SECTION 2. BACKGROUND

.01 Section 263A requires taxpayers to capitalize the direct costs and indirect costs that are properly allocable to real property or tangible personal property the taxpayer produces and real property or personal property described in § 1221(a)(1) that the taxpayer acquires for resale. Taxpayers must allocate costs required to be capitalized to property produced or acquired for resale during the taxable year using a cost allocation method described in the regula

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tions. For example, taxpayers may 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 inventory property produced or acquired for resale.

.02 Under § 471, when the use of inventories is necessary to clearly determine the income of any taxpayer, inventories must be taken on the basis that most clearly reflects income. Section 1.471– 2(c) permits merchants and manufacturers to value inventories at either (1) cost, or (2) cost or market, whichever is lower. Under § 1.471–3(b), the cost of merchandise purchased by taxpayers is, in general, the invoice price less trade or other discounts.

.03 On January 13, 2014, the Internal Revenue Service and Treasury Department published final regulations under §§ 263A and 471 (TD 9652, 79 Fed. Reg. 2094) relating to (1) the capitalization and allocation of royalties that a taxpayer incurs only upon the sale of property produced or acquired for resale (sales-based royalties), and (2) the adjustment of the cost of inventory for sales-based vendor chargebacks, a type of sales-based vendor allowance. The final regulations apply to taxable years ending on or after January 13, 2014.

.04 Section 1.263A–1(e)(3)(ii)(U) of the final regulations clarifies that salesbased royalties, which are royalties 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, are indirect costs and are properly allocable to property produced or acquired for resale to the extent the costs directly benefit or are incurred by reason of production or resale activities. Under § 1.263A– 1(e)(3)(ii)(U)( 2 ) of the final regulations, a taxpayer may allocate capitalizable salesbased royalties entirely to the units of property produced or acquired for resale that are sold and, in the case of inventory property, allocate these costs only to cost of goods sold.

.05 Under § 1.263A–1(c)(5) of the final regulations, a cost that is allocated entirely to inventory 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.

.06 Section 1.471–3(e)(1) of the final regulations provides that a sales-based vendor chargeback, one type of salesbased vendor allowance, is an allowance or price rebate that reduces only cost of goods sold and does not adjust the cost of goods on hand at the end of the taxable year. A sales-based vendor chargeback is defined as an allowance, discount, or price rebate to which a taxpayer becomes unconditionally entitled by selling a vendor’s merchandise to specific customers identified by the vendor at a price determined by the vendor. The final regulations reserve rules addressing other types of sales-based vendor allowances.

.07 The final regulations under §§ 1.263A–2(b) and 1.263A–3(d) revise the simplified production method and the simplified resale method by providing that additional § 263A costs incurred during the taxable year, § 471 costs incurred during the taxable year, and § 471 costs remaining on hand at year end do not include costs specifically described in § 1.263A–1(e)(3)(ii) (currently only capitalizable depletion and sales-based royalties) and cost reductions described in § 1.471–3(e) (such as sales-based vendor chargebacks) that are properly allocated to property that has been sold. Consequently, a taxpayer allocating sales-based royalties or sales-based vendor chargebacks to cost of goods sold and currently including these amounts in § 471 costs or additional § 263A costs must remove the sales-based royalties or sales-based vendor chargebacks in the same manner that the taxpayer included them. Changes in methods of accounting for depletion under these regulations will be addressed in separate guidance.

.08 Sections 446(e) and 1.446–1(e)(2) state that, except as otherwise provided, a taxpayer must secure the consent of the Commissioner before changing a method of accounting for federal income tax purposes. Section 1.446–1(e)(3)(ii) authorizes the Commissioner to prescribe administrative procedures setting forth the limitations, terms, and conditions necessary to permit a taxpayer to obtain consent to change a method of accounting in accordance with § 446(e).

.09 Rev. Proc. 97–27, 1997–1 C.B. 680, modified and amplified by Rev. Proc. 2002–19, 2002–1 C.B. 696, amplified and

clarified by Rev. Proc. 2002–54, 2002–2 C.B. 432, modified by Rev. Proc. 2007– 67, 2007–2 C.B. 1072, clarified and modified by Rev. Proc. 2009–39, 2009–38 C.B. 371, modified by Rev. Proc. 2011– 14,2011–4 C.B. 330, and clarified and modified by Rev. Proc. 2012–39, 2012–41 C.B. 470, provides the general procedures for obtaining the advance consent of the Commissioner to change a method of accounting. See also Rev. Proc. 2014–1, 2014–1 I.R.B. 1 (or successor). .10 Rev. Proc. 2011–14, 2011–1 C.B. 330, provides procedures for a taxpayer to obtain automatic consent of the Commissioner to change to a method of accounting described in the APPENDIX of Rev. Proc. 2011–14.

.11 Section 481(a) requires the adjustments necessary to prevent amounts from being duplicated or omitted when a taxpayer’s taxable income is determined under a method of accounting different from the method used to determine taxable income for the preceding taxable year.