Part IV. Items of General Interest

Notice of Proposed Rulemaking

Allocation of Costs Under the Simplified Methods

REG–126770–06

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

SUMMARY: This document contains proposed regulations on allocating costs to certain property produced by the taxpayer or acquired by the taxpayer for resale. The proposed regulations affect taxpayers that are producers or resellers of property that are required to capitalize certain costs to the property and that allocate costs under the simplified production method or the simplified resale method. The proposed regulations provide rules for the treatment of negative additional costs.

DATES: Written (including electronic) comments and requests for a public hearing must be received by December 4, 2012.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG–126770–06), room 5205, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG–126770–06), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, DC. Taxpayers also may submit comments electronically via the Federal eRulemaking Portal at www.regulations.gov (IRS REG–126770–06).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Christopher Call, (202) 622–4970; concerning submissions of comments or to request a public hearing, Oluwafunmilayo Taylor, (202) 622–7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

This document contains proposed amendments to the Income Tax Regulations, 26 CFR part 1, relating to the allocation of costs under the simplified methods of accounting under section 263A of the Internal Revenue Code (Code).

Section 263A requires taxpayers to capitalize the direct costs and indirect costs that are properly allocable to: (1) real or tangible personal property the taxpayer produces, and (2) real property and personal property described in section 1221(a)(1) that the taxpayer acquires for resale. Section 1.263A–1(e)(2)(i) of the Income Tax Regulations provides that direct costs for producers are direct material costs and direct labor costs. Section 1.263A–1(e)(2)(ii) provides that resellers must capitalize the acquisition cost of property acquired for resale. Section 1.263A–1(e)(3)(i) defines indirect costs as all costs other than direct material costs and direct labor costs (in the case of property produced) or acquisition costs (in the case of 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 the performance of production or resale activities.

Section 263A generally requires taxpayers to allocate capitalizable section 263A costs to specific items in inventory. The legislative history of section 263A indicates that Congress intended that taxpayers would allocate additional section 263A costs (costs, other than interest, that were not capitalized under the taxpayer’s method of accounting immediately prior to the effective date of section 263A, but that are required to be capitalized under section 263A) with the same degree of specificity that was required of inventoriable costs prior to the enactment of section 263A. Congress contemplated that taxpayers would continue to use the same methods of allocating costs to items in their inventory that were available under prior law. See S. Rep. No. 313, 99 ^th Cong. 2d Sess. 142 (1986). Consistent with these principles, the regulations under §1.263A–1(f)(2) and (f)(3) provide that taxpayers may

elect to use a “facts-and-circumstances” allocation method, such as the specific identification method, burden rate, standard cost method, or any other method to allocate direct and indirect costs to units of property produced or acquired for resale, if the method is reasonable within the meaning of §1.263A–1(f)(4).

Section 1.263A–1(f)(1) authorizes taxpayers to use the simplified methods provided in §1.263A–2(b) (the simplified production method) or §1.263A–3(d) (the simplified resale method) to allocate costs to eligible property produced or eligible property acquired for resale in lieu of a facts-and-circumstances allocation method. The simplified methods differ from facts-and-circumstances methods in that, as applied to inventories, they allocate a pool of capitalizable costs (additional section 263A costs) between ending inventory and cost of goods sold using a defined ratio and are an exception to the general rule that additional section 263A costs must be allocated to specific items of inventory. Thus, the simplified methods are intended to reduce the complexity and administrative burdens of having to develop detailed cost accounting systems for the additional costs required to be capitalized under section 263A.

Under the simplified production method, a taxpayer must allocate additional section 263A costs to produced property on hand at the end of the taxable year based on the ratio of these costs incurred during the year to the taxpayer’s total section 471 costs incurred during the year (the absorption ratio). The current regulations define additional section 263A costs as the costs, other than interest, that were not capitalized under the taxpayer’s method of accounting immediately prior to the effective date of section 263A, but that are required to be capitalized under section 263A. See §1.263A–1(d)(3). The current regulations define section 471 costs as costs, other than interest, capitalized under the taxpayer’s method of accounting immediately prior to the effective date of section 263A. If a taxpayer was not in existence before the effective date of section 263A, section 471 costs are generally those costs that would have been required to be capitalized under §1.471–11. See

2012–38 I.R.B. 347 September 17, 2012

ing them as negative additional section 263A costs. The proposed regulations generally prohibit treating cash or trade discounts described in §1.471–3(b) as negative amounts under any of the simplified methods. Comments are requested on reasonable methods of allocating between ending inventory and cost of goods sold cash or trade discounts that taxpayers do not capitalize for book purposes (and therefore are not section 471 costs within the meaning of §1.263A–1(d)(2)).

2. New Modified Simplified Production Method

In response to Notice 2007–29, a commentator suggested an alternative to the simplified production method that would reduce overcapitalization and distortion, including distortions resulting from including negative amounts in additional section 263A costs. The commentator suggested that the simplified production method may allocate an excessive amount of section 263A costs to raw materials inventories because the formula does not take into account the fact that taxpayers incur fewer indirect costs for raw materials and because different inventoriable costs turn over at different rates. The commentator’s alternative simplified method would allocate additional section 263A costs related to raw materials using a formula that is different from the formula used to allocate additional section 263A costs related to work-in-process and finished goods.

As suggested by this comment, the proposed regulations allow producers to use a new modified simplified production method that reduces the distortions that exist under the traditional simplified methods by more precisely allocating additional section 263A costs, including negative amounts, among raw materials, work-in-process, and finished goods inventories. Under the modified simplified production method, producers determine the allocable portion of preproduction related additional section 263A costs (such as storage and handling for raw materials) using a preproduction cost absorption ratio. The preproduction cost absorption ratio is applied to raw material section 471 costs incurred during the taxable year and remaining on hand at year end. For

§1.263A–1(d)(2). The absorption ratio is multiplied by the section 471 costs incurred during the taxable year that remain in ending inventory or are otherwise on hand at year end to determine the additional section 263A costs allocable to produced property on hand at the end of the taxable year.

Under the simplified resale method, an eligible taxpayer computes a combined absorption ratio and multiplies it by the section 471 costs incurred during the taxable year that remain in its ending inventory or are otherwise on hand at year end to determine the additional section 263A costs allocable to eligible property on hand at year end. Section 1.263A–3(d)(3)(i)(C)( 1 ) defines the combined absorption ratio as the sum of the storage and handling costs absorption ratio as defined by §1.263A–3(d)(3)(i)(D) and the purchasing costs absorption ratio as defined by §1.263A–3(d)(3)(i)(E).

Notice 2007–29, 2007–1 C.B. 881, requests comments on the treatment of negative amounts under the simplified methods. A negative amount generally occurs when a taxpayer capitalizes a cost as a section 471 cost in an amount that is greater than the amount required to be capitalized for tax purposes. For example, if a taxpayer included book depreciation in section 471 costs in accordance with §1.471–11(c)(2)(iii)(b) and the book depreciation is greater than tax depreciation for the year, the taxpayer would have capitalized more depreciation than is required to be capitalized under section 263A for that year. A negative amount may result if the taxpayer does not remove this excess depreciation amount by adjusting section 471 costs but instead makes an adjustment to its additional section 263A costs. See §601.601(d)(2)(ii)( b ).

In some situations, including negative amounts in the numerator of the simplified production method formula may result in significant distortions of the amount of additional section 263A costs that is allocated to ending inventory. Distortions may also occur when the method used to capitalize a cost under section 471 is different than the method used under the simplified production method to remove the cost from ending inventory. The extent of the distortion, and whether it is favorable or unfavorable to the taxpayer, gen

erally depends on when the cost is incurred in the production process and how the cost was allocated to raw materials, work-in-process, or finished goods inventories for purposes of section 471.

Notice 2007–29 provides that, pending the issuance of additional published guidance, the IRS will not challenge the inclusion of negative amounts in computing additional costs under section 263A or the permissibility of aggregate negative additional section 263A costs. The notice solicits public comments regarding possible changes to the simplified methods involving negative additional section 263A costs. Comments were received and considered in developing these proposed regulations.

Explanation of Provisions

1. Prohibition on Negative Amounts

To reduce the distortions that occur by including negative amounts under the simplified methods, the proposed regulations provide that, subject to certain exceptions described later in this preamble, taxpayers may not include negative amounts in additional section 263A costs. Specific comments are requested on transition rules for taxpayers currently using the simplified production method with the historic absorption ratio election (see section 1.263A–2(b)(4)), including comments on how the regulations should apply to taxpayers that are part way through the qualifying period as described in section 1.263A–2(b)(4)(ii)(C). To reduce the administrative burden for smaller taxpayers using the simplified production method for which the costs and burdens of excluding negative amounts from additional section 263A costs may otherwise outweigh the benefits, the proposed regulations allow producers with average annual gross receipts of $10,000,000 or less to include negative amounts in additional section 263A costs under the simplified production method.

Additionally, because negative additional section 263A costs cause less distortion under the simplified resale method than under the simplified production method, the proposed regulations allow taxpayers using the simplified resale method to remove section 471 costs that are not required to be capitalized for tax purposes from ending inventory by treat

September 17, 2012 348 2012–38 I.R.B.

does not apply to these regulations. Because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, this notice of proposed rulemaking has been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Comments and Requests for Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any comments that are submitted timely to the IRS as prescribed in this preamble under the “Addresses” heading. The IRS and the Treasury Department request comments on all aspects of the proposed rules. All comments will be available at www.regulations.gov or upon request.

A public hearing will be scheduled if requested in writing by any person who timely submits written comments. If a public hearing is scheduled, notice of the date, time, and place for the public hearing will be published in the Federal Register .

Drafting Information

The principal author of these proposed regulations is W. Thomas McElroy, Jr. of the Office of Associate Chief Counsel (Income Tax and Accounting). However, other personnel from the IRS and the Treasury Department participated in their development.

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Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows: