SECTION 2. BACKGROUND

.01 Section 471 of the Internal Revenue Code provides that inventories must be taken on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting income.

.02 Section 1.471–3(d) of the Income Tax Regulations provides that in any industry in which the usual rules for computation of cost are inapplicable, cost may be approximated upon such basis as may be reasonable and in conformity with established trade practice in the particular industry.

.03 Section 472(a) provides that a taxpayer may use the last-in, first-out (LIFO) inventory method. Under the LIFO inventory method, a taxpayer treats those goods remaining on hand at the close of the taxable year as being: First, those included in the opening inventory of the taxable year

(in the order of acquisition) to the extent thereof, and second, those acquired in the taxable year. The change to, and use of, the LIFO inventory method must be in accordance with such regulations as the Secretary may prescribe as necessary in order that the use of such method may clearly reflect income.

.04 Section 472(b)(2) provides that a taxpayer using the LIFO inventory method must inventory its goods at cost.

.05 Section 1.472–8(a) provides that a taxpayer may elect to determine the cost of its LIFO inventories under the dollarvalue LIFO method, provided such method is used consistently and clearly reflects the income of the taxpayer in accordance with the rules of that section.

.06 Section 1.472–8(e)(2)(ii) provides that the total current-year cost of items making up a dollar-value LIFO pool may be determined: (a) by reference to the actual cost of the goods most recently purchased or produced; (b) by reference to the actual cost of the goods purchased or produced during the taxable year in the order of acquisition; (c) by application of an average unit cost equal to the aggregate cost of all the goods purchased or produced throughout the taxable year divided by the total number of units so purchased or produced; or (d) pursuant to any other proper method which, in the opinion of the Commissioner, clearly reflects income.

.07 Section 263A generally requires direct costs and an allocable portion of indirect costs of certain property produced or acquired for resale by a taxpayer to be included in inventory costs, in the case of property that is inventory, or to be capitalized, in the case of other property. Section 1.263A–1(e)(2)(ii) provides that resellers must capitalize the acquisition costs of property acquired for resale. In addition, resellers must capitalize the indirect costs described in § 1.263A–1(e)(3), which are properly allocable to property acquired for resale. These indirect costs often include purchasing, handling, and storage costs. See § 1.263A–3(c)(1).

.08 In Mountain State Ford v. Commissioner, 112 T.C. 58 (1999), the Tax Court held that a taxpayer that sold heavy truck parts and used the dollar-value LIFO method to account for its parts inventory was not entitled to determine the current-year cost of the parts in its ending inventory by reference to their

January 23, 2006 350 2006–4 I.R.B.

method to approximate the actual cost of its heavy equipment parts inventory. Under the replacement cost method, a taxpayer must determine the cost of the heavy equipment parts in its inventory by reference to the replacement cost of the heavy equipment parts as defined in section 4.02 of this revenue procedure, determine the replacement cost using a standard price list as defined in section 4.03 of this revenue procedure, and satisfy the book conformity requirement as described in section 4.04 of this revenue procedure. Taxpayers within the scope of this revenue procedure may use the replacement cost method in conjunction with either the first-in, first-out inventory method or the LIFO inventory method. Taxpayers that use the replacement cost method provided by this section 4 and that are subject to the provisions of § 263A must include in inventory costs the additional amounts that are required by §§ 1.263A–1 and 1.263A–3 ( e.g., freight costs).

.02 Replacement Cost . Replacement cost means the amount provided in a standard price list at which a heavy equipment part may be purchased by the taxpayer on the date of the inventory. If, on the date of the inventory, the heavy equipment part is not provided in a standard price list, the replacement cost for the part is equal to the last amount provided in a standard price list ( i.e., the price at which the part was last offered for purchase in a standard price list).

.03 Use of Standard Price List . A “standard price list” is a price list that is widely recognized and used for business purposes in the heavy equipment dealer industry and that is used by the taxpayer in the ordinary course of its business to purchase the heavy equipment parts for which it is determining the cost.

.04 Book Conformity . A taxpayer satisfies the book conformity requirement if it determines the cost of heavy equipment parts in its inventory using the replacement cost of the heavy equipment parts as defined in section 4.02 when it ascertains the income, profit, or loss of its trade or business for purposes of its books, records, and reports (including financial statements) to its shareholders, partners, other proprietors, beneficiaries, and creditors.

.05 Heavy Equipment Dealer Defined . For purposes of this revenue procedure,

replacement cost. In so doing, the court found that the taxpayer’s replacement cost method was not in accordance with the method elected on its Form 970, Appli- cation To Use LIFO Inventory Method . The taxpayer’s Form 970 indicated that it would determine the current-year cost of the items in its ending inventory by reference to the actual cost of the goods most recently purchased or produced in accordance with § 1.472–8(e)(2)(ii)(a). The court further concluded that even if the taxpayer had elected to use another proper method under § 1.472–8(e)(2)(ii)(d), it could not use the replacement cost of the parts to determine current-year cost because replacement cost does not determine current-year cost on the basis of, or by reference to, actual cost (or in some instances a reasonable approximation of actual cost) in accordance with § 472(b).

.09 Subsequent to the Mountain State Ford decision, the Internal Revenue Service gave careful consideration to the following unique circumstances surrounding the use of replacement cost by automobile dealers:

(1) Industry practice . It has been the long-standing and widespread practice of automobile dealers to use replacement cost to determine the cost of their vehicle parts inventory both for financial accounting and federal income tax purposes.

(2) Use of replacement cost required by third party . Automobile dealers are commonly required by their franchisors ( i.e., the vehicle’s manufacturer) to value their vehicle parts inventory using replacement cost, rather than actual cost.

(3) Substantial burden associated with switching to actual cost . The automobile dealer industry has represented that automobile dealers that are presently using replacement cost to value their vehicle parts inventory likely would incur substantial expense if they were required to modify their existing record keeping systems to determine the cost of such inventory using actual cost.

(4) Replacement cost approximates ac- tual cost in this industry . The automobile dealer industry has provided data to demonstrate that, on average, in their industry, due to relatively low inflation and high inventory turnover, the replacement cost of vehicle parts approximates the actual cost of such parts.

.10 Consideration of these factors led the Service to conclude that, for reasons of administrative convenience, burden reduction, and avoidance of further controversy in this area, a safe harbor method of accounting to determine the cost of vehicle parts inventory using replacement cost to approximate actual cost should be provided to automobile dealers. Accordingly, automobile dealers were provided a safe harbor method of accounting in Rev. Proc. 2002–17, 2002–1 C.B. 676. The Service stated in Rev. Proc. 2002–17 that it was willing to consider requests of other industries for similar safe harbors if the facts of those industries are similar to those described above.

.11 Subsequent to the publication of Rev. Proc. 2002–17, the heavy equipment dealer industry asked the Service to provide a similar safe harbor that would allow heavy equipment dealers to value their heavy equipment parts inventories at replacement cost. The information submitted on behalf of the heavy equipment dealers has led the Service to conclude that the circumstances in the heavy equipment dealer industry are similar to those described in section 2.09 of this revenue procedure. Accordingly, the Service has concluded, for reasons of administrative convenience and burden reduction, that a safe harbor method of accounting to determine the cost of heavy equipment parts inventory, using replacement cost to approximate actual cost, should be provided to heavy equipment dealers. The safe harbor method is provided in section 4 of this revenue procedure and is available to heavy equipment dealers described in section 4.05 of this revenue procedure.