By Kevin J. Bonnett, CPA,
Vice President & Director
As many importers begin receiving refunds of tariffs imposed under the International Emergency Economic Powers Act (IEEPA), an important—and often overlooked—question arises: how should these refunds be treated for federal income tax purposes?
While the refund process itself is administrative, the tax consequences can be more nuanced, especially since in most cases the tariffs were paid in one income tax year and the refunds of such amounts are being received in the subsequent tax year. The key factor in determining tax treatment is identifying how the tariffs were originally treated for tax purposes:
Tariffs Capitalized into Inventory – For most importers, when tariffs are paid, they are capitalized in inventory costs under §263A and ultimately expensed through cost of goods sold (COGS) when items are sold. In this scenario, since an expense is not recognized immediately upon payment of the tariff to determine the treatment of the refund, we must segregate inventory items which were sold in the same year the tariffs were paid from those that were still on hand at the end of the tax reporting period.
For inventory items which were sold during the same period in which the tariffs were paid, the taxpayer has effectively expensed the tariff costs when inventory was relieved. Because the tariffs have been previously recognized as an expense (i.e. a tax benefit was obtained in a prior period), refunds of such amounts will result in recognizing income in the year the refund is received. The classification of such refunds will typically be reported as “other income” for tax reporting purposes.
Conversely for inventory items which were not sold in the prior tax reporting period, since the tariffs remained on the balance sheet in the prior year and did not result in additional deductible expenses it would generally not be appropriate to recognize the refunds as current income. Therefore, the refund of these tariffs would be recognized as a reduction to the carrying value of inventory in the year received, effectively removing the capitalized cost.
Tariffs Deducted as Business Expenses – In some situations, such as taxpayers using simplified methods or certain smaller taxpayers, tariffs may not have been capitalized into inventory but rather directly deducted when paid. In these situations, since a deduction was taken in a prior period providing a tax benefit, the refund of such amounts will result in recognition of income in the year the refund is received.
Other Tax Considerations
In addition to receiving a refund of the amounts paid, refunds of IEEPA tariffs will include interest paid by U.S. Customs and Border Protection. This interest is separately includible in taxable income as ordinary income, regardless of how the underlying tariffs were treated (i.e. capitalized vs. expensed).
The timing of income recognition for income tax purposes is determined based on the taxpayer’s accounting method. Accrual basis taxpayers recognize income when the right to the refund is fixed and determinable, while cash-basis taxpayers generally recognize income when the refund is received. Therefore, for accrual basis taxpayers it is possible for amounts to be included in taxable income before the refunds have actually been received.
State tax treatment will typically follow federal principles, but there may be variations depending on state conformity to the Internal Revenue Code and apportionment factors. Accordingly, taxpayers should evaluate the treatment of these refunds in each jurisdiction in which they file returns to ensure the proper treatment in each jurisdiction.
See Also: Update on IEEPA Tariff Refunds
