Part I. Rulings — Internal Revenue Bulletin 2014-12

TD 9659

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Property Transferred in Connection with the Performance of Services under Section 83

AGENCY: Internal Revenue Service, Department of Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations relating to property transferred in connection with the performance of services under section 83 of the Internal Revenue Code (Code). These final regulations affect certain taxpayers who receive property transferred in connection with the performance of services.

DATES: Effective Date: These regulations are effective on February 26, 2014.

Applicability Date: For dates of applicability, see §1.83–3(l).

FOR FURTHER INFORMATION CONTACT: Thomas Scholz or Michael Hughes at (202) 317-5600 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On May 30, 2012, the Department of Treasury (Treasury) and the Internal Revenue Service (IRS) published a notice of proposed rulemaking (REG–141075–09) in the Federal Register (77 FR 31783) under section 83 of the Code. Treasury and the IRS received two comments responding to the notice of proposed rulemaking. No public hearing was requested and no public hearing was held. After consideration of these comments, Treasury and the IRS adopt the proposed regulations as final regulations with the modifications described in this preamble.

Explanation of Provisions

Section 83 of the Code addresses the tax consequences of the transfer of property in connection with the performance of services. These final regulations provide several clarifications regarding whether a substantial risk of forfeiture exists in connection with property subject to section 83. Specifically, the final regulations clarify that (1) except as specifically provided in section 83(c)(3) and §§1.83– 3(j) and (k), a substantial risk of forfeiture may be established only through a service condition or a condition related to the purpose of the transfer, (2) in determining whether a substantial risk of forfeiture exists based on a condition related to the purpose of the transfer, both the likelihood that the forfeiture event will occur and the likelihood that the forfeiture will be enforced must be considered, and (3) except as specifically provided in section 83(c)(3) and §§1.83–3(j) and (k), transfer restrictions do not create a substantial risk of forfeiture, including transfer restrictions that carry the potential for forfeiture or disgorgement of some or all of the property, or other penalties, if the restriction is violated.

Summary of Comments

Treasury and the IRS received two written comments on the notice of proposed rulemaking. The first comment was not responsive to the notice of proposed rulemaking. The second comment expressed concern that the proposed regulations result in a narrowing of the circumstances that would establish a substantial risk of forfeiture and requested clarification regarding whether an involuntary separation from service without cause could establish a substantial risk of forfeiture. The comment noted that, for purposes of section 409A, an amount that is payable only upon a service provider’s involuntary separation from service without cause is subject to a substantial risk of forfeiture if the possibility of forfeiture is substantial, and it suggested that these regulations specifically state that an involuntary separation without cause may qual

ify as a substantial risk of forfeiture under section 83 in appropriate circumstances.

These regulations are intended to clarify the definition of a substantial risk of forfeiture and are consistent with the interpretation that the IRS historically has applied, and therefore from the perspective of Treasury and the IRS they do not constitute a narrowing of the requirements to establish a substantial risk of forfeiture. See Robinson v. Commissioner, 805 F.2d 38 (1 ^st Cir. 1986). Further, Treasury and the IRS believe that these regulations should not be modified to state that an involuntary separation from service without cause may qualify as a substantial risk of forfeiture under section 83. While a service provider’s right to receive property (or an amount in cash) in the future upon the service provider’s involuntary separation from service without cause may be subject to a substantial risk of forfeiture for purposes of section 409A if the possibility of forfeiture is substantial, a substantial risk of forfeiture under section 83 can exist only when property is actually transferred in connection with the performance of services. A right to receive property in the future is generally not property for purposes of section 83. See § 1.83–3(e). Accordingly, an involuntary separation from service without cause cannot qualify as a substantial risk of forfeiture under section 83 if property is not transferred until after the separation from service occurs.

When a transfer of property does occur, a substantial risk of forfeiture may be established through a substantial services condition or a condition related to the purpose of the transfer if the possibility of forfeiture is substantial. The acceleration of vesting upon an involuntary separation from service without cause (or separation from service as a result of death or disability) will not cause a requirement of substantial services that otherwise would be treated as a substantial risk of forfeiture to fail to qualify as a substantial risk of forfeiture, provided that facts and circumstances do not demonstrate that the occurrence of an involuntary separation from

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service without cause is likely to occur during the agreed upon service period.

Certain practitioners informally requested clarification regarding the application of section 83(c)(3) to a variation of the facts set forth in Example 4 of proposed regulation § 1.83–3(j)(2). Specifically, practitioners asked whether the purchase of shares in a transaction not exempt from section 16(b) of the Securities Exchange Act of 1934 prior to the exercise of a stock option that would not otherwise give rise to section 16(b) liability would defer taxation of the stock option exercise. Treasury and the IRS do not believe that such a non-exempt purchase of shares would defer taxation of the subsequent stock option exercise. This result is consistent with Example 3 of § 1.83– 3(j)(2). In response to these requests for clarification, Treasury and the IRS have revised Example 4 of proposed regulation § 1.83–3(j)(2) to address the situation raised.

Applicability Date

These regulations apply to property transferred on or after January 1, 2013.

Effect on Other Documents

Rev. Rul. 2005–48 (2005–2 CB 259) is obsolete as of February 26, 2014.

Special Analyses

It has been determined that this final regulation is not a significant regulatory action as defined in Executive Order 12866, as supplemented by Executive Order 13653. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and 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, the notice of proposed rule making preceding these final regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Drafting Information

The principal authors of these final regulations are Thomas Scholz and Michael Hughes, Office of the Division Counsel/ Associate Chief Counsel (Tax Exempt and Government Entities). Other personnel from Treasury and the IRS also participated in their development.

List of Subjects in 26 CFR Part 1

Adoption of Amendments to the Regulations

Accordingly, 26 CFR Part 1 is amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for Part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 - - Par. 2. Section 1.83–3 is amended by:

Revising paragraph (c)(1).
Adding Example 6 and Example 7 to paragraph (c)(4).
Adding Example 4 to paragraph (j)(2).
Removing paragraph (j)(3).
Removing paragraph (k).
Redesignating paragraph (k)(1) as paragraph (k).
Adding paragraph (l).

The revisions and additions read as follows:

§ 1.83–3 Meaning and use of certain terms .

- - - (c) Substantial risk of forfeiture . (1) In general . For purposes of section 83 and these regulations, whether a risk of forfeiture is substantial or not depends upon the facts and circumstances. Except as set forth in paragraphs (j) and (k) of this section, a substantial risk of forfeiture exists only if rights in property that are transferred are conditioned, directly or indirectly, upon the future performance (or refraining from performance) of substantial services by any person, or upon the occurrence of a condition related to a purpose of the transfer if the possibility of forfeiture is substantial. Property is not

transferred subject to a substantial risk of forfeiture if at the time of transfer the facts and circumstances demonstrate that the forfeiture condition is unlikely to be enforced. Further, property is not transferred subject to a substantial risk of forfeiture to the extent that the employer is required to pay the fair market value of a portion of such property to the employee upon the return of such property. The risk that the value of property will decline during a certain period of time does not constitute a substantial risk of forfeiture. A nonlapse restriction, standing by itself, will not result in a substantial risk of forfeiture. A restriction on the transfer of property, whether contractual or by operation of applicable law, will result in a substantial risk of forfeiture only if and to the extent that the restriction is described in paragraph (j) or (k) of this section. For this purpose, transfer restrictions that will not result in a substantial risk of forfeiture include, but are not limited to, restrictions that if violated, whether by transfer or attempted transfer of the property, would result in the forfeiture of some or all of the property, or liability by the employee for any damages, penalties, fees, or other amount.

- - - (4) - - Example 6 . On April 3, 2013, Y corporation grants to Q, an officer of Y, a nonstatutory option to purchase Y common stock. Although the option is immediately exercisable, it has no readily ascertainable fair market value when it is granted. Under the option, Q has the right to purchase 100 shares of Y common stock for $10 per share, which is the fair market value of a Y share on the date of grant of the option. On August 1, 2013, Y sells its common stock in an initial public offering. Pursuant to an underwriting agreement entered into in connection with the initial public offering, Q agrees not to sell, otherwise dispose of, or hedge any Y common stock from August 1 through February 1 of 2014 (“the lock-up period”). Q exercises the option and Y shares are transferred to Q on November 15, 2013, during the lock-up period. The underwriting agreement does not impose a substantial risk of forfeiture on the Y shares acquired by Q because the provisions of the agreement do not condition Q’s rights in the shares upon anyone’s future performance (or refraining from performance) of substantial services or on the occurrence of a condition related to the purpose of the transfer of shares to Q. Accordingly, neither section 83(c)(3) nor the imposition of the lock-up period by the underwriting agreement precludes taxation under section 83 when the shares resulting from exercise of the option are transferred to Q.

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Section 197.—Amortization of goodwill and certain other intangibles

Procedures are provided by which a taxpayer may obtain the automatic consent of the Commissioner of Internal Revenue to change from improperly amortizing leasehold improvements to which § 197 applies over the term of the lease (including renewals, if applicable) to properly amortizing these improvements under § 197. See Rev. Proc. 2014–17, page 661.

TD 9652

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Sales-Based Royalties and Vendor Allowances

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations relating to the capitalization and allocation of royalties that are incurred only upon the sale of property produced or property acquired for resale (sales-based royalties). This document also contains final regulations relating to adjusting inventory costs for a type of an allowance, discount, or price rebate earned on the sale of merchandise (salesbased vendor chargebacks). These regulations modify the simplified production method and the simplified resale method of allocating capitalized costs between ending inventory and cost of goods sold. These regulations affect taxpayers that incur capitalizable sales-based royalties or earn sales-based vendor chargebacks.

DATES: Effective Date : These regulations are effective on January 13, 2014.

Comment Date : Comments will be accepted until April 14, 2014.

Applicability Date : For dates of applicability, see §§1.263A–1(l), 1.263A–2(f), 1.263A–3(f), and 1.471–3(g).

ADDRESSES: Written (including electronic) comments should be submitted to Internal Revenue Service, CC:PA:

Example 7 . Assume the same facts as in Example 6, except that on August 1, 2013, Y also adopts an insider trading compliance program, under which, as applied to 2013, insiders (such as Q) may trade Y shares only during a limited number of days following each quarterly earnings release (“a trading window”). Under the program, if Q trades Y shares outside a trading window without Y’s permission, Y has the right to terminate Q’s employment. However, the exercise of the nonstatutory options outside a trading window for Y shares is not prohibited under the insider trading compliance program. Q fully exercises the option, and Y shares are transferred to Q, on November 15, 2013. The exercise of the option occurs outside a trading window, and, on the date of exercise, Q is in possession of material nonpublic information concerning Y that would subject him to liability under Rule 10b–5 under the Securities Exchange Act of 1934 if Q sold the Y shares while in possession of such information. Neither the insider trading compliance program nor the potential liability under Rule 10b–5 impose a substantial risk of forfeiture on the Y shares acquired by Q because the provisions of the program and Rule 10b–5 do not condition Q’s rights in the shares upon anyone’s future performance (or refraining from performance) of substantial services or on the occurrence of a condition related to the purpose of the transfer of shares to Q. Accordingly, none of section 83(c)(3), the imposition of the trading windows by the insider trading compliance program, and the potential liability under Rule 10b–5 preclude taxation under section 83 when the shares resulting from exercise of the option are transferred to Q.

- - - (j) - - (2) - - Example 4 . (i) On June 3, 2013, Y corporation grants to Q, an officer of Y, a nonstatutory option to purchase Y common stock. Y stock is traded on an established securities market. Although the option is immediately exercisable, it has no readily ascertainable fair market value when it is granted. Under the option, Q has the right to purchase 100 shares of Y common stock for $10 per share, which is the fair market value of a Y share on the date of grant of the option. The grant of the option is not one that satisfies the requirements for a transaction that is exempt from section 16(b) of the Securities Exchange Act of

On December 15, 2013, Y stock is trading at more than $10 per share. On that date, Q fully exercises the option, paying the exercise price in cash, and receives 100 Y shares. Q’s rights in the shares received as a result of the exercise are not conditioned upon the future performance of substantial services. Because no exemption from section 16(b) was available for the June 3, 2013 grant of the option, the section 16(b) liability period expires on December 1, 2013. Accordingly, the section 16(b) liability period expires before the date that Q exercises the option and the Y common stock is transferred to Q. Thus, the shares acquired by Q pursuant to the exercise of the option are not subject to a substantial risk of forfeiture under section 83(c)(3) as a result of section 16(b). As a result, section 83(c)(3) does not preclude taxation under section 83 when the shares acquired pursuant to the December 15, 2013 exercise of the option are transferred to Q.

(ii) Assume the same facts as in paragraph (i) of this Example 4 except that Q exercises the nonstatutory option on October 30, 2013 when Y stock is trading at more than $10 per share. The shares acquired are subject to a substantial risk of forfeiture under section 83(c)(3) as a result of section 16(b) through December 1, 2013.

(iii) Assume the same facts as in paragraph (i) of this Example 4 except that on November 5, 2013, Q also purchases 100 shares of Y common stock on the public market. The purchase of the shares is not a transaction exempt from section 16(b) of the Securities Exchange Act of 1934. Because no exemption from section 16(b) was available for the November 5, 2013 purchase of shares, the section 16(b) liability period with respect to such shares will last for a period of six months after the November 5, 2013 purchase of shares. Notwithstanding the non-exempt purchase of Y common stock on November 5, 2013, the shares acquired by Q pursuant to the December 15, 2013 exercise of the option are not subject to a substantial risk of forfeiture under section 83(c)(3) as a result of section 16(b). As a result, section 83(c)(3) does not preclude taxation under section 83 when the shares acquired pursuant to the December 15, 2013 exercise of the option are transferred to Q.

- - - (l) Effective/applicability date . This section applies to property transferred on or after January 1, 2013. For rules relating to property transferred before that date, see § 1.83–3 as contained in 26 CFR part 1 (as of April 1, 2012).

John Dalrymple, Deputy Commissioner for Services and Enforcement.

Approved, January 31, 2014.

Mark J. Mazur, Assistant Secretary of the Treasury

(Tax Policy).

(Filed by the Office of the Federal Register on February 25, 2014, 8:45 a.m., and published in the issue of the Federal Register for February 26, 2014, 79 F.R. 10663)

Section 167.—Depreciation

Procedures are provided by which a taxpayer may obtain the automatic consent of the Commissioner of Internal Revenue to change to the methods of accounting provided in § 1.167(a)–4 of the Income Tax Regulations (T.D. 9636) and § 1.167(a)–4T of the temporary regulations (T.D. 9564). See Rev. Proc. 2014–17, page 661.

Bulletin No. 2014–12 655 March 17, 2014

ing specific merchandise is a reduction in the cost of the merchandise sold or deemed sold under a taxpayer’s cost flow assumption. The preamble to the proposed regulations referred to this type of allowance as a sales-based vendor allowance. The proposed regulations required that these allowances reduce cost of goods sold and not reduce ending inventory cost or value of goods on hand at the end of the taxable year.

A commentator disagreed with the requirement in the proposed regulations that the vendor allowances described in the proposed regulations always must reduce cost of goods sold. The commentator disputed that a vendor allowance should reduce cost of goods sold merely because the allowance is dependent on a sale of merchandise. Citing Pittsburgh Milk Co. v. Commissioner, 26 T.C. 707 (1956), the commentator suggested that sales-based vendor allowances that are the subject of an advance agreement between the vendor and the purchaser at the time the merchandise is purchased must be netted against the original cost of the merchandise and applied to ending inventory or cost of goods sold depending on the taxpayer’s inventory cost flow assumption. Accordingly, the commentator suggested that the regulations be revised to provide that a sales-based vendor allowance may properly reduce the value of goods on hand at the end of the taxable year.

The final regulations reflect the commentator’s suggestion that a vendor allowance does not reduce the cost of goods sold merely because the allowance is dependent on a sale of merchandise. The proposed regulations were overbroad because they required taxpayers to allocate to cost of goods sold all allowances that arise from selling merchandise. For example, if, after selling a certain number of units, a taxpayer earns a discount off each unit purchased during the taxable year, the allowance properly may be allocable to both the cost of units that remains in ending inventory and the cost of units included in cost of goods sold during the year. Similarly, a sales-volume allowance that provides only a reduction in the cost of any purchases made by a taxpayer in the next taxable year properly reduces the cost of the units of the product purchased in the next year. As the preceding two

LPD:PR (REG–149338–08), Room 5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044, or electronically to www.regulations.gov (IRS REG–149338–08). Alternatively, comments may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG–149338–08), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW., Washington, DC. All comments will be available for public inspection and copying.

FOR FURTHER INFORMATION CONTACT: John Roman Faron, 202317-7005 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains final regulations that amend the Income Tax Regulations (26 CFR part 1) relating to the allocation under section 263A of the Internal Revenue Code (Code) of certain salesbased royalties and relating to the determination of cost of merchandise in inventory under section 471 when a taxpayer earns a type of sales-based vendor allowance. On December 17, 2010, a notice of proposed rulemaking (REG–149335–08) was published in the Federal Register (75 FR 78940). Written comments responding to the notice of proposed rulemaking were received. The comments are available for public inspection at www.regulations.gov or on request. A public hearing was requested and held on April 13, 2011. After consideration of all the comments, the proposed regulations are adopted as revised by this Treasury decision. The comments are discussed in the preamble.

Summary of Comments and Explanation of Provisions

Sales-based royalties

The proposed regulations clarified that sales-based royalties, like other royalties, may be capitalizable to property a taxpayer produces or acquires for resale. Royalty costs are capitalizable when they are incurred in securing the contractual right to use a trademark, corporate plan, manufacturing procedure, special recipe, or other similar right associated with

property produced or property acquired for resale. Sales-based royalty costs are royalties that are incurred only upon the sale of property produced or acquired for resale.

The proposed regulations provided that sales-based royalties required to be capitalized must be allocated only to property that has been sold or, for inventory property, deemed to be sold under the taxpayer’s inventory cost flow assumption. In response to concerns that the requirement to allocate sales-based royalties only to cost of goods sold would unduly burden taxpayers using simplified allocation methods, the final regulations provide that the allocation of sales-based royalties to property sold is optional rather than mandatory. Therefore, the final regulations permit taxpayers to either allocate salesbased royalties entirely to property sold and include those costs in cost of goods sold or to allocate sales-based royalties between cost of goods sold and ending inventory using a facts-and-circumstances cost allocation method described in § 1.263A–1(f) or a simplified method provided in § 1.263A–2(b) (the simplified production method) or § 1.263A–3(d) (the simplified resale method). The final regulations also clarify that sales-based royalties that a taxpayer allocates entirely to inventory property sold are included in cost of goods sold and may not be included in determining the cost of goods on hand at the end of the taxable year regardless of the taxpayer’s cost flow assumption.

A commentator suggested that the final regulations acknowledge that a salesbased royalty payable by a reseller of inventory to its supplier is a direct acquisition cost under section 471 and included in cost of goods sold when the inventory item is sold. The final regulations do not adopt this comment because whether a cost is a royalty described in §1.263A– 1(e)(3)(ii)(U) or is a contingent acquisition cost is beyond the scope of these regulations.

Sales-based vendor allowances in general

The proposed regulations provided that the amount of an allowance, discount, or price rebate that a taxpayer earns by sell

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examples illustrate, the proposed regulations were overbroad in that they could be interpreted to require these allowances to reduce cost of goods sold solely because they arose as a result of selling merchandise. The extent to which a vendor allowance is properly allocable to the cost of goods in ending inventory or the cost of goods sold depends on all facts and circumstances, including the terms and conditions of the agreement between the vendor and the taxpayer. See Pittsburgh Milk Co. v. Commissioner . As described later in this preamble, the final regulations more clearly identify a type of sales-based vendor allowance that, to clearly reflect income, must reduce the cost of goods sold.

The commentator also asserted that Rev. Rul. 2001–8 (2001–1 CB 726), see § 601.601(d)(2), and earlier rulings support the proposition that sales-based vendor allowances are an adjustment to the cost of merchandise physically removed from inventory. Although allowances, discounts, and price rebates properly are treated as adjustments to the price of merchandise, the final regulations do not adopt the commentator’s rationale for determining whether these adjustments properly reduce ending inventory or cost of goods sold. Rev. Rul. 2001–8 does not establish a general principle that sales-based vendor allowances reduce the invoice cost of merchandise physically sold. Rev. Rul. 2001–8 addresses a unique cost adjustment (floor stocks payments) that relates to goods physically on hand on a particular date and should not be applied beyond its specific facts.

Sales-based vendor chargebacks

In response to comments that the proposed regulations were overbroad, the Treasury and IRS are considering alternatives to a broad definition of sales-based vendor allowances. The final regulations, however, specifically identify one type of sales-based vendor allowance (salesbased vendor chargebacks) that, to clearly reflect income, reduces cost of goods sold and does not reduce the cost of goods on hand at the end of the taxable year. Therefore, the final regulations apply the rule articulated in the notice of proposed rulemaking to sales-based vendor charge

backs. A sales-based vendor chargeback is defined as an allowance, discount, or price rebate that a taxpayer becomes unconditionally entitled to by selling a vendor’s merchandise to specific customers identified by the vendor at a price determined by the vendor. Sales-based vendor chargebacks protect a taxpayer from realizing a loss or a reduced profit on the sale of specific merchandise when the taxpayer is obligated by contract with the vendor of the merchandise to resell the merchandise at a specific price (in some cases below the taxpayer’s cost). Under the terms and conditions of the agreement between the vendor and the taxpayer and the economics of the transaction, it is inappropriate to treat the allowance as an adjustment to the cost of goods in ending inventory. A sales-based vendor chargeback properly reduces only cost of goods sold because it arises from and relates only to merchandise sold. Thus, it reduces the invoice cost of the merchandise sold and clearly reflects income only if it reduces cost of goods sold.

Sales-based vendor allowances other than chargebacks

The final regulations reserve rules for the treatment of other sales-based vendor allowances. Given the factual nature of particular vendor allowance arrangements between sellers and purchasers of merchandise, the IRS and Treasury Department request comments regarding additional guidance defining or describing particular sales-based vendor allowances and on objective rules for allocating such allowances to the purchase price of goods acquired in the future, ending inventory, or cost of goods sold.

Effective/Applicability Date

These regulations apply for taxable years ending on or after January 13, 2014.

Special Analyses

This Treasury decision is not a significant regulatory action as defined in Executive Order 12866, as supplemented by Executive Order 13563. Therefore, a regulatory assessment is not required. Section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to

these regulations, and 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, the notice of proposed rulemaking that preceded these final regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business. No comments were received from the Small Business Administration.

Drafting Information

The principal author of these regulations is John Roman Faron of the Office of the Associate Chief Counsel (Income Tax and Accounting). However, other personnel from the IRS and Treasury Department participated in their development.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 - - Section 1.263A–1 also issued under 26 U.S.C. 263A.

Section 1.263A–2 also issued under 26 U.S.C. 263A.

Section 1.263A–3 also issued under 26 U.S.C. 263A. - - Section 1.471–3 also issued under 26 U.S.C. 471. - - Par. 2. Section 1.263A–0 Table of Contents is amended by adding new entries for §§ 1.263A–1(c)(5), (k), and (l); 1.263A–2(b)(3)(ii)(C), (e), and (f); 1.263A–3(d)(3)(i)(C)( 3 ) and (f); and revising the entry for § 1.263A–1(e)(3)(ii) to read as follows:

§ 1.263A–0 Outline of regulations under section 263A .

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§ 1.263A–1 Uniform Capitalization of Costs .

- - - (c) - - (5) Costs allocable only to property sold.
- - - (e) - - (3) - - (ii) Examples of indirect costs required to be capitalized.
- - - (k) Change in method of accounting. (1) In general. (2) Scope limitations. (3) Audit protection. (4) Section 481(a) adjustment. (5) Time for requesting change. (l) Effective/applicability date.

§ 1.263A–2 Rules Relating to Property Produced by the Taxpayer .

- - - (b) - - (3) - - (ii) - - (C) Costs allocable only to property sold.
- - - (e) Change in method of accounting. (1) In general. (2) Scope limitations. (3) Audit protection. (4) Section 481(a) adjustment. (5) Time for requesting change. (f) Effective/applicability date.

§ 1.263A–3 Rules Relating to Property Acquired for Resale .

- - - (d) - - (3) - - (i) - - (C) - - ( 3 ) Costs allocable only to property sold.
- - - (f) Effective/applicability date.
- - - Par. 3. Section 1.263A–1 is amended by:

Adding a new paragraph (c)(5).
Revising paragraph (e)(3)(i), the introductory text of paragraph (e)(3)(ii), and paragraph (l).
Redesignating paragraph (e)(3)(ii)(U) as paragraph (e)(3)(ii)(U)( 1 ), revising the

second sentence of newly-designated paragraph (e)(3)(ii)(U)( 1 ), and adding a sentence to the end of newly-designated paragraph (e)(3)(ii)(U)( 1 ).

Adding a new paragraph (e)(3)(ii)(U)( 2 ). The additions and revisions read as follows:

§ 1.263A–1 Uniform capitalization of costs .

- - - (c) - - (5) Costs allocable to property sold . A cost that is allocated under this section, § 1.263A–2, or § 1.263A–3 entirely to property sold must be included in cost of goods sold and may not be included in determining the cost of goods on hand at the end of the taxable year.
- - - (e) - - (3) - - (i) In general . (A) Indirect costs are defined 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). Taxpayers subject to section 263A must capitalize all indirect costs properly allocable to property produced or property acquired for resale. Indirect costs are properly allocable to property produced or property acquired for resale when the costs directly benefit or are incurred by reason of the performance of production or resale activities. Indirect costs may directly benefit or be incurred by reason of the performance of production or resale activities even if the costs are calculated as a percentage of revenue or gross profit from the sale of inventory, are determined by reference to the number of units of property sold, or are incurred only upon the sale of inventory. Indirect costs may be allocable to both production and resale activities, as well as to other activities that are not subject to section 263A. Taxpayers must make a reasonable allocation of indirect costs between production, resale, and other activities.

(B) Example . The following example illustrates the provisions of this paragraph (e)(3)(i):

Example . (i) Taxpayer A manufactures tablecloths and other linens. A enters into a licensing agreement with Company L under which A may label its tablecloths with L’s trademark if the table

cloths meet certain specified quality standards. In exchange for its right to use L’s trademark, the licensing agreement requires A to pay L a royalty of $X for each tablecloth carrying L’s trademark that A sells. The licensing agreement does not require A to pay L any minimum or lump-sum royalties.

(ii) The licensing agreement provides A with the right to use L’s intellectual property, a trademark. The licensing agreement also requires A to conduct its production activities according to certain standards as a condition of exercising that right. Thus, A’s right to use L’s trademark under the licensing agreement is directly related to A’s production of tablecloths. The royalties the licensing agreement requires A to pay for using L’s trademark are the costs A incurs in exchange for these rights. Therefore, although A incurs royalty costs only when A sells a tablecloth carrying L’s trademark, the royalty costs directly benefit production activities and are incurred by reason of production activities within the meaning of paragraph (e)(3)(i)(A) of this section.

(ii) Examples of indirect costs required to be capitalized . The following are examples of indirect costs that must be capitalized to the extent they are properly allocable to property produced or property acquired for resale:

- - - (U) Licensing and franchise costs . ( 1 )
- - These costs include the otherwise deductible portion (such as amortization) of the initial fees incurred to obtain the license or franchise and any minimum annual payments and any royalties that are incurred by a licensee or a franchisee. These costs also include fees, payments, and royalties otherwise described in this paragraph (e)(3)(ii)(U) that a taxpayer incurs (within the meaning of section 461) only upon the sale of property produced or acquired for resale.

( 2 ) If a taxpayer incurs (within the meaning of section 461) a fee, payment, or royalty described in this paragraph (e)(3)(ii)(U) only upon the sale of property produced or acquired for resale and the cost is required to be capitalized under this paragraph (e)(3), the taxpayer may properly allocate the cost entirely to property produced or acquired for resale by the taxpayer that has been sold.

- - - (l) Effective/applicability date . (1) Paragraphs (h)(2)(i)(D), (k), and (l) of this section apply for taxable years ending on or after August 2, 2005.

(2) Paragraphs (c)(5), (e)(3)(i), and (e)(3)(ii)(U) of this section apply for taxable years ending on or after January 13, 2014.

Par. 4. Section 1.263A–2 is amended by:

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Adding paragraphs (b)(3)(ii)(C) and (b)(4)(ii)(A)( 4 ).
Revising paragraph (f). The additions and revision read as follows:

§ 1.263A–2 Rules relating to property produced by the taxpayer .

- - - (b) - - (3) - - (ii) - - (C) Costs allocated to property sold . Additional section 263A costs incurred during the taxable year, as defined in paragraph (b)(3)(ii)(A)( 1 ) of this section, section 471 costs incurred during the taxable year, as defined in paragraph (b)(3)(ii)(A)( 2 ) of this section, and section 471 costs remaining on hand at year end, as defined in paragraph (b)(3)(ii)(B) of this section, do not include costs described in § 1.263A–1(e)(3)(ii) or cost reductions described in § 1.471–3(e) that a taxpayer properly allocates entirely to property that has been sold.
- - - (4) - - (ii) - - (A) - - ( 4 ) Additional section 263A costs incurred during the test period, as defined in paragraph (b)(4)(ii)(A)( 2 ) of this section, and section 471 costs incurred during the test period, as defined in paragraph (b)(4)(ii)(A)( 3 ) of this section, do not include costs specifically described in § 1.263A–1(e)(3)(ii) or cost reductions described in § 1.471–3(e) that a taxpayer properly allocates entirely to property that has been sold.
- - - (f) Effective/applicability date . (1) Paragraphs (b)(2)(i)(D), (e), and (f) of this section apply for taxable years ending on or after August 2, 2005.

(2) Paragraphs (b)(3)(ii)(C) and (b)(4)(ii)(A)( 4 ) of this section apply for taxable years ending on or after January 13, 2014. Par. 5. In § 1.263A–3, paragraphs (d)(3)(i)(C)( 3 ), (d)(3)(i)(D)( 3 ), (d)(3)(i)(E)( 3 ), and (f) are added to read as follows:

§ 1.263A–3 Rules relating to property acquired for resale .

- - - (d) - - (3) - - (i) - - (C) - - ( 3 ) Costs allocable to property sold . Section 471 costs remaining on hand at year end, as defined in paragraph (d)(3)(i)(C)( 2 ) of this section, do not include costs that are specifically described in § 1.263A–1(e)(3)(ii) or cost reductions described in § 1.471–3(e) that a taxpayer properly allocates entirely to property that has been sold.

(D) - - ( 3 ) Current year’s storage and handling costs, beginning inventory, and current year’s purchases, as defined in paragraph (d)(3)(i)(D)( 2 ) of this section, do not include costs that are specifically described in § 1.263A–1(e)(3)(ii) or cost reductions described in § 1.471–3(e) that a taxpayer properly allocates entirely to property that has been sold.

(E) - - ( 3 ) Current year’s purchasing costs and current year’s purchases, as defined in paragraph (d)(3)(i)(E)( 2 ) of this section, do not include costs that are specifically described in § 1.263A–1(e)(3)(ii) or cost reductions described in § 1.471–3(e) that a taxpayer properly allocates entirely to property that has been sold.

- - - (f) Effective/applicability date . Paragraphs (d)(3)(i)(C)( 3 ), (d)(3)(i)(D)( 3 ), and (d)(3)(i)(E)( 3 ) of this section apply for taxable years ending on or after January 13, 2014. Par. 6. Section 1.471–3 is amended by:

Adding paragraphs (e) and (g).
Designating the undesignated text following paragraph (d) as paragraph (f).

The additions read as follows:

§ 1.471–3 Inventories at cost .

- - - (e) Sales-based vendor allowances (1) Treatment of sales-based vendor chargebacks —(i) In general . A salesbased vendor chargeback is an allowance, discount, or price rebate that a taxpayer becomes unconditionally entitled to by

selling a vendor’s merchandise to specific customers identified by the vendor at a price determined by the vendor. A salesbased vendor chargeback decreases cost of goods sold and does not reduce the cost of goods on hand at the end of the taxable year.

(ii) Example . The following example illustrates the provisions of this paragraph (e)(1).

Example . (i) W is a wholesaler of pharmaceuticals. W purchases Drug X from the manufacturer, M, for $10x per unit. M has agreements with specific customers that allow those customers to acquire Drug X from M’s wholesalers for $6x per unit. Under an agreement between W and M, W is required to sell Drug X to specific customers at the prices M has negotiated with such customers ($6x per unit) and, in exchange, M agrees to provide a price rebate to W equal to the difference between W’s cost for Drug X and the price W is required to charge specific customers under the agreement (a difference of $4x per unit). W sells Drug X to specific customer Y for $6x. Under the agreement between W and M, the price rebate can be paid to W, credited against M’s invoice to W for W’s purchase of Drug X, or it can be credited to W’s future purchases of drugs from M.

(ii) Under the terms of the agreement, W is unconditionally entitled to the price rebate of Drug X when it sells Drug X to specific customer Y, a specifically identified customer of M. The price rebate received by W for the sale of Drug X to Y is a sales-based vendor chargeback. Therefore, the amount of the sales-based vendor charge back, $4x per unit for Drug X, whether paid to W, credited against M’s invoice to W for W’s purchase of Drug X or credited against a future purchase, decreases cost of goods sold and does not reduce the cost of Drug X on hand at the end of the taxable year.

(2) Treatment of other sales-based ven- dor allowances . [Reserved]

- - - (g) Effective/applicability date . Paragraph (f) of this section applies to taxable years ending on or after January 13, 2014.

John Dalrymple Deputy Commissioner for Services and Enforcement.

Approved, December 13, 2013

Mark J. Mazur Assistant Secretary of the Treasury

(Tax Policy).

(Filed by the Office of the Federal Register on January 10, 2014, 8:45 a.m., and published in the issue of the Federal Register for January 13, 2014, 79 F.R. 2094)

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Section 446.—General rule for methods of accounting

Modifications are made to the procedures in Rev. Proc. 2012–20, 2012–14 I.R.B. 700, and Rev. Proc. 2011–14, 2011–4 I.R.B. 330, regarding certain changes in method of accounting for dispositions of tangible depreciable property. Procedures are provided by which a taxpayer may obtain the automatic

consent of the Commissioner of Internal Revenue to change to the methods of accounting provided in §§ 1.167(a)–4 and 1.168(i)–7 of the Income Tax Regulations (T.D. 9636), §§ 1.167(a)–4T, 1.168(i)– 1T, 1.168(i)–7T, and 1.168(i)–8T of the temporary regulations (T.D. 9564), and §§ 1.168(i)–1, 1.168(i)–7, and 1.168(i)–8 of the proposed regulations (REG–110732–13). Modifications are also made to Rev. Proc. 2011–14 to allow a late partial

disposition election under Prop. Reg. § 1.168(i)–8 or a revocation of a general asset account election under § 1.168(i)–1T or Prop. Reg. § 1.168(i)–1 to be treated as a change in method of accounting for a limited period of time. Finally, modifications are made to section 6.01 of the APPENDIX of Rev. Proc. 2011–14 to waive a scope limitation in certain circumstances. See Rev. Proc. 2014–17, page 661.

March 17, 2014 660 Bulletin No. 2014–12