Sec. 1.1502-18 Inventory adjustment.

(a) Definition of intercompany profit amount. For purposes of this section, the term "intercompany profit amount" for a taxable year means an amount equal to the profits of a corporation (other than those profits which such corporation has elected not to defer pursuant to section 1.1502-13(c)(3) or which have been taken into account pursuant to section 1.1502-13(f)(1)(viii)) arising in transactions with other members of the group with respect to goods which are, at the close of such corporation's taxable year, included in the inventories of any member of the group. See section 1.1502-13(c)(2) with respect to the determination of profits. See the last sentence of section 1.1502-13(f)(1)(i) for rules for determining which goods are considered to be disposed of outside the group and therefore not included in inventories of members.

(b) Addition of initial inventory amount to taxable income. If a corporation:

then the intercompany profit amount of such corporation for such separate return year (hereinafter referred to as the "initial inventory amount") shall be added to the income of such corporation for the consolidated return year (or years) in which the goods to which the initial inventory amount is attributable are disposed of outside the group or such corporation becomes a nonmember. Such amount shall be treated as gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231.

(c) Recovery of initial inventory amount.

(d) Examples. The provisions of paragraphs (a), (b), and (c) of this section may be illustrated by the following examples:

Example 1. Corporations P, S, and T report income on the basis of a calendar year. Such corporations file separate returns for 1965. P manufactures widgets which it sells to both S and T, who act as distributors. The inventories of S and T at the close of 1965 are comprised of widgets which they purchased from P and with respect to which P derived profits of $5,000 and $8,000, respectively. P, S, and T file a consolidated return for 1966. During 1966, P sells widgets to S and T with respect to which it derives profits of $7,000 and $10,000, respectively. The inventories of S and T as of December 31, 1966, are comprised of widgets on which P derived net profits of $4,000 and $8,000, respectively. P's initial inventory amount is $13,000, P's intercompany profit amount for 1965 (such $13,000 amount is the profits of P with respect to goods sold to S and T and included in their inventories at the close of 1965). Assuming that S and T identify their goods on a first-in, first-out basis, the entire opening inventory amount of $13,000 is added to P's income for 1966 as gain from the sale or exchange of property which is neither a capital asset nor properly described in section 1231, since the goods to which the initial inventory amount is attributable were disposed of in 1966 outside the group. However, since P's unrecovered inventory amount for 1966, $12,000 (the intercompany profit amount for the year, which is less than the initial inventory amount), is less than the unrecovered inventory amount for 1965, $13,000, this decrease of $1,000 is treated by P for 1966 as a loss from the sale or exchange of property which is neither a capital asset nor property described in section 1231.

Example 2. Assume the same facts as in example (1) and that at the close of 1967, a consolidated return year, the inventories of S and T are comprised of widgets on which P derived profits of $5,000 and $3,000, respectively. Since P's unrecovered inventory amount for 1967, $8,000, is less than $12,000, the unrecovered inventory amount for 1966, this decrease of $4,000 is treated by P for 1967 as a loss from the sale or exchange of property which is neither a capital asset nor property described in section 1231.

Example 3. Assume the same facts as in examples (1) and (2) and that in 1968, a consolidated return year, P's intercompany profit amount is $11,000. P will report $3,000 (the excess of $11,000, P's unrecovered inventory amount for 1968, over $8,000, P's unrecovered inventory amount for 1967) for 1968 as a gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231.

Example 4. Assume the same facts as in examples (1), (2), and (3) and that in 1969 P, S, and T file separate returns. P will report $11,000 (its unrecovered inventory amount for 1968, $11,000, minus the portion of the initial inventory amount which has not been added to income during 1966, 1967, and 1968, zero) as a loss from the sale or exchange of property which is neither a capital asset nor property described in section 1231.

Example 5. Corporations P and S file a consolidated return for the first time for the calendar year 1966. P manufactures machines and sells them to S, which sells them to users throughout the country. At the close of 1965, S has on hand 20 machines which it purchased from P and with respect to which P derived profits of $3,500. During 1966, P sells 6 machines to S on which it derives profits of $1,300, and S sells 5 machines which it had on hand at the beginning of the year (S specifically identifies the machines which it sells) and on which P had derived profits of $900. P's initial inventory amount is $3,500, of which $900 is added to P's income in 1966 as gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231, since such $900 amount is attributable to goods disposed of in 1966 outside the group, which goods were included in S's inventory at the close of 1965. If P and S continue to file consolidated returns, the remaining $2,600 of the initial inventory amount will be added to P's income as the machines on which such profits were derived are disposed of outside the group.

Example 6. Assume that in example (5) S had elected to inventory its goods under section 472 (relating to last-in, first-out inventories). None of P's initial inventory amount of $3,500 would be added to P's income in 1966, since none of the goods to which such amount is attributable would be considered to be disposed of during such year under the last-in, first-out method of identifying inventories.

(e) Section 381 transfer. If a member of the group is a transferor or distributor of assets to another member of the group within the meaning of section 381(a), then the acquiring corporation shall be treated as succeeding to the initial inventory amount of the transferor or distributor corporation to the extent that as of the date of distribution or transfer such amount has not yet been added to income. Such amount shall then be added to the acquiring corporation's income under the provisions of paragraph (b) of this section. For purposes of applying paragraph (c) of this section:

(f) Transitional rules for years before 1966.

(g) Transitional rules for years beginning on or after July 12, 1995. Paragraphs (a) through (f) of this section do not apply for taxable years beginning on or after July 12, 1995. Any remaining unrecovered inventory amount of a member under paragraph (c) of this section is recovered in the first taxable year beginning on or after July 12, 1995, under the principles of paragraph (c)(3) of this section by treating the first taxable year as the first separate return year of the member. The unrecovered inventory amount can be recovered only to the extent it was previously included in taxable income. The principles of this section apply, with appropriate adjustments, to comparable amounts under paragraph (f) of this section.