Thursday, June 2, 2016

Kentucky, Bourbon and Tax Accounting

I came across a proposed tax bill that caught my eye.

It has to do with bourbon.

Bourbon is closely associated with Kentucky, as the state produces approximately 95% of the world supply. I have heard that there are more barrels of bourbon aging in Kentucky than there are residents (of which I am one). I do not know if that is true, but it does summarize the importance of the industry to the commonwealth.

So Kentucky senators and representatives have introduced a tax bill to exempt bourbon producers from the interest capitalization rules.

This is relatively old tax law, having entered the Code in 1986. It caused practitioners quite a bit of problem at start-up (I was a young CPA), but for the most part it has settled down since.

The explanation for the law was to bring consistency to inventory tax accounting. By itself that was laudable, but the law went further. Congress also decided that certain costs associated with a manufacturing or production process were not being appropriately captured by generally accepted accounting principles (GAAP). To correct that accounting oversight, the tax Code would henceforth require the capitalization of costs not previously capitalized on financial statements.

In accounting-speak, “capitalizing” means removing an expense from net income by putting it (that is, by “capitalizing” it) on the balance sheet as an asset. It can remain there for six months, fifteen years or until the end of time, depending upon. The common result is that it is not an expense on the income statement. Extrapolate that and it probably is not a deduction on the tax return.

You can see Congress’ fascination with becoming tax accounting experts.

This tax provision is referred to as uniform capitalization, or - for the hard core – Section 263A, which is the Code section that houses it. Most of the accountants I have worked with consider uniform capitalization little more than a slight-of-hand (and other earthier words) to increase taxes on inventory-intensive businesses.

Let’s be blunt: if there were issues with the inventories of Kimberley-Clark or Proctor & Gamble, the resulting lawsuits would have self-corrected the matter years ago.

Interest expense is one of the costs that have to be capitalized under Section 263A.

A perfect tax trap would be an expensive inventory which takes many, many years to get to market. One would have to capitalize interest every year. Granted, there would be a tax deduction down the line when the inventory was sold, but the wait to get there could get expensive.

What would be an example of such an inventory?

Well, bourbon.

Some high-end bourbons are aged for a long time. Take a personal favorite – Pappy Van Winkle Family Reserve 15 Year. It has a 20-year brother, but many aficionados consider the 15 a better product. There are bourbons aged even longer. That is a lot of years to carry an inventory.

The problem is that many bourbon competitors do not have this tax issue. Consider rum or vodka, for example, with a short ageing process.  Scotch whisky would be comparable, but the UK does not have an equivalent to Section 263A. This means that scotch producers do not have the tax problem of their US bourbon counterparts. Wine production would be comparable. Perhaps the Kentucky delegation could join forces with their California peers on this matter.

But why exempt bourbon producers but not others adversely affected by interest capitalization?

It is a fair question.

To which there is a fair answer: if international accounting firms are willing to be sued for the amount of inventory shown on audited financial statements, should we not presume that number is substantially correct? Why then does the Code require another calculation of inventory for the tax return?

We know why. It is the same as you losing a credit for your kid’s college tuition because you make enough money to send your kid to college. The tax Code is riddled with these things. Interest capitalization is a clever backdoor, however, as it dives into tax accounting itself. This area is arcane and boring and likely to keep someone from looking too closely. That is – of course – why it was done.

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