SECTION 9. DEFAULT PROCEDURES

.01 In general. Section 9 of this revenue procedure applies to the resolution of any timing issue unless the Service provides the notice required by section 7.01 of this revenue procedure, or the Service resolves the timing issue on a nonaccounting-method-change basis and the Service and the taxpayer execute a closing agreement as required by section 8.01 of this revenue procedure. See section 10.05 of this revenue procedure for an example of the application of section 9 of this revenue procedure.

.02 Effect of adjustments. For timing issues resolved under section 9 of this revenue procedure:

(1) No omission or duplication. The Service and the taxpayer are required to treat all items in a manner that prevents the duplication or omission of items of income or deduction;

(2) No change in method. The resolution does not constitute a change in method of accounting. The taxpayer is required to continue to use its current method of accounting for all items not affected by the adjustments made by the Service, unless the taxpayer obtains the consent of the Commissioner to change from its current method or the Service changes the taxpayer from its current method on subsequent examination;

(3) Subsequent change. The Service is not precluded from changing the taxpayer’s method of accounting in any open taxable year; and

(4) Effect of subsequent change. If the taxpayer’s method of accounting is changed (voluntarily or involuntarily) in a subsequent taxable year, the § 481(a) adjustment (if any) will be determined by reference to all items arising prior to the year of change (including the items af

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the costs not covered by the closing agreement (that is, the costs incurred in 1994 and the costs incurred in 1997 and all subsequent taxable years), unless the taxpayer obtains the consent of the Commissioner to change the method or the Service changes the taxpayer from the method on subsequent examination. If the Service changes the taxpayer’s method in 1997, the Service will compute a § 481(a) adjustment of $1,000,000 (including the amount of the costs deducted in 1994 which are not covered by the closing agreement and excluding the amount of the costs deducted in 1995 and 1996 because the costs are covered by the closing agreement). The Service will also disallow the deduction of $5,000,000 in 1997. The taxpayer’s basis in the property as of the end of 1997 will be increased by an additional $6,000,000 (representing the $1,000,000 § 481(a) adjustment and the disallowance of the $5,000,000 deduction in 1997). The method change (once final) is effective for 1997. Thus, the taxpayer is required to capitalize the costs in 1997 and all subsequent taxable years, unless the taxpayer obtains the consent of the Commissioner to change the method or the Service changes the taxpayer from the method on subsequent examination.

Alternatively, the timing issue may be resolved by providing in the closing agreement that the taxpayer will capitalize $1,000,000 of the costs incurred in each of 1995 and 1996 (when the closing agreement is silent as to the manner in which the other $1,000,000 of costs incurred in each of 1995 and 1996 are to be accounted for). The results for 1995 and 1996 will be the same as under the closing agreement in the original facts described in section 10.03(1) of this revenue procedure. That is, the appeals officer will disallow $1,000,000 of the deduction in each of 1995 and 1996. The taxpayer’s basis in the property as of the end of 1996 is increased by $2,000,000 (representing the disallowance of the $1,000,000 of deductions in each of 1995 and 1996). Because the taxpayer’s current method of accounting for the costs is not changed, the taxpayer is required to continue to deduct the costs not covered by the closing agreement (that is, the costs incurred in 1994, the remaining $1,000,000 of costs incurred in each of 1995 and 1996, and the

hazards of litigation. The appeals officer and the taxpayer agree to resolve the timing issue by changing the taxpayer’s method of accounting for the costs, but with compromise terms and conditions to reflect the hazards of litigation.

(2) Effect. Under section 6.02 of this revenue procedure, when the appeals officer changes the taxpayer’s method of accounting, the appeals officer is required to properly apply the law to the facts and change the taxpayer to the capitalization method of accounting for the costs. The appeals officer will provide the notice required by section 7.01 of this revenue procedure.

The appeals officer may make the change using the cut-off method. If the appeals officer makes the change in 1995 using the cut-off method, the appeals officer will disallow the deductions of $2,000,000 in each of 1995 and 1996. The taxpayer’s basis in the property as of the end of 1996 will be increased by $4,000,000 (representing the disallowance of the $2,000,000 of deductions in each of 1995 and 1996). The method change (once final) is effective for 1995. Thus, the taxpayer is required to capitalize the costs in 1995 and all subsequent taxable years, unless the taxpayer obtains the consent of the Commissioner to change the method or the Service changes the taxpayer from the method on subsequent examination.

Alternatively, the appeals officer may compromise the amount of the § 481(a) adjustment. If the appeals officer makes the change in 1995 and agrees to reduce the § 481(a) adjustment by 25%, the appeals officer will impose a § 481(a) adjustment of $750,000 (representing 75% of the amount of the costs deducted in 1994), the entire amount of which will be taken into account in computing taxable income in 1995. The appeals officer will disallow the deductions of $2,000,000 in each of 1995 and 1996. The taxpayer’s basis in the property as of the end of 1996 will be increased by $5,000,000 (representing the unreduced § 481(a) adjustment of $1,000,000 and the disallowance of the $2,000,000 of deductions in each of 1995 and 1996). The method change (once final) is effective for 1995. Thus, the taxpayer is required to capitalize the costs in 1995 and all subsequent taxable years, unless the taxpayer obtains the con

sent of the Commissioner to change the method or the Service changes the taxpayer from the method on subsequent examination.

As another alternative, the appeals officer may compromise the year of change and/or the § 481(a) adjustment period. For example, the appeals officer may agree to make the change in 1996 with a two-year § 481(a) adjustment period. The appeals officer will impose a § 481(a) adjustment of $3,000,000 (representing the $1,000,000 of costs deducted in 1994 and the $2,000,000 of costs deducted in 1995) one-half of which will be taken into account in computing taxable income in each of 1996 and 1997. The appeals officer will disallow the deduction of $2,000,000 in 1996. The taxpayer’s basis in the property as of the end of 1996 will be increased by $5,000,000 (representing the $3,000,000 § 481(a) adjustment and the disallowance of the $2,000,000 of deductions in 1996). The method change (once final) is effective for 1996. Thus, the taxpayer is required to capitalize the costs in 1996 and all subsequent taxable years, unless the taxpayer obtains the consent of the Commissioner to change the method or the Service changes the taxpayer from the method on subsequent examination.

.03 Appeals resolution of timing issue on an alternative-timing basis.

(1) Facts. The facts are the same as in section 10.02 of this revenue procedure, except that the appeals officer and the taxpayer agree to resolve the issue on an alternative-timing basis as described in section 6.02(3) of this revenue procedure and they enter into a closing agreement as required by section 8.01 of this revenue procedure. The timing issue is resolved by providing in the closing agreement that the taxpayer will deduct 50% of the costs incurred in 1995 and 1996 and capitalize the other 50% of the costs incurred in those years.

(2) Effect. The appeals officer will disallow $1,000,000 of the deductions in each of 1995 and 1996. The taxpayer’s basis in the property as of the end of 1996 is increased by $2,000,000 (representing the disallowance of the $1,000,000 of deductions in each of 1995 and 1996). The taxpayer’s current method of accounting for the costs is not changed. Thus, the taxpayer is required to continue to deduct

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costs incurred in 1997 and all subsequent taxable years). However, if the Service changes the taxpayer’s method in 1997, the Service will compute a § 481(a) adjustment of $3,000,000 (including the $1,000,000 of the costs deducted in 1994, and the remaining $2,000,000 of the costs deducted in 1995 and 1996 because the costs are not items covered by the closing agreement). The Service will also disallow the deduction of $5,000,000 in 1997. The taxpayer’s basis in the property as of the end of 1997 will be increased by an additional $8,000,000 (representing the $3,000,000 § 481(a) adjustment and the disallowance of the $5,000,000 deduction in 1997). The method change (once final) is effective for 1997. Thus, the taxpayer is required to capitalize the costs in 1997 and all subsequent taxable years, unless the taxpayer obtains the consent of the Commissioner to change the method or the Service changes the taxpayer from the method on subsequent examination.

Assuming, in the alternative, that the timing issue is resolved by providing in the closing agreement that, for the costs incurred in 1994 through 1996, the taxpayer will deduct 50% of the costs and capitalize the other 50% of the costs, and will increase taxable income by $500,000 in 1995 (representing the disallowance of $500,000 of costs in 1994). The appeals officer will disallow $1,000,000 of the deductions in each of 1995 and 1996. The taxpayer’s basis in the property as of the end of 1996 is increased by $2,500,000 (representing the disallowance of the $500,000 of deductions in 1994 and the $1,000,000 of deductions in each of 1995 and 1996). The taxpayer’s current method of accounting for the costs is not changed. Thus, the taxpayer is required to continue to deduct the costs not covered by the closing agreement (that is, the costs incurred in 1997 and all subsequent taxable years), unless the taxpayer obtains the consent of the Commissioner to change the method or the Service changes the taxpayer from the method on subsequent examination. If the Service changes the taxpayer’s method in 1997, the Service will compute a § 481(a) adjustment of $0 (excluding the amount of the costs deducted in 1994 through 1996 because the manner in which the costs are to be accounted for is specifically covered by the closing agreement). The Service

will also disallow the deduction of $5,000,000 in 1997. The taxpayer’s basis in the property as of the end of 1997 will be increased by an additional $5,000,000 (representing the disallowance of the $5,000,000 deduction in 1997). The method change (once final) is effective for 1997. Thus, the taxpayer is required to capitalize the costs in 1997 and all subsequent taxable years, unless the taxpayer obtains the consent of the Commissioner to change the method or the Service changes the taxpayer from the method on subsequent examination.

.04 Appeals resolution of timing issue on time-value-of-money basis.

(1) Facts. The facts are the same as section 10.02 of this revenue procedure, except that the appeals officer and the taxpayer agree to settle the issue on a timevalue-of-money basis as described in section 6.02(4) of this revenue procedure. The taxpayer files its return on a calendar year basis. The appeals officer believes that an appropriate factor to reflect the hazards of litigation is 25%. The taxpayer pays the specified amount on May 15, 1998. The highest marginal tax rate applicable to the taxpayer for 1995 and 1996 is 35% and the quarterly large corporation underpayment rates in effect for January 1, 1996 through June 30, 1998 are: 11%, 10%, 11%, 11%, 11%, 11%, 11%, 11%, 11%, 10%. The specified amount under section 6.02(4) of this revenue procedure would by deductible under § 163(a) by the taxpayer if it were treated as interest expense arising from an underpayment of tax.

(2) Computation of specified amount. The hypothetical underpayment of tax for 1995 is $1,050,000, computed as follows: the net increase in taxable income of $3,000,000 (representing the § 481(a) adjustment of $1,000,000 and the disallowance of the deduction of $2,000,000 computed as if Examination had changed the taxpayer’s method in 1995) multiplied by the applicable tax rate of 35%. The hypothetical underpayment of tax for 1996 is $700,000, computed as follows: the net increase in taxable income of $2,000,000 (representing the disallowance of the deduction of $2,000,000 computed as if Examination had changed the taxpayer’s method in 1995) multiplied by the applicable tax rate of 35%.

The applicable time-value rate for 1995 is 7.02%, which is computed as follows: The applicable period for 1995 is March 15, 1996 (the due date of the return) to May 15, 1998 (the date the specified amount is paid). The underpayment rates in effect for the applicable period are 11%, 10%, 11%, 11%, 11%, 11%, 11%, 11%, 11%, and 10%. The average underpayment rate in effect for the applicable period is 10.8% [(11+10+11+11+11+ 11+11+11+11+10)/10]. The applicable after-tax time-value rate is 7.02%, computed by multiplying the average underpayment rate by one minus the applicable tax rate [10.8% * (1–.35)].

The applicable time-value rate for 1996 is 7.04%, which is computed as follows: The applicable period for 1996 is March 15, 1997 (the due date of the return) to May 15, 1998 (the date the specified amount is paid). The underpayment rates in effect for the applicable period are 11%, 11%, 11%, 11%, 11%, and 10%. The average underpayment rate in effect for the applicable period is 10.83%

[(11+11+11+11+11+10)/6]. The applicable after-tax time-value rate is 7.04%, computed by multiplying the average underpayment rate by one minus the applicable tax rate [10.83% * (1-.35)].

The time-value-of-money benefit for each taxable year is computed by using the following formula:

U - {[1+(r/365)] ⁿ –1} where U = hypothetical underpay

ment for the taxable year r = the applicable time-value

rate n = the number of days in the

applicable period The time-value-of-money benefit for 1995 is $172,512, computed as follows: $1,050,000 * {[1+(.0702/365)] ⁷⁹¹ –1}. The time-value-of-money benefit for 1996 is $59,939, computed as follows: $700,000 * {[1+(.0704/365)] ⁴²⁶ –1}.

The specified amount is the sum of the time-value-of-money benefit for 1995 and 1996 reduced by 25% to reflect the hazards of litigation. The specified amount is $174,338 computed as follows: ($172,512+$59,939)*(1-.25).

(3) Effect. The Service will not propose any adjustments to taxable income with respect to the taxpayer’s method of accounting for the costs for 1995 and 1996. The taxpayer’s basis in the prop

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erty as of the end of 1996 is not changed. The taxpayer’s current method of accounting for the costs is not changed. Thus, the taxpayer is required to continue to deduct the costs in 1997 and all subsequent taxable years, unless the taxpayer obtains the consent of the Commissioner to change the method or the Service changes the taxpayer from the method on subsequent examination. If the Service changes the taxpayer’s method in 1997, the Service will compute a § 481(a) adjustment of $5,000,000 (representing the $1,000,000 of the costs deducted in 1994 and the $2,000,000 of costs deducted in each of 1995 and 1996). The Service will also disallow the deduction of $5,000,000 in 1997. The taxpayer’s basis in the property as of the end of 1997 will be increased by $10,000,000 (representing the $5,000,000 § 481(a) adjustment and the disallowance of the $5,000,000 deduction in 1997). The method change (once final) is effective for 1997. Thus, the taxpayer is required to capitalize the costs in 1997 and all subsequent taxable years, unless the taxpayer obtains the consent of the Commissioner to change the method or the Service changes the taxpayer from the method on subsequent examination.

The interest on the taxpayer’s deficiency (which reflects the inclusion of the $5,000,000 § 481(a) adjustment in taxable income) for 1997 is $100,000. A portion of the $100,000 of interest will be treated as paid to the extent necessary to prevent duplicate payment of the time-value-ofmoney benefit relating to the § 481(a) adjustment. The interest on the deficiency for 1997 includes the time-value-ofmoney benefit attributable to the § 481(a) adjustment for the period March 15, 1998, through the date of payment of the deficiency. The taxpayer previously paid the Service the time-value-of-money benefit attributable to $3,000,000 of the § 481(a) adjustment for the period March 15, 1996, through May 15, 1998, and $2,000,000 of the § 481(a) adjustment for the period March 15, 1997 through May 15, 1998. The interest on the deficiency for 1997 attributable to the overlap period of March 15, 1998, through May 15, 1998, is $20,073, computed as follows:

r = the applicable time-value

rate (computed for the overlap period) n = the number of days in the

overlap period

$5,000,000 * .35 * {[1+(.06825/365)] ⁶¹ –1}

The $20,073 is reduced by 25% (the factor used by the appeals officer to reflect the hazards of litigation). The Service will treat the $15,055 as a payment toward the $100,000 of interest on the taxpayer’s deficiency for 1997.

.05 Default procedures.

(1) Facts. The facts are the same as section 10.01 of this revenue procedure, except that the examining agent does not provide the notice required by section 7.01 of this revenue procedure. Specifically, the examining agent disallows the deductions of $2,000,000 in each of 1995 and 1996, but does not compute the § 481(a) adjustment of $1,000,000 or otherwise provide notice that the timing issue is being treated as an accounting method change.

subsequent examination.

Assume that the examining agent disallows the deductions of $2,000,000 in each of 1995 and 1996 and computes the § 481(a) adjustment of $1,000,000, but does not label the § 481(a) adjustment or otherwise provide notice that the timing issue is being treated as an accounting method change. The taxpayer’s basis in the property as of the end of 1996 is increased by $5,000,000 (representing the $1,000,000 adjustment and the disallowance of the $2,000,000 of deductions in each of 1995 and 1996). The taxpayer’s current method of accounting for the costs is not changed. Thus, the taxpayer is required to continue to deduct the costs in 1997 and all subsequent taxable years, unless the taxpayer obtains the consent of the Commissioner to change the method or the Service changes the taxpayer from the method on subsequent examination. If the Service changes the taxpayer’s method in 1997, the Service will compute a § 481(a) adjustment of $0 (excluding the $1,000,000 of the costs deducted in 1994 and the $2,000,000 of the costs deducted in each of 1995 and 1996 because the costs were accounted for in the prior adjustments). The Service will also disallow the deduction of $5,000,000 in 1997. The taxpayer’s basis in the property as of the end of 1997 will be increased by an additional $5,000,000 (representing the disallowance of the $5,000,000 deduction in 1997). The method change (once final) is effective for 1997. Thus, the taxpayer is required to capitalize the costs in 1997 and all subsequent taxable years, unless the taxpayer obtains the consent of the Commissioner to change the method or the Service changes the taxpayer from the method on subsequent examination.