Editor: Michael Dell, CPA
Expenses & Deductions
The IRS has issued proposed regulations (REG-126770-06) on allocating costs to property produced or acquired by a taxpayer for resale.
Background
Under Sec. 263A, taxpayers must capitalize the direct and indirect costs that are properly allocable to (1) real or tangible personal property the taxpayer produces and (2) real and personal property described in Sec. 1221(a)(1) that the taxpayer acquires for resale. Existing Regs. Sec. 1.263A-1(e)(2)(i) defines “direct costs” for producers as direct material costs and direct labor costs. Existing Regs. Sec. 1.263A-1(e)(2)(ii) requires resellers to capitalize the acquisition cost of property acquired for resale. Existing Regs. Sec. 1.263A-1(e)(3)(i) defines “indirect costs” as all costs other than direct material and labor costs for property produced and as all other costs other than acquisition costs for property acquired for resale. Indirect costs are properly allocable to property produced or acquired for resale when the costs directly benefit or are incurred by reason of production or resale activities.
To allocate capitalizable Sec. 263A costs to specific items in inventory, Regs. Secs. 1.263A-1(f)(1), (f)(2), and (f)(3) allow taxpayers to elect a facts-and-circumstances allocation method (e.g., specific identification method, burden rate, or standard cost method), provided the method is reasonable within the meaning of Regs. Sec. 1.263A-1(f)(4). Taxpayers may also use one of the simplified methods provided in Regs. Sec. 1.263A-2(b) or 1.263A-3(d) in lieu of a facts-and-circumstances allocation method. Many taxpayers have adopted one of the simplified methods to ease the administrative burden associated with preparing these tax calculations.
Under the simplified production method in Regs. Sec. 1.263A-2(b), a taxpayer must capitalize additional Sec. 263A costs to produced property that is on hand at the end of the tax year, based on the ratio of those additional Sec. 263A costs incurred during the year to the taxpayer’s total Sec. 471 inventory costs incurred during the year (the absorption ratio). Additional Sec. 263A costs are costs, other than interest, that were not capitalized under the taxpayer’s accounting method immediately before the effective date of Sec. 263A, but that are required to be capitalized under Sec. 263A (preamble to REG-126770-06). Under Regs. Sec. 1.263A-1(d)(2), Sec. 471 costs generally are the costs, other than interest, capitalized under a taxpayer’s method of accounting immediately prior to the effective date of Sec. 263A. The absorption ratio is multiplied by the Sec. 471 costs incurred during the tax year that are on hand at year end to determine the additional Sec. 263A costs allocable to produced property on hand at the end of the tax year.
The simplified resale method under Regs. Sec. 1.263A-3(d) allows taxpayers to calculate a combined absorption ratio and multiply it by the Sec. 471 costs incurred during the tax year to determine the additional Sec. 263A costs allocable to ending inventory. Regs. Sec. 1.263A-3(d)(3)(i)(C)(1) defines the combined absorption ratio as the sum of the storage and handling costs absorption ratio and the purchasing costs absorption ratio.
In Notice 2007-29, the IRS requested comments on the treatment of negative amounts as additional Sec. 263A costs under the simplified methods. A negative amount generally occurs when a taxpayer capitalizes a cost as a Sec. 471 cost that is greater than the amount required to be capitalized for tax purposes, which the taxpayer seeks to remove from inventory cost using its Sec. 263A formula. In the notice, the IRS stated that, pending the issuance of additional guidance, it would not challenge the inclusion of negative amounts in calculating additional costs under Sec. 263A or the permissibility of aggregate negative additional Sec. 263A costs. In developing the proposed regulations, the IRS considered the comments it received in response to the notice.
Proposed Regulations
The proposed regulations would generally prohibit taxpayers from including negative amounts in additional Sec. 263A costs, subject to a few exceptions. The proposed regulations would allow producers with average annual gross receipts of $10 million or less to include negative amounts in additional Sec. 263A costs under the simplified production method.
The proposed regulations would also allow taxpayers using the simplified resale method to remove Sec. 471 costs that are not required to be capitalized for tax purposes from ending inventory by treating them as negative additional Sec. 263A costs. The proposed regulations would generally prohibit treating cash or trade discounts under Regs. Sec. 1.471-3(b) as negative amounts under either simplified method.
Additionally, the proposed regulations would add a new modified simplified production method that allows producers to determine the capitalizable portion of preproduction-related, additional Sec. 263A costs (e.g., storage and handling of raw materials) using a preproduction costs absorption ratio. The preproduction costs absorption ratio would be applied to raw material Sec. 471 costs incurred during the tax year and remaining on hand at year end. Raw material costs on hand at year end include unprocessed raw materials and the raw material portion of work in progress and finished goods. The capitalizable portion of all other additional Sec. 263A costs would be determined by using a production costs absorption ratio. This new modified simplified production method would reduce the distortions that exist under the traditional simplified methods by more precisely allocating additional Sec. 263A costs, including negative amounts, among raw materials, work in process, and finished goods inventories.
Under the new modified simplified production method, producers may remove Sec. 471 costs that are not required to be capitalized for tax purposes from ending inventory by treating them as negative additional Sec. 263A costs.
The proposed regulations would also adopt a new definition of Sec. 471 costs that applies to all taxpayers regardless of the simplified method used. The proposed regulations define Sec. 471 costs as costs, other than interest, that a taxpayer capitalizes to its inventory in its financial statements. But a taxpayer must include all direct costs in its Sec. 471 costs, regardless of the taxpayer’s treatment of the costs in its financial statements. The proposed regulations require taxpayers that are not allowed to remove Sec. 471 costs as negative additional Sec. 263A costs to reduce their Sec. 471 costs by using a reasonable method that approximates the manner in which the taxpayer originally capitalized the costs.
Thus, after more than five years since placing a moratorium on so-called negative additional 263A cost issues, the IRS has finally proposed regulations that would address these issues. If adopted as final, the proposed regulations would require most taxpayers to revisit their Sec. 263A methodologies to ensure consistency with the new rules. In addition, many taxpayers not currently using simplified methods should consider the new modified simplified production method, if finalized, as it may provide many of the same benefits as their current (and likely more complicated) Sec. 263A methodology. Other key points to consider include:
1. By redefining “Sec. 471 costs,” the proposed regulations would make the definition of this term more consistent with how most taxpayers have been using it. For taxpayers that strictly complied with the old definition, and to the extent that it required adjustments from book amounts, those taxpayers would need to file a method change to comply with the new definition. In addition, taxpayers that do not currently capitalize all direct costs to inventory for financial statement purposes and taxpayers that treat some indirect costs capitalized for financial statement purposes as additional Sec. 263A costs instead of Sec. 471 costs would be required to file a method change to comply with the new definition.
2. By prohibiting the removal of Sec. 471 costs from inventory via the Sec. 263A computation for taxpayers using certain methodologies, the proposed regulations would require most large taxpayers to file an accounting method change either to use the new modified simplified production method or to remove such “negative Sec. 263A” costs using a reasonable method that approximates the manner in which the costs were originally capitalized to inventory. It remains to be seen what methods the IRS will consider reasonable for this purpose.
3. The new modified simplified production method may provide a taxpayer-favorable result by reducing distortions in the existing simplified production method that generally result in overcapitalization of additional Sec. 263A costs. However, the additional complexity in the calculation may cause some heartburn to taxpayers with limited ability to obtain the required data. The proposed regulations, as written, may push taxpayers that currently are not using a simplified method to consider using one, since it is not entirely clear whether the rules permit the inclusion of negative amounts in facts-and-circumstances or other nonsimplified uniform capitalization methodologies.
4. For some taxpayers, the new modified simplified method may provide many of the same benefits that a more complicated burden rate methodology has in the past, because raw materials would not be burdened with production costs. Taxpayers using a burden rate method because they hold a significant amount of raw materials or in-transit inventory at the end of each year should consider the new modified simplified production method.
All considered, many manufacturers could benefit from the proposed regulations, if finalized, although additional work may be required. In addition, certain taxpayers will be required to undertake a Sec. 263A compliance scrub to ensure compliance with the new rules.
EditorNotes
Michael Dell is a partner with Ernst & Young LLP in Washington, D.C.
For additional information about these items, contact Mr. Dell at 202-327-8788 or michael.dell@ey.com.
Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.
