In general, taxpayers subject to Sec. 263A, governing capitalization and inclusion in inventory costs of certain expenses, must categorize service costs as capitalizable, deductible, or mixed service costs. The IRS has been scrutinizing how taxpayers have allocated mixed service costs to self-constructed assets under Sec. 263A. As a result, the IRS has issued a number of industry director directives (IDDs) and has elevated the method of allocating these costs to Tier I status. It has divided the issues into two phases.
The first phase of the Tier I issue emanated from taxpayers asking to change accounting methods for uniform capitalization from the facts-and-circumstances method to the simplified service cost method to allocate mixed service costs between inventory and self-constructed property. The second phase is related to the reasonableness of methods used to allocate mixed service costs between inventory and self-constructed assets based on a facts-and-circumstances method. IDD No. 5 (LMSB 04-0809-033), issued in fall 2009, provides examples of proper and improper methods of allocating mixed service costs using a facts-and-circumstances approach.
In accordance with Regs. Sec. 1.263A-1(e)(4)(ii)(C), mixed service costs are defined as service costs that are partially allocable to production or resale activities (capitalizable) and partially allocable to nonproduction or non-resale activities (deductible). Mixed service costs are typically thought of as general and administrative costs. Thus, for example, a company’s personnel department may incur costs to recruit employees engaged in the production of self-constructed assets (capitalizable) as well as costs to recruit employees engaged in nonproduction activities (deductible). Under the uniform capitalization rules of Sec. 263A, a variety of methods exist to allocate mixed service costs between capitalizable and deductible costs.
One such method is the simplified service cost method, which allows taxpayers to allocate mixed service costs using a labor-based allocation ratio or a production cost allocation ratio. Many taxpayers, primarily in the utility industry, changed to the simplified service cost method due to its generally favorable outcome when applied to self-constructed property. The end result was that companies changing to the simplified service cost method capitalized fewer costs to self-constructed assets, which are capitalized and recovered over a period of years, and more costs to the production of electricity, effectively causing those costs to be expensed immediately.
Phase one of the IRS’s examination of mixed service costs dealt with the use of the simplified service cost method applied to self-constructed property—primarily for use in the utility industry. The government took the position that certain self-constructed assets did not qualify as eligible property for the simplified service cost method because the property was not produced on a routine and repetitive basis. Through the issuance of Rev. Rul. 2005-53, the IRS defined property produced on a routine and repetitive basis as property either mass produced or having a high degree of turnover. Based on this definition, the ruling concluded that certain companies could no longer apply the simplified service cost method to allocate mixed service costs to self-constructed assets such as an electrical substation, which under the ruling is not mass produced and does not have a high degree of turnover. Later in 2005, Treasury solidified this definition of routine and repetitive by promulgating regulations. IDD No. 4 (LMSB 4-0509-022), issued in June 2009, changed the phase one issue’s status from active to monitoring, meaning that the IRS believes the technical issues have been resolved.
The second phase of the IRS’s examination of mixed service costs arose as a result of the newly issued regulations’ causing some taxpayers to no longer be eligible to use the simplified service cost method of allocating mixed service costs to self-constructed assets. Those taxpayers were consequently required to change accounting methods from the simplified service cost method to a facts-and-circumstances method of allocating mixed service costs. IDD No. 5 provides guidance to IRS examining agents regarding facts-and-circumstances methods of allocating mixed service costs and the reasonableness of those methods within the meaning of Regs. Sec. 1.263A-1(e)(3)(i).
Examination of an Allocation’s Reasonableness
According to IDD No. 5, examining agents must perform broad-ranging inquiries into taxpayers’ production and associated service activities to understand the reasonableness of certain mixed service cost allocation methods. Some methods of allocating mixed service costs increase the risk of noncompliance with the reasonableness requirement of the regulations. The directive provides four examples of allocation methods posing a significant risk to this compliance:
- Generation departments as mixed service departments. The first example deals with a company in the utility industry. In the example, costs incurred by generation departments are included as mixed service costs. The directive states that a department that clearly supports a production activity does not incur mixed service costs even though the department may incur a cost that is deductible under Regs. Sec. 1.263A-1(e)(3)(iii), such as a Sec. 174 cost. Accordingly, the utility should allocate the costs associated with a generation department to the production of electricity.
- Costs of working in an energized environment. The second example also deals specifically with the utility industry. Additional costs of working in an energized environment are treated as costs of maintaining electric service. All these costs are effectively expensed immediately because of allocation to the production of electricity instead of to self-constructed property. Technical Advice Memorandum (TAM) 200811021 deals specifically with this issue and concludes that in certain situations a utility company should not necessarily expense the costs associated with working in an energized environment. TAMs are taxpayer-specific rulings furnished by the IRS National Office in response to requests made by taxpayers or IRS officials, and under Sec. 6110(k)(3) they cannot be used or cited as precedent.
- Overly broad or other inappropriate cost drivers. The third example, which is more general in nature, involves the use of overly broad or other inappropriate cost drivers. Thus, the IRS is concerned with taxpayers either using a method of allocating mixed service costs to departments that do not receive benefits from the mixed service department’s activities or using otherwise unreasonable allocation methods.
- Imputation of production costs based on hypothetical events. The final example of a method of allocating mixed service costs that pose a significant risk to compliance with the reasonableness requirement is the imputation of production costs based on hypothetical events. The directive states that a taxpayer might estimate the amount of cost to generate power rather than to purchase power. If a taxpayer were to use a headcount ratio, the taxpayer might estimate a headcount of the number of people required to generate electricity instead of purchasing it.
Along with the examples of allocation methods posing a significant risk to compliance with the reasonableness requirement, IDD No. 5 also provides two examples of allocation methods posing less risk to compliance:
- Consistent headcount ratio. In the example, a utility company allocates mixed service costs between transmission/distribution and other departments and between production and nonproduction activities within a transmission/distribution department using a consistent headcount ratio; the denominator includes only those employees who actually benefit from the mixed service costs. The utility consistently applies the ratio across all service departments and redetermines it annually. Because transmission and distribution do not involve the generation of electricity, presumably the production activities of such departments relate primarily to self-constructed assets. Nevertheless, according to IDD No. 5 this headcount ratio should be appropriate in allocating mixed service costs between production and nonproduction activities as well as between various types of production activities such as producing power generation and self-constructed assets.
- Production cost ratio. This example builds upon the previous example using a consistent headcount ratio and demonstrates an allocation of mixed service costs in which two types of production activities take place: the production of self-constructed assets and the generation of electricity. In this example, a production cost ratio is developed. The numerator of the ratio is the total Sec. 263A costs of self-constructed assets. The denominator is the total Sec. 263A costs for production activities reduced by 50% of the costs of the taxpayer’s purchased power. Both the numerator and the denominator exclude any mixed service costs and interest capitalized under Sec. 263A. This ratio is then applied to the total capitalizable mixed service costs using a headcount cost driver to arrive at the mixed service costs allocated to self-constructed assets. Thus, the headcount ratio is used to allocate mixed service costs between production and nonproduction activities, and the production cost ratio is used to allocate production-related mixed service costs between self-constructed assets and other production-related activities.
IDD No. 5 instructs examining agents not to challenge allocation methods posing less risk to compliance with the reasonableness requirement of the regulations.
Since the final regulations may preclude many taxpayers from using the simplified service cost method to allocate mixed service costs to self-constructed assets, taxpayers may want to examine a variety of facts-and-circumstances approaches to allocate such costs. The headcount ratio and production cost ratio examples described above give taxpayers alternatives for allocating costs between production and nonproduction activities as well as between various types of production activities (e.g., power generation and self-constructed assets).
Although other facts-and-circumstances approaches might be reasonable and should be considered, using one of the acceptable ratios outlined in IDD No. 5 potentially offers taxpayers a methodology for establishing factors and relationships between mixed service costs and production or resale activities with less administrative hardship than other permissible allocation methods. In addition, although IDD No. 5 specifically addresses the utility industry, the same methodologies may be applicable to other industries, such as the retail industry, where mixed service costs need to be allocated between inventoriable goods and self-constructed assets.
Editor: Mary Van Leuven, J.D., LL.M.
Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.
For additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or email@example.com.
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