (1) all or a major portion of the proceeds of the issue are to be used in any trade or business of a person other than a governmental unit or tax-exempt organization and (2) payment of principal or interest is secured by an interest in, or derived from payments with respect to, property or borrowed money used in a trade or business (see. 103(b)(2)).

Present law provides an exception for certain "small issues" to the general rule of taxability of interest paid on industrial development bonds (sec. 103 (b) (6)). This exception applies to issues of $1 million or less if the proceeds are used for the acquisition, construction, or improvement of land or depreciable property.

At the election of the issuer, the $1 million limitation may be increased to $10 million. If this election is made, the exception is restricted to projects where the aggregate amount of outstanding exempt small issues and capital expenditures (financed otherwise than out of the proceeds of an exempt small issue) made over a six-year period 1 does not exceed $10 million. The combined issue amount/capital expenditure limitation of $10 million has the effect of precluding availability of an interest exemption where industrial development bonds would have a face amount not exceeding the $10 million dollar limitation but would be used in connection with large scale, high cost projects.

Both the $1 million and $10 million limitations are determined by aggregating the face amount of all outstanding related issues, plus, in the case of the $10 million limitation, certain capital expenditures for all facilities used by the same or related principal users which are located within the same county or same incorporated municipality. Under Treasury regulations, expenditures are treated as capital expenditures for this purpose if they are properly chargeable to the capital account of any person or State or local governmental unit. This determination is to be made without regard to any rule of the Internal Revenue Code that permits expenditures properly chargeable to capital account to be tretaed as current expenses (Reg. § 1.103–10(b) (2) (ii) (e)).

1 The relevant six-year period is the period beginning three years before the date of the issue and ending three years after that date.


Treatment of research expenditures

As a general rule, business expenditures to develop or create an asset which has a useful life that extends substantially beyond the taxable year must be capitalized and cannot be deducted in the year paid or incurred. For example, research expenditures to develop a new consumer product must be capitalized, because such expenditures relate to an asset which will have a useful life exceeding one year. Such capital costs usually may be recovered on a disposition or abandonment of the asset, or through depreciation or amortization deductions over the useful life of the asset.

However, present law permits a taxpayer to elect to deduct currently the amount of research or experimental expenditures incurred in connection with the taxpayer's trade or business, even if such expenses are treated as capital account charges or deferred expenses on the taxpayer's books or financial statements (sec. 174(a); Rev. Rul. 58-78, 1958-1 C.B. 148). In the case of research expenditures resulting in property which does not have a determinable useful life (such as secret processes or formulae), the taxpayer alternatively may elect to deduct the costs ratably over a period of not less than 60 months (sec. 174(b)).2

Because research and experimentation expenditures constitute capital expenditures, such expenses are to be taken into account for purposes of determining whether the exempt small issue limitation of $10 million is exceeded, whether or not the taxpayer elects to deduct its research expenses currently or to amortize them over a period of 60 months or more (Rev. Rul. 77-27, 1977-1 C.B. 23).

In addition to the favorable deduction treatment provided under Code section 174 for research expenditures, the Economic Recovery Tax Act of 1981 provides a 25-percent tax credit for certain research and experimental expenditures paid in carrying on a trade or business of the taxpayer to the extent exceeding the amount of such expenditures during a base period (Code sec. 44F).


The issue is whether research and experimental expenditures should be counted toward the $10 million limitation for exemption of interest on "small issue" industrial development bonds.

Explanation of bills and effective dates

S. 768

Under S. 768, research and experimental expenditures (within the meaning of sec. 174) would not be taken into account for purposes of the capital expenditure limitation on small issue industrial development bonds. The bill does not expressly restrict such treatment to research expenditures which the taxpayer elects under section 174 to deduct currently or amortize.

2 If expenditures relating to development of a product are not eligible for these elections, or if the taxpayer chooses not to elect either current deductions or amortization for qualifying research costs, such expenditures must be capitalized. If the capitalized expenses relate to depreciable property, deductions may be taken in the form of depreciation allowances spread over the property's useful life. If the capitalized expenses relate to nondepreciable property, those costs cannot be recovered until disposition or abandonment of the property.


S. 768 would apply to obligations issued after the date of enactment, in taxable years ending after that date. Also, the bill would apply to capital expenditures made after December 31, 1980, for purposes of applying the $10 million limitation in the case of obligations issued prior to the enactment date.

S. 1472

Under S. 1472, research or experimental expenditures which the taxpayer elects to deduct currently under section 174(a) would not be taken into account for purposes of the capital expenditure limitation on small issue industrial development bonds.

S. 1472 would apply to research or experimental expenditures paid or incurred after March 11, 1981, with respect to obligations issued after that date.

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