Rev. Rul. 78-165

Advice has been requested whether, under the circumstances described below, one-tenth of an adjustment required under section 481(a) of the Internal Revenue Code of 1954 is includable in two separate short period consolidated returns that together cover only 12 calendar months.

Corporation X uses the accrual method of accounting and files its returns on a calendar year basis. X was granted permission by the Internal Revenue Service to change to the full absorption method of inventory costing pursuant to section 1.471-11 of the Income Tax Regulations and to take the resulting section 481 adjustment into account ratably over a 10-year period starting with its taxable year beginning January 1, 1976.

On July 31, 1976, all of the stock of X was acquired by corporation Y in a reorganization described in section 368(a) of the Code. X remained in existence as a subsidiary of Y. Y also files its returns on a calendar year basis.

For the period January 1, 1976, through July 31, 1976, X filed a consolidated return with the group it was affiliated with prior to the reorganization. For the period August 1, 1976, through December 31, 1976, X filed a consolidated return with Y. X made the change to the full absorption method of inventory costing in the short-period return filed for the period January 1, 1976, through July 31, 1976.

Section 1.471-11(e)(3) of the regulations provides, in part, that a taxpayer who properly makes an election to change to the full absorption method of inventory costing may elect to take any adjustment required by section 481 of the Code with respect to any inventory being revalued under the full absorption method into account ratably over a period designated by the taxpayer at the time of election, not to exceed 10 taxable years, commencing with the year of transition.

Section 1.1502-76(b)(1) of the regulations provides, in part, that the consolidated return of a group must include the income of the common parent for that corporation's entire taxable year and the income of each subsidiary for the portion of such taxable year during which it was a member of the group.

Section 1.1502-76(b)(2) of the regulations provides, in part, that if the consolidated return of a group properly includes the income of a corporation for only a portion of the corporation's taxable year (determined without regard to the change of year), then the income for the portion of such taxable year not included in the consolidated return must be included in a separate return (or, if the corporation is a member of another group that files a consolidated return for such portion of the year, then in such consolidated return). Section 1.1502-76(b)(4) provides, in part, that taxable income to be reported in each such return shall be determined on the basis of the corporation's income shown on its permanent records (including workpapers). If a portion of an item of income or deduction to be reported in each such return cannot be clearly determined from the permanent records, the portion of such item to be reported in each such return shall be the amount of the item for a full taxable year (determined without regard to the change of year) multiplied by a fraction, the numerator of which is the number of days for which the member's income is to be included in such return and the denominator of which is the total number of days in such year.

Section 1.1502-76(d) of the regulations provides that any period of less than 12 months for which either a separate return or a consolidated return is filed under the provisions of this section shall be considered as a separate taxable year.

Section 441(b) of the Code provides, in part, that the term "taxable year" means the period for which a return is made, if a return is made for a period of less than 12 months.

In Rev. Rul. 58-329, 1958-1 C.B. 337, each short period for which a return was filed was considered a separate taxable year for net operating loss carryforward and carryback purposes.

In the instant situation, X has been granted permission to elect the full absorption method of inventory costing and, pursuant to section 1.471-11(e)(3) of the regulations, has elected to take the section 481 adjustment into account ratably over a period of 10 taxable years. Each period for which a return is made is considered a taxable year. See section 441(b) of the Code and section 1.1502-76(d) of the regulations. Because a taxable year occurs each time a short period return is filed, X must take into account one-tenth of the 481 adjustment each time it files such a return.

Accordingly, in the instant situation, one-tenth of the section 481 adjustment is includable in the return of X for the period January 1, 1976, through July 31, 1976, and one-tenth of the section 481 adjustment is also includable in the return of X for the period August 1, 1976, through December 31, 1976.