Bob Richardson

IRS Revenue Ruling 78-246 provides an exception to the LIFO conformity rule for foreign-controlled consolidated groups. The use of a non-LIFO method of calculating income, profit and loss in the consolidated statements of a foreign-controlled consolidated group even when one or more of the subsidiaries uses LIFO for U.S. income tax reporting is not in violation of the LIFO conformity rule as long as the consolidated group has operating assets used in “substantial foreign operations”.

What is a Foreign-controlled Consolidated Group?

Rev. Ruling 78-246 provides that operating assets are considered to be used in foreign operations if they are owned by, and used in the business of, corporations that:

  • Are members of the consolidated group
  • Are foreign corporations
  • The foreign Parent does not use the LIFO method for federal income tax purposes
  • The foreign Parent engages in a business outside the U.S.

For purposes of the substantial foreign operations test, operating assets are all the assets necessary for the conduct of an active operating company.

What Constitutes Substantial Foreign Operations?

One of the following two requirements must be met to qualify as a company engaged in substantial foreign operations:

  • Satisfy the 30% test – The consolidated group is deemed to have substantial foreign operations if 30% or more of the group’s total operating assets are used in foreign operations. Said another way, the percentage of operating assets used by the worldwide group in foreign operations as reflected in the consolidated financial statements of the group must constitute 30% or more of the total worldwide operating assets. For example, if a foreign company that is based in Europe has $100 of total worldwide operating assets on a consolidated basis, and $40 of operating assets from foreign operations in the U.S., then 40% of the consolidated group’s total operating assets are used in foreign operations and therefore meets the 30% test.
  • Facts and circumstances basis – Entities with less than 30% of the total operating assets used in foreign operations may still meet the qualification of substantial foreign operations on a facts and circumstances basis. For example, in Letter Ruling 20073018, a foreign parent with U.S. subsidiaries requested for the IRS to rule if the foreign parent is permitted to issue financial statements on a non-LIFO basis based on the taxpayer’s specific facts and circumstances. In this particular case, the taxpayer represented that they did not meet the 30% test described above. In this example, the IRS concluded that the Parent had substantial foreign operations on a facts and circumstances basis within the meaning of Rev. Ruling 78-246. As a result, the IRS ruled that the Parent’s issuance of consolidated financial statements reporting on the U.S. Subs’ operations on a non-LIFO basis does not violate the LIFO conformity rule even though the U.S. sub uses the LIFO method on its U.S. tax return. In the ruling, the IRS cited the Parent’s foreign operations was substantial as evidenced by financial & operating factors, including:
    • Financial factors:
      • The amounts of the Parent’s revenues and assets that are attributable to the operation of an active business in the foreign Parent’s country
      • The profitability of Parent’s foreign assets is underscored by the amounts of operating income and EBITDA generated by its active business operations in the Parent’s foreign country, as well as the substantial percentages that those amounts constitute of the total worldwide amounts of operating income and EBITDA
    • Operational factors:
      • Parent first established its business operations in the parent’s foreign country before expanding into the U.S. market, and the Parent has developed, substantially supplied and serviced a significant number of franchised retail outlets in the Parent’s foreign country
      • Parent both owns and leases numerous store locations to franchisees, and leases then subleases numerous store locations to franchisees, to ensure that prime store locations remain under the banner of the Parent’s name

Reporting Requirements Issued for Credit Purposes for U.S. Subsidiaries of Foreign-controlled Consolidated Groups

As discussed in a Journal of Accountancy article titled Avoiding missteps in the LIFO conformity rule, there are cases where U.S. subsidiaries of Foreign-controlled Consolidated Groups that use LIFO for tax purposes are required to provide financial statements to their bank for credit purposes. The LIFO conformity rule requires all financial statements issued for credit purposes by U.S. subsidiaries of foreign-controlled Consolidated Groups that use LIFO for tax purposes to be issued on a LIFO basis within the primary presentation of income. Although the financial statement issued to creditors can also provide supplemental disclosures or reconciliation schedules on a non-LIFO basis (such as IFRS), they must be labelled as a supplemental disclosure or appendix, and the primary face of the income statement must present inventory on a LIFO basis. See IRS legal advice memorandum FAA20114702F.

Key Takeaways

  • The financial reports of Foreign-owned consolidated groups with U.S. subsidiaries that use the LIFO method for tax purposes are allowed to issue IFRS financial reports on a non-LIFO basis without violating the LIFO conformity rule as long as they meet the substantial foreign operations test. See IRS Revenue Ruling 78-246
  • Any U.S. subsidiary of a foreign-controlled Consolidated Group that uses LIFO for tax purposes who is required by their lender to issue financial reports for credit purposes must use LIFO on the face of the primary presentation of income. See the Journal of Accountancy article Avoiding missteps in the LIFO conformity rule and IRS legal advice memorandum FAA20114702F.

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