Rev. Rul. 55-28

Advice has been requested concerning the method to be used in computing the amount of earnings and profits available for dividend distribution where the involuntary liquidation and replacement provisions of section 22(d)(6) of the Internal Revenue Code of 1939 are applicable, and the effect to be given any increase or decrease in the Federal income and excess profits tax liability resulting from the replacement of inventories involuntarily liquidated. Advice is also requested as to what effect a net operating loss and/or an unused excess profits credit carryback will have upon the earnings and profits available for dividend distribution for a prior taxable year.

With regard to the replacement of an inventory involuntarily liquidated section 22(d)(6) of the 1939 Code provides, in part, as follows:

SEC. 22. GROSS INCOME.

*

(d) Last-in first-out inventory method. -

(6) INVOLUNTARY LIQUIDATION AND REPLACEMENT OF INVENTORY.-

(A) Adjustment of net income and resulting tax.-Years beginning prior to January 1, 1948.-If, for any taxable year beginning after December 31, 1940, and prior to January 1, 1948, the closing inventory of a taxpayer inventorying goods under the method provided in this subsection reflects a decrease from the opening inventory of such goods for such year, and if the taxpayer elects * * * to have the provisions of this paragraph apply, and if it is established * * * that such decrease is attributable to the involuntary liquidation of such inventory * * * and if the closing inventory of a subsequent taxable year, ending prior to January 1, 1953, reflects a replacement, in whole or in part, of the goods so previously liquidated, the net income of the taxpayer otherwise determined for the year of such involuntary liquidation shall be adjusted as follows:

(i) Increased by an amount equal to the excess, if any, of the aggregate cost of such goods reflected in the opening inventory of the year of involuntary liquidation over the aggregate replacement cost; or

(ii) Decreased by an amount equal to the excess, if any, of the aggregate replacement cost of such goods over the aggregate cost thereof reflected in the opening inventory of the year of the involuntary liquidation.

This section of the Code and the regulations promulgated thereunder, affords taxpayers using the last-in first-out method of inventorying goods an opportunity, by election, to use replacement cost rather than actual cost for goods liquidated and, because of certain reasons therein outlined, not replaced at the close of the taxable year.

In commenting upon section 119 of the Revenue Act of 1942, which added section 22(d)(6) of the Code, the Senate Finance Committee stated, in report No. 1631, C.B. 1942-2, 504, at 567, as follows:

It is not intended that any adjustment should be made with respect to the closing inventory of the year of liquidation, or with respect to the opening or closing inventories of intervening years, as an incident to the ultimate replacement. It is intended, however, that the earnings and profits account for the year of liquidation and for all intervening years shall be adjusted in a manner consistent with the increase or decrease of net income provided for with respect to the year of liquidation. Any determination of earnings and profits available for dividend distribution, of the earnings and profits factor in invested capital, and of all related matters shall reflect the proposed adjustments.

Therefore, where the replacement of an inventory involuntarily liquidated is involved an adjustment of income shall be made in the year of liquidation notwithstanding that such adjustment is not determinable until the subsequent year in which the replacement is made.

Section 35.718-2 of Regulations 112, applicable to taxable year beginning after December 31, 1941 and prior to January 1, 1946 and section 40.458-4 of Regulations 130, applicable to taxable years ending after June 30, 1950 and beginning prior to January 1, 1954, provides in part that in the determination of equity invested capital, upon which the excess profits credit is based, accumulated earnings and profits at the beginning of the taxable year shall be decreased by the amount of Federal income and excess profits tax liability for the preceding taxable year.

With regard to the net operating loss and unused excess profits credit carrybacks, the Senate Report No. 1631, C.B. 1942-2, 504, 597, in commenting upon section 155 of the Revenue Act of 1942 which amended section 122 of the Internal Revenue Code, states in part as follows:

A taxpayer entitled to a carry-back of a net operating loss or unused excess profits credit (see section 204 of the bill) will not be able to determine the deduction on account of such carry-back until the close of the future taxable year in which he sustains the net operating loss or has an unused excess profits credit. He must therefore file his return and pay his tax without regard to such deduction, and must file a claim for refund at the close of the succeeding taxable year when he is able to determine the amount of such carry-back. * * *.

Therefore, where the carryback of a net operating loss or an unused excess profits credit is involved the adjustments will not be determinable until the close of the taxable year in which such adjustments arose.

Accordingly, it is held that in determining the amount of earnings and profits available for dividend distribution in a year in which there is an involuntary liquidation of inventory, replacement of which was made in a subsequent year, the earnings and profits for the year of liquidation, the year of replacement, and all intervening years must be adjusted to reflect any increase or decrease in income attributable to such replacement as required by section 22(d)(6) of the Code.

It is further held that in computing invested capital under section 718, and excess profits credit under section 714 of the Code applicable to years beginning after December 31, 1941 and prior to January 1, 1946, or invested capital under section 437, and excess profits credit under section 436 of the Code applicable to taxable years ending after June 30, 1950 and beginning prior to January 1, 1954, accumulated earnings and profits must be decreased by the amount of accrued Federal income and excess profits tax liability for the preceding taxable year, computed on the basis of income as adjusted under section 22(d)(6) of the Code, and without benefit of any net operating loss or unused excess profits credit carryback. The accumulated earnings and profits to be included in invested capital should not reflect a net operating loss carryback, or the adjustments for taxes due to a net operating loss carryback or an unused excess profits credit carryback, prior to the beginning of the first taxable year subsequent to the end of the taxable year in which the net operating loss was sustained, or the year in which the unused excess profits credit carryback was determined. It follows that tax adjustments for such carrybacks will not be reflected in the amount of earnings and profits available for dividends in prior years