[Federal Register Volume 59, Number 249 (Thursday, December 29, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-31431]
[[Page Unknown]]
[Federal Register: December 29, 1994]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
[T.D. 8584]
RIN 1545-AK03
Capitalization of Interest
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document contains final regulations relating to the
requirement to capitalize interest with respect to the production of
property. The regulations provide guidance necessary for taxpayers to
comply with the requirement to capitalize interest with respect to
certain produce property.
EFFECTIVE DATE: January 1, 1995.
FOR FURTHER INFORMATION CONTACT:
Jan L. Skelton, (202) 622-4970 (not a toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information contained in these final regulations
have been reviewed and approved by the Office of Management and Budget
in accordance with the Paperwork Reduction Act (44 U.S.C. 3504(h))
under control number 1545-1265. The estimated average annual burden per
recordkeeper is 14 minutes. The estimated average annual reporting
burden per respondent is 2 hours.
Comments concerning the accuracy of this burden estimate and
suggestions for reducing this burden should be sent to the Internal
Revenue Service, Attn: IRS Reports Clearance Officer PC:FP, Washington
DC 20224, and to the Office of Management and Budget, Attention: Desk
Officer for the Department of the Treasury, Office of Information and
Regulatory Affairs, Washington DC 20503.
Background
On Friday, August 16, 1991, the Federal Register published proposed
amendments (56 FR 40815) to the Income Tax Regulations (26 CFR part 1)
under section 263A(f) of the Internal Revenue Code (Code). Written
comments responding to the notice were received and a public hearing
was held on November 20, 1991. After careful consideration of all the
comments, the proposed amendments are adopted, except as revised and
renumbered by this document.
In General
The uniform capitalization rules of section 263A generally require
the capitalization of certain costs relating to the acquisition of
property for resale or the production of property. Interest is a cost
subject to section 263A. Section 263A(f) provides special rules for
capitalizing interest.
In general, section 263A(f) limits the capitalization of interest
to interest that is paid or incurred during the production period of
certain property (referred to as designated property). Designated
property includes all real property and certain tangible personal
property.
The amount of interest required to be capitalized is determined
using the avoided cost method. Under the avoided cost method, interest
on any indebtedness directly attributable to production expenditures
for designated property (traced debt) is capitalized first. If
production expenditures for designated property exceed the amount of
traced debt, interest on any other debt is capitalized to the extent
such interest could have been reduced if production expenditures had
not been incurred. The application of the avoided cost method does not
depend on whether the taxpayer actually would have used amounts
expended for production to repay or reduce debt. Instead, the avoided
cost method is based on the assumption that if production expenditures
had not been incurred, debt of the taxpayer would have been repaid or
reduced without regard to the taxpayer's subjective intentions or to
restrictions against repayment or use of the debt proceeds.
For example, if Corporation X has incurred $1.5 million of
production expenditures for a unit of real property it is constructing,
and has an outstanding $1 million loan (from an unrelated party) for
the construction of the real property, Corporation X must capitalize
interest on the loan as provided in section 263A(f). In addition,
because Corporation X has production expenditures ($1.5 million) that
exceed traced debt ($1 million), Corporation X must capitalize interest
on any other debt (subject to certain limitations) as provided in
section 263A(f). In general, to determine the amount of interest it
must capitalize on its other debt, Corporation X multiplies its excess
production expenditures ($.5 million) by a weighted average interest
rate for its other debt.
Public Comments
Simplification
The proposed regulations include several provisions designed to
reduce administrative complexity without undermining the principles of
section 263A(f). These provisions include (1) a de minimis rule
exempting certain insignificant production activities from the
requirement to capitalize interest; (2) an exception from the
requirement to capitalize interest for inventory property that has a
class life of 20 years or more but does not satisfy the other
classification thresholds for tangible personal property; (3) an
election not to trace debt to designated property; (4) an election to
calculate interest under the avoided cost method on a taxable year
basis in lieu of a monthly or more frequent basis; and (5) a simplified
method to calculate the amount of interest required to be capitalized
with respect to certain inventory property.
Commentators made several suggestions for further simplifying the
proposed rules. As discussed in more detail below, the final
regulations add a number of these simplifying suggestions. For example,
the final regulations permit certain small taxpayers to use a specified
external rate as a substitute for the weighted average interest rate.
In addition, the final rules make the 3-month, $10,000 de minimis rule
of the proposed regulations more flexible by increasing the dollar
threshold for production expenditures to $1 million divided by the
number of days in the production period. Further, the final regulations
shorten the time required to qualify for the suspension rule from 12
months to 120 consecutive days and apply the suspension rule
retroactively.
Designated Property
In General
Designated property includes all real property produced by the
taxpayer. Tangible personal property produced by the taxpayer is also
designated property, but only if it has a class life of 20 years or
more, an estimated production period of more than 1 year and total
production costs of more than $1 million, or an estimated production
period of more than 2 years.
De Minimis Exception
The proposed regulations provide a de minimis exception from
interest capitalization for property that would otherwise be designated
property. This exception applies if the property has a production
period that does not exceed 3 months and a total cost of production
that does not exceed $10,000.
Commentators recommended a number of changes to this de minimis
rule. Several commentators argued that the proposed de minimis rule
should be liberalized by either applying the production period and cost
thresholds in the disjunctive or increasing the thresholds. One
commentator recommended that, in addition to a de minimis rule for
property, the final regulations should provide a ``small taxpayer''
exception.
The final regulations revise the 3-month, $10,000 de minimis rule.
The revised rule liberalizes the de minimis rule and provides more
flexibility in its application by adopting a dollar-day rule. As
revised the de minimis rule excepts from interest capitalization
property with a production period of not more than 90 days and a total
cost of production that does not exceed $1,000,000 divided by the
number of days in the production period. The final regulations,
however, do not adopt a small taxpayer exception.
Commentators also recommended that interest that would be
capitalized if property were designated property be excluded from
production costs in determining whether the $10,000 threshold of the
proposed de minimis rule is met. The final regulations adopt this
recommendation for purposes of determining production expenditures
under the revised de minimis rule.
Definition of Real Property
The proposed regulations provide that real property includes land,
unsevered natural products of land, buildings, and inherently permanent
structures. An inherently permanent structure is property that is
affixed to real property and that will ordinarily remain affixed for an
indefinite period of time.
Certain commentators believed that the proposed definition of real
property is too broad. They argued that the section 263A(f) regulations
should define real property to exclude property classified as section
1245 property, as well as property classified or treated as personal
property for investment tax credit purposes (former section 48).
Neither section 263A(f) nor its legislative history expressly
defines ``real property.'' Nevertheless, the IRS and Treasury do not
believe it is necessary or appropriate to define ``real property'' as
narrowly as some commentators have suggested.
Section 1245 provides for the recapture of the benefit of
accelerated depreciation on, or amortization with respect to, certain
property. Congress clearly intended to classify certain real property
as property subject to the section 1245 rules. See section
1245(a)(3)(B) and (C). Nothing in either section 263A(f) or its
legislative history (or in section 189, the predecessor of section
263A(f), and its legislative history) suggests Congress intended to
exclude real property subject to section 1245 from the definition of
real property for purposes of interest capitalization. See S. Rep. No.
169, 98th Cong., 2d Sess. I-280 n. 19 (1984).
Congress intended that the benefit of the investment tax credit
apply expansively under former section 48. See H. Rep. No. 1447, 87th
Cong., 2d Sess. (1962) 1962-3 C.B. 405, 415. Consistent with this
intent, tangible personal property was not to be defined narrowly and
was not to follow state law. Id. Nothing in the legislative history of
section 263A(f) suggests, however, that Congress intended that such a
broad definition of personal property be adopted for interest
capitalization purposes.
Some commentators interpreted certain language in proposed
Sec. 1.263A(f)-1 (relating to the classification of property for
purposes of former section 48 and Sec. 1.48-1(c) and Sec. 1.48-1(d)) to
provide that property that would otherwise be an inherently permanent
structure under section 263A(f) (i.e., because it is affixed to real
property and will ordinarily remain affixed for an indefinite period of
time) is not an inherently permanent structure under section 263A(f) if
such property would constitute property in the nature of machinery
under the principles of former section 48 and Sec. 1.48-1(c).
As indicated above, however, the IRS and Treasury do not believe
that the classification or treatment of property as personal property
for purposes of former section 48 should be determinative of the
classification of property as personal property for purposes of section
263A(f). Accordingly, the final regulations provide that a structure
may be an inherently permanent structure, and not property in the
nature of machinery or essentially an item of machinery, even if the
structure is necessary to operate or use, supports, or is otherwise
associated with machinery.
Classification Thresholds for Personal Property
Under the proposed regulations, designated property includes
tangible personal property that is (i) property with a class life of 20
years or more, but only if produced for self-use, (ii) property with an
estimated production period exceeding 2 years (2-year property), or
(iii) property with an estimated production period exceeding 1 year and
a cost exceeding $1 million (1-year property). Commentators made
recommendations regarding the $1 million cost threshold for 1-year
property and the production period thresholds for 1-year and 2-year
property produced under a contract.
One commentator recommended the final regulations clarify whether
interest that would be required to be capitalized if property were
designated property is taken into account in determining whether the
production costs for property exceed the $1 million production costs
threshold. The final regulations clarify that such interest is not
taken into account in determining whether property is designated
property.
Classification Thresholds for Personal Property Produced Under a
Contract
In the case of tangible personal property produced under a
contract, the proposed regulations require the contractor and the
customer each to determine whether the 1-year and 2-year production
period thresholds are satisfied. For this purpose, the proposed
regulations require the customer to treat the production period as
beginning on the earlier of the date the contract is executed or the
date the customer's accumulated production expenditures are at least 5
percent of the customer's total estimated production expenditures
(contract date rule). One commentator recommended that a customer be
allowed to elect to use the contract date rule, and in the absence of
an election, treat the production period as beginning when the
customer's accumulated production expenditures are at least 5 percent
of the total estimated production expenditures.
The final regulations retain the contract date rule. However, to
address commentators' concerns, the final regulations provide that a
customer may elect to determine the 1- and 2-year production period
thresholds by treating the customer's production period as beginning on
the date that aggregate accumulated production expenditures for both
the contractor and the customer are at least 5 percent of the
customer's estimated production expenditures for the property. The IRS
and Treasury believe that a 5-percent rule based only on production
expenditures incurred by a customer could be abused (e.g., a customer
could avoid designated property classification and, thus, interest
capitalization by simply withholding payments to the contractor).
Definition of a Contract
Section 263A(g)(2) provides that the taxpayer shall be treated as
producing any property produced for the taxpayer under a contract with
the taxpayer. The final regulations under section 263A (relating to the
capitalization of costs other than interest) published in the Federal
Register on August 9, 1993, reserved the definition of a contract for
this purpose.
The preamble to those regulations stated that the definition of a
contract was being studied under the section 263A(f) regulations.
Commentators believed that the definition of a contract provided in the
proposed regulations under section 263A(f) should be modified, for
example, to exclude routine purchase orders.
For purposes of determining whether property is produced under a
contract, the final regulations define a contract as any agreement
providing for the production of property if the agreement is entered
into before the production of the property to be delivered under the
contract is completed. Whether an agreement exists depends on all the
facts and circumstances. Facts and circumstances to be taken into
account include making a prepayment, or entering into an arrangement to
make a prepayment, for property prior to the date of completion of the
production of property or incurring significant expenditures for
property of specialized design or specialized application.
In response to commentators' concerns, the amendments to the final
regulations provide that a routine purchase order for the production of
fungible property is not a contract for purposes of section 263A(g)(2).
Under this rule, an agreement will not be treated as a routine purchase
order for the production of fungible property if the seller is required
to make more than de minimis modifications to the property to tailor it
to the customer's specific needs, or if at the time the agreement is
entered into, the customer knows or has reason to know that the seller
cannot satisfy the agreement within 30 days out of existing stocks and
normal production of finished goods.
The Avoided Cost Method
In General
The proposed regulations require taxpayers to use the avoided cost
method described in proposed Sec. 1.263A(f)-(2) to calculate the amount
of interest required to be capitalized under section 263A(f). A number
of commentators argued that, for purposes of capitalizing interest
under section 263A(f), taxpayers should be permitted to elect to use
Statement of Financial Accounting Standards No. 34 (SFAS 34), which
establishes standards for capitalizing interest for financial statement
purposes.
Congress indicated that it intended interest to be capitalized
under the avoided cost method, using rules similar to those applicable
under former section 189. See S. Rep. No. 313, 99th Cong., 2d Sess. 144
(1986). Former section 189 applied rules similar to those contained in
Financial Accounting Standards Board (FASB) Statement No. 34. H.R.
Conf. Rep. No. 760, 97th Cong., 2d Sess. 484-85 (1982). The proposed
section 263A(f) regulations adopt an approach similar to the rules in
SFAS 34 in that they treat interest that would have been avoided if
production expenditures had been used to repay indebtedness of the
taxpayer as interest subject to capitalization.
Although the proposed regulations use an approach similar to SFAS
34, the IRS and Treasury are not persuaded that the regulations should
be changed to permit the use of the financial accounting rules of SFAS
34 instead of the avoided cost method in the proposed regulations. The
IRS and Treasury believe that the results obtained by applying SFAS 34
could diverge significantly from the results obtained by applying tax
principles. For example, differences in the amount of interest
capitalized could result because: the bases of assets for book and tax
purposes differ; SFAS 34 allows more discretion and subjectivity (e.g.,
in identifying borrowings used to determine interest capitalization)
that does the statute; and materiality standards used for financial
accounting rules may not be acceptable for tax purposes. Accordingly,
the final regulations do not permit the use of SFAS 34 as an
alternative to the avoided cost method set forth in the regulations.
Accounts Payable and Simplification Rule for Tracing
Under the proposed regulations, the calculation of the amount of
interest required to be capitalized is made by reference to eligible
debt. Eligible debt generally includes all debt of the taxpayer on
which interest is deductible in computing taxable income. However,
noninterest bearing debt is excluded from the definition of eligible
debt unless the debt is traced debt (or, if the taxpayer makes an
election not to trace debt, is debt that would have been treated as
traced debt in the absence of such an election).
Commentators indicated that noninterest bearing debt such as
accounts payable should be treated as eligible debt whether or not the
debt is traced to the accumulated production expenditures of designated
property.
The IRS and Treasury continue to believe that treating all
noninterest bearing debt as eligible debt is inconsistent with
Congressional intent. Such treatment is not similar to the FASB 34 rule
and would distort the interest capitalization rate. The final
regulations, therefore, maintain the treatment prescribed in the
proposed regulations.
Some commentators believed that it is administratively
impracticable or virtually impossible for certain taxpayers to
determine the noninterest bearing debt traced to the accumulated
production expenditures of designated property. These commentators
recommended that, if the regulations do not treat all accounts payable
as eligible debt, the regulations should provide a simplification
measure under which a taxpayer may ``deem'' a certain portion of
noninterest bearing debt as constituting traced debt.
One commentator suggested a safe harbor under which the amount of
noninterest bearing debt deemed to be traced debt would be that portion
of accounts payable equal to the ratio of the production expenditures
for designated property over the production expenditures for all
property. IRS and Treasury believe that this recommendation would not
sufficiently approximate the portion of noninterest bearing debt that
is traced debt for all or certain segments of taxpayers. Moreover, the
IRS and Treasury were unable to establish a workable safe harbor.
Finally, except for immaterial amounts, taxpayers must perform the same
sort of tracing to adjust production expenditures for noninterest
bearing accounts payable when they prepare financial statements. Under
SFAS 34, the expenditures that attract interest capitalization include
only expenditures requiring the payment of cash, the transfer of other
assets, or the incurring of a liability on which interest is charged.
Accordingly, the final regulations do not adopt a safe harbor under
which a certain portion of noninterest bearing debt would be deemed
traced debt.
Interest Capitalized on Traced Debt
Under the avoided cost method in the proposed regulations, the
interest capitalized on debt traced to the accumulated production
expenditures for a unit of designated property includes the interest on
the traced debt for the entire measurement period for any measurement
period in which production occurs (traced debt amount).
Commentators objected to this rule because the production period of
a unit may not begin on the first day of the first measurement period
of the production period and may not end on the last day of the last
measurement period of the production period. In these situations, the
commentators argued that only interest incurred on traced debt for the
actual number of days encompassing the production period of a unit
should constitute the traced debt amount.
The IRS and Treasury believe that the proposed traced debt amount
rule is an appropriate simplification measure. Moreover, a taxpayer
desiring a more precise traced debt amount can effect greater precision
by choosing more frequent measurement dates. Under the proposed rule,
taxpayers can choose their measurement periods, the choice is not a
method of accounting, and taxpayers may change measurement periods each
taxable year. Accordingly, the final regulations adopt the proposed
traced debt amount rule without change.
External Rate--Substitute for Weighted Average Interest Rate
The avoided cost method involves the capitalization of two amounts
of interest with respect to a unit of property: (1) an amount of
interest with respect to traced debt and (2) an amount of interest with
respect to nontraced debt. The amount of interest required to be
capitalized with respect to nontraced debt is determined by multiplying
the accumulated production expenditures that exceed traced debt for a
unit (excess expenditures) by the weighted average interest rate
determined on all eligible debt of a taxpayer other than traced debt
(nontraced debt).
To simplify the interest capitalization computation with respect to
nontraced debt, commentators suggested that the final regulations
permit taxpayers to elect to use an external rate as a substitute for
the weighted average interest rate. Most commentators suggested the
election of a rate based on the applicable federal rate (AFR). Certain
commentators believed that small taxpayers, at a minimum, should be
allowed this simplifying election.
The IRS and Treasury believe that an election to use an external
rate as a substitute for the weighted average interest rate on
nontraced debt would generally be inappropriate because of the
difficulty in establishing a suitable external rate for all taxpayers.
Accordingly, the final regulations do not adopt the recommendation to
permit all taxpayers to elect to use an external rate as a substitute
for the weighted average interest rate.
The final regulations do, however, permit certain small taxpayers
to elect to use the highest AFR under section 1274(d) in effect during
the computation period plus 3 percentage points (AFR plus 3) as a
substitute for the weighted average interest rate. A taxpayer may elect
to use the AFR plus 3 for a taxable year if the average annual gross
receipts of the taxpayer (or any predecessor) for the preceding 3
taxable years do not exceed $10,000,000 (the $10,000,000 gross receipts
test), and the taxpayer has met the $10,000,000 gross receipts test for
all prior taxable years beginning after December 31, 1994. The rules of
Sec. 1.263A-3(b) apply in determining whether a taxpayer satisfies the
$10,000,000 gross receipts test. A taxpayer making the AFR plus 3
election may not trace debt.
Notional Principal Contracts
The treatment of notional principle contracts and other derivatives
under section 263A(f) is reserved in the final regulations.
Definition of Unit of Property
The proposed regulations provide that a unit includes any
components owned by the taxpayer or a related party that are
functionally interdependent. Components of property are functionally
interdependent when the placing in service of one component is
dependent on the placing in service of one or more other components.
Certain commentators recommended that the final regulations adopt
the definition of a unit provided under Sec. 1.167(a)-11(d)(2)(vi),
which defines a unit of property for purposes of applying the elective
alternative depreciation (ADR) repair allowance provisions. Section
1.167(a)-11(d)(2)(vi) defines a unit to include each operating unit
that performs a discrete function and that a taxpayer customarily
acquires for original installation and retires as a unit. Commentators
argued that taxpayers are already familiar with this definition of a
unit.
The IRS and Treasury believe that section 263A(f) and its
legislative history indicate that property includes the functionally
interdependent components of property. Congress repealed former section
189 (relating to the capitalization of interest and taxes during the
construction period of real property) and enacted the more expansive,
uniform capitalization rules under section 263A(f). Under former
section 189, an entire building (including the land component) was
property to which interest was capitalized. See H.R. Conf. Rep. No.
760, 97th Cong., 2d Sess. 48 (1982). The IRS and Treasury believe that
Congress did not intend that property be defined more narrowly under
section 263A(f) than under former section 189. Accordingly, under
section 263A(f), property also includes an entire building (including
the land component), as the aggregation of functionally interdependent
components of property. Section 263A(f) defines property uniformly, and
therefore, property in all circumstances includes the functionally
interdependent components of property.
Treating the functionally interdependent components of property as
a single property for interest capitalization is consistent with the
concept of a single property that applies under section 167 in
determining the date on which components of a single property are
placed in service. As the commentators recognized, this concept of a
single property may differ from the concept of a single or separate
property that taxpayers use for other purposes (e.g., for computing
amounts of depreciation deductions or separately tracking the bases of
assets).
The Sec. 1.167(a)-11(d)(2)(vi) definition of a unit may not
encompass the functionally interdependent components of property. This
definition of a unit applied for purposes of applying the alternative
depreciation (ADR) repair allowance provisions, which were elective.
The provisions provided a simplification procedure for treating a
taxpayer's expenditures as either capitalized expenditures or
deductible expenses. Taxpayers that elected the provisions, and used
this Sec. 1.167(a)-11(d)(2)(vi) definition of a unit, we required to
use the same standard that other taxpayers used in determining the date
on which property was placed in service (i.e., the standard consistent
with the concept of a single property as an aggregation of functionally
interdependent components). Accordingly, the final regulations do not
adopt commentators' recommendation to modify the definition of a unit
of property.
Common Feature Rules
Land Attributable to Benefitted Property
Under the proposed regulations, an allocable share of a common
feature that benefits real property and the real property being
benefitted are a single unit of real property (common feature rule).
The production period for the entire unit begins when production begins
on either the benefitted real property or a common feature allocable to
the unit. Thus, commencing production on only a common feature results
in interest being capitalized not only on the costs of the common
feature but also on the costs of land underlying the benefitted
property.
Commentators argued that the proposed common feature rule produces
harsh consequences. For example, when construction commences on a
single common feature that benefits each house in a housing
development, interest capitalization commences on all land in the
housing development even if no direct production activity has been
undertaken on any house. Commentators also indicated that the proposed
interest suspension rule provides insufficient relief in these
circumstances. Under the proposed regulations, interest capitalization
may be suspended prospectively for a unit only when production
activities have ceased for the unit for at least a 12-month period.
Thus, in the case of the housing development described above, the
proposed regulations would require interest on land costs attributable
to the houses to be capitalized from the commencement of construction
of the common feature until the 13th month after its completion.
Interest capitalization would be required with respect to those costs
for that period even if no direct production activity will be
undertaken on the houses for several years.
The final regulations continue to provide that the allocable share
of a common feature and the benefitted property are a single unit of
real property, but provide two new rules in response to the
commentators' concerns. Under the first new rule, the land costs of the
benefitted property are not treated as included in the accumulated
production expenditures for the unit (i.e., are not treated as included
in the costs that attract interest capitalization) until a direct
production activity commences on the benefitted property. Thus, for
example, if no direct production activities have been undertaken on
planned houses, such as clearing and grading activities on the land
underlying the houses, the cost of the land underlying the houses is
not treated as included in the accumulated production expenditures for
the unit. This treatment is permitted until direct production
activities begin on the houses, even though the production periods for
the house units have begun because production has begun on common
features benefitting the houses.
The second new rule provides that if after clearing and grading has
been undertaken with respect to the land attributable to the benefitted
property (the land underlying the houses in the above example), there
is no direct production activity taken with respect to the benefitted
property for a period of at least 120 consecutive days, the accumulated
production expenditures attributable to the benefitted property are
treated as not included in the accumulated production expenditures of
the unit from the first measurement period after the beginning on the
120-day period until the measurement period in which direct production
activity resumes with respect to the benefitted property.
Benefitted Property Completed
The proposed regulations indicate that, when benefitted property is
sold or placed in service prior to the completion of a common feature
allocable to a unit, the costs of the benefitted property and allocable
common features no longer attract interest capitalization. See
Sec. 1.263A-10(b)(6), Example 5.
Commentators suggested that the final regulations provide a rule
under which the costs of a benefitted property would not be included in
accumulated production expenditures when the benefitted property is
completed prior to the completion of a common feature included in the
unit, irrespective of whether such benefitted property is sold or
placed in service.
The IRS and Treasury believe the exception provided in the proposed
regulations should not be extended to cases where a benefitted property
is not sold or placed in service prior to the completion of the common
feature. Accordingly, the final regulations do not adopt the
commentators' recommendation.
Rev. Proc. 92-29, 1992-1 C.B. 748, permits a developer to include
in the basis of properties sold their allocable share of the estimated
cost of common improvements without regard to whether the costs are
incurred under section 461(h) of the Code, relating to economic
performance. As of the end of any taxable year, however, the total
amount of common improvement costs included in the basis of the
properties sold may not exceed the amount of common improvement costs
that have been incurred under section 461(h) (``the alternative cost
limitation''). The final regulations clarify that Rev. Proc. 92-29 does
not affect the determination of accumulated production expenditures of
unsold units even if the costs of common improvements for those unsold
units have been used to determine the alternative cost limitation for
purposes of including common improvement costs in the basis of sold
units.
Utilities--Construction Work in Process
Under the proposed regulations, the accumulated production
expenditures for a unit of property (i.e, the costs that attract
interest capitalization) generally include the amount of the direct and
indirect costs that are required to be capitalized with respect to the
unit.
Certain commentators indicated that if construction work in process
(CWIP) is included in rate base for ratemaking purposes (of utilities,
for example), the CWIP should be excluded from the accumulated
production expenditures. These commentators pointed out that in
enacting section 263A(f), Congress intended to match the interest
incurred in producing property with the related income from property.
These commentators argued that by including CWIP in rate base for
ratemaking purposes, income is currently taken into account, and that
to match interest with its related income, the interest attributable to
CWIP should be currently deductible. They believed that to achieve this
match, CWIP should be excluded from accumulated production
expenditures.
Under the avoided cost method of section 263A(f), CWIP expenditures
are incurred with respect to property produced, and no statutory
exception excludes them from the production expenditures for property.
The legislative history of section 263A(f) indicates that the avoided
cost method is intended to apply to a taxpayer, such as a regulated
utility company, irrespective of whether the method is required,
authorized, or considered appropriate under financial or regulatory
accounting principles. See H.R. Conf. Rep. No. 841, 99th Cong., 2d
Sess. II-309 (1986). CWIP is therefore intended to be included in the
production expenditures for property produced, and interest capitalized
with respect to CWIP is intended to become a cost of the property
produced, which is recovered as the property is used in the taxpayer's
trade or business. Moreover, the suggestion that the commentators urge
the IRS and Treasury to adopt in the final regulations is inconsistent
with the rules that apply to determine the date on which CWIP is placed
in service for depreciation purposes and is inconsistent with the rules
that apply under broader section 263A provisions to capitalize other
direct and indirect costs to CWIP during periods for which the
commentators argue the CWIP is generating income.
Further, the commentators' suggestion would not present a
consistent resolution to the matching concerns that the commentators
argue exist with respect to the treatment of CWIP within regulated
utilities industries. Interest incurred prior to the beginning of the
production period on CWIP that is not included in rate base, for
example, presents matching concerns that would not be resolved by the
commentators' suggestion. For this and the other reasons summarized
above, the commentators' suggestion has not been adopted in the final
regulations.
As an alternative suggestion, commentators urged the IRS and
Treasury to adopt a book conformity rule for the treatment of interest
on CWIP. This suggestion was not adopted, however, for principally the
same reasons that the use of the FAS 34 computation as a substitute for
section 263A(f) avoided cost computations was not adopted.
Additionally, the difference between the regulatory accounting for CWIP
and the required statutory treatment of CWIP under section 263A(f) is
but one example of the many inconsistencies between regulatory and tax
accounting (some of which were illustrated above). Therefore, the IRS
and Treasury believe it would be inappropriate to adopt a book
conformity rule for interest capitalization alone given the existence
of these other inconsistencies.
Improvements to Real Property
Property Taken Out of Service
The proposed regulations provide special rules for determining the
accumulated production expenditures for an improvement to existing real
property. The accumulated production expenditures for an improvement
include all direct and indirect costs required to be capitalized with
respect to the improvement, plus an allocable portion of the cost of
associated land. Additionally, the adjusted bases of any existing
structure or common features that directly benefit or are incurred by
reason of the improvement are included in the accumulated production
expenditures if they either are not already placed in service or must
be taken out of service in order to complete the improvement.
Commentators indicated that sometimes property must be temporarily
disconnected or otherwise taken out of service for health, safety, or
regulatory reasons in order to make certain improvements (e.g., a power
generating facility must be taken out of service in order to make
capital improvements). Commentators suggested that the regulations
provide that property is taken out of service only if the property is
taken out of service for depreciation purposes.
The final regulations do not adopt the suggestion concerning when
property should be considered taken out of service. However, the final
regulations provide a de minimis rule for property taken out of
service. Under the de minimis rule, the aggregate costs of all property
or common features taken out of service to complete an improvement
(associated property costs) are excluded from the accumulated
production expenditures for the improvement unit during its production
period if, on the date the production period of the unit begins, the
taxpayer reasonably expects that on no date during the production
period of the unit will the accumulated production expenditures for the
unit, determined without regard to associated property costs, exceed 5
percent of associated property costs.
Inclusion of Land
The proposed regulations provide that an improvement to existing
real property includes the allocable portion of land associated with
the improvement. As such, the basis of land may be included in the
accumulated production expenditures for more than one unit of
designated property. For example, a portion of the basis of land
included in the accumulated production expenditures for a building unit
must also be included in the accumulated production expenditures for a
separate tenant improvement unit.
Commentators objected to this rule. They suggested that, once land
was included in the accumulated production expenditures for a unit of
property, it should not be included in the accumulated production
expenditures for any other unit of property.
Section 263A(f)(4)(C) provides that the production expenditures for
property include all capitalized costs of property, whether or not
those costs are incurred during the production period of property. Land
expenditures are part of the capitalized costs of property, and land
costs should be included in the accumulated production expenditures for
property during its production period, even if they are incurred before
the production period. Accordingly, the final regulations do not adopt
the commentators' recommendation.
End of the Production Period--Customizing Activities
The proposed regulations provide that the production period
generally ends for a unit of property that will be held for sale on the
date the unit is ready to be held for sale and all production
activities reasonably expected to be undertaken with respect to the
unit are completed. The proposed regulations provide that the
production period generally ends for a unit of property produced for
self-use on the date the unit is ready to be placed in service and all
production activities reasonably expected to be undertaken with respect
to the unit are completed.
Commentators believe it is unfair for the production period to
continue for a residential or commercial unit that is complete except
for activities relating to ``de minimis'' production expenditures for
customized features chosen by a buyer or lessee. These features, which
include carpeting, cabinets, appliances, wall coverings, and flooring,
are often not added to a unit until an identified buyer or lessee
selects the features, or the unit is sold. These commentators
recommended that the production period should end for a unit when only
``de minimis'' customizing activities remain to be performed.
The final regulations do not adopt this recommendation, however,
because the IRS and Treasury continue to believe that customizing
activities are production activities and that the production period
does not end until these activities are completed. Nevertheless, a
shortened, retroactive suspension period rule adopted in the final
regulations (and explained below) will provide relief in situations
that involve long periods of delay in the performance of customizing
activities.
Suspension Period
The proposed regulations provide that, when production activities
related to the production of a unit of designated property cease for a
period of 12 consecutive months, the capitalization of interest is not
required (i.e., is suspended) for the period beginning with the 13th
month of cessation. The suspension period ends when production
activities resume. For administrative convenience, the proposed
regulations use an objective time test, and therefore, the reasons for
suspending production are not considered.
Commentators believed that the rule in the proposed regulations
unduly delays the suspension of interest capitalization. They argued
that a taxpayer should not have to wait 12 months before suspending
interest capitalization if production activities cease for reasons such
as strikes, fires, or natural disasters. Some commentators believed
that the determination of whether activities have ceased should be a
facts and circumstances test and that interest capitalization should be
suspended in the month following the cessation of production
activities. Others argued that the cessation period should be only 3 or
4 months. Still others argued that, if the 12-month cessation period is
retained, the suspension of interest capitalization should apply
retroactively as of the first month of cessation.
In response to these comments, the final regulations shorten the
cessation period from 12 consecutive months to 120 consecutive days
and, once the cessation period is satisfied, permit taxpayers to
retroactively suspend interest capitalization as of the first
measurement period following the measurement period in which production
activities ceased. Alternatively, if the cessation period spans more
than one taxable year, and a taxpayer does not want to file an amended
return for the prior year, the taxpayer may suspend the capitalization
of interest with respect to its units of designated property beginning
with the first measurement period of the taxable year in which the 120-
day period is satisfied.
In connection with the shorter 120-day cessation period, however,
the final regulations introduce several new criteria for determining
whether production activities are considered to have ceased. Production
activities are not considered to have ceased under the final
regulations if they cease because of any delays inherent in the asset
production process.
Oil and Gas Provisions
Section 614 Costs in Accumulated Production Expenditures
Under the proposed regulations, the costs with respect to a section
614 property (section 614 costs) are included in the accumulated
production expenditures for the first well in a multi-phase
development. Each subsequent well includes a pro rata share of these
undepleted costs based on total wells that the taxpayer could feasibly
drill on the section 614 property. However, the taxpayer may partition
the section 614 costs among the number of wells to be drilled on the
section 614 property if the taxpayer can devise a ``definite plan''
upfront that identifies the number and location of wells to be drilled.
Commentators indicated that the ``definite plan'' requirement is
impracticable. According to them, the number and location of wells to
be drilled on a property may not be known on the date that a first
drilling activity is undertaken on the section 614 property.
Commentators, therefore, suggested that the final regulations allow
taxpayers to partition the section 614 costs among the number of wells
``feasibly expected'' to be drilled on the section 614 property.
Alternatively, commentators suggested that the final regulations
require taxpayers to include the section 614 costs only in the
accumulated production expenditures for a first well drilled on the
section 614 property.
The final regulations retain the definite plan rule. In light of
the unique nature of a mineral interest and the circumstances
surrounding the development of such an interest, however, the final
regulations revise the rule for taxpayers unable to establish a
definite plan. Under the revised rule, the section 614 costs are
generally only included once in the accumulated production expenditures
for a first productive well unit on the section 614 property. (However,
the final regulations provide that the undepleted portion of section
614 costs allocated to the first productive well unit must be included
in the accumulated production expenditures for an improvement to the
unit.) The final regulations provide that a first productive well unit
generally includes all wells that are drilled on a section 614 property
prior to the date the first productive well on the property is placed
in service and all production activities reasonably expected to be
undertaken are completed. Accordingly, the section 614 costs are
included in a unit (to attract interest capitalization) from the date
the first physical site activity is undertaken with respect to the
section 614 property until the date the first productive well on the
section 614 property is placed in service and all production activities
reasonably expected to be undertaken are completed. Generally, each
well on a section 614 property that is drilled subsequent to such date
comprises a separate unit of property. The IRS and Treasury believe
this rule is more objective and practical than a rule that would
require the section 614 costs to be partitioned among the number of
wells ``feasibly expected'' to be drilled on a section 614 property.
The final regulations provide a rule for common feature costs
similar to the rule provided for section 614 property costs. Under the
final regulations, the costs of the common features are generally
included only in the accumulated production expenditures for the first
productive well unit.
Beginning of Production Period
The proposed regulations provide that the production period begins
for an oil or gas well on the first date physical site preparation
activities are undertaken with respect to the property.
Certain commentators believed that the production period should
begin for an onshore oil or gas well unit on the ``spud date,'' rather
than on the first date of physical site preparation activity.
Commentators indicated that taxpayers often do not separately track the
first date of physical site activity on a property, but do maintain
records with respect to the spud date for purposes of applying other
provisions of the Code, such as section 291(b).
The IRS and Treasury do not believe that the spud date is an
appropriate date to adopt as the beginning of the production period for
an onshore oil or gas well unit. The spud date may occur long after the
first date that a physical site preparation activity is undertaken on a
section 614 property. Using the spud date could, therefore, be too
great a deviation from the general rule that treats site preparation as
the beginning of the production period of other real property.
Accordingly, the final regulations do not adopt the commentators'
recommendation regarding the spud date.
Surface Equipment and End of Production Period
The proposed regulations provide that the production period
generally ends for an oil or gas well on the date that surface
production equipment is installed and the well is placed in service.
Commentators argued that the production period for a well unit
should not continue beyond the date a ``Christmas tree'' is installed
on the well and that the accumulated production expenditures for the
well should not include the costs of surface production equipment.
The final regulations provide that the production period generally
ends for a productive well unit on the date that the productive well
included in the unit is placed in service and all production activities
reasonably expected to be undertaken are completed. These rules are
consistent with the general rules that apply in the case of other types
of produced property.
Casing Point
The proposed regulations provide that the production period
generally ends for a nonproductive well on the date that the
nonproductive well is plugged and abandoned.
Commentators believed that the production period for a
nonproductive well unit should end at the casing point, which they
indicate is the date that a decision is made not to complete the well
for production.
The final regulations do not address the date on which the
production period ends for a nonproductive well. The IRS and Treasury
believe, however, that the general standards that apply in the case of
other types of abandoned property should be used to determine the date
on which the production period ends for a nonproductive well.
Allocation of Capitalized Interest to Depreciable or Depletable Unit
Components
The proposed regulations provide that the interest required to be
capitalized with respect to a unit is added to the basis of designated
property, rather than to the bases of any assets used to produce the
designated property. Additionally, interest required to be capitalized
with respect to the production of land is added to the basis of any
related depreciable improvement.
Commentators believed that the final regulations should provide
that interest required to be capitalized with respect to an oil or gas
well unit is first capitalized into the basis of the unit's depreciable
property components, if any, prior to the bases of the unit's
depletable property components. The commentators believed that this
rule is substantially similar to the rule in the proposed regulations
with respect to the allocation of capitalized interest to components of
a land improvement unit.
The IRS and Treasury believe that interest capitalized with respect
to components of a unit of property that are not subject to an
allowance for depreciation or depletion is appropriately added to the
basis of the components of a unit of property that are subject to an
allowance for depreciation or depletion. Thus, the proposed regulations
provided that interest capitalized with respect to land, the cost of
which is not depreciable or depletable, is added to the basis of
related depreciable improvements, if any. However, interest capitalized
with respect to the depletable property components of a well unit is
subject to an allowance for depletion. Accordingly, the final
regulations do not adopt the commentators' suggestions.
Independent Producer Onshore Well Exemption
Certain commentators suggested that independent producer onshore
wells should be exempted from interest capitalization based on their
belief that the compliance costs for these wells outweigh the tax
revenues to be gained.
Under section 263A(c)(3), Congress exempted from the uniform
capitalization rules certain costs incurred with respect to oil and gas
activities, but did not exempt oil and gas activities themselves. Thus,
the IRS and Treasury do not believe that a specific exemption for all
independent onshore wells is appropriate. Accordingly, the final
regulations do not provide a specific exemption for independent onshore
wells.
Examples
The final regulations provide examples, but delete the
comprehensive real estate example. The IRS anticipates providing
illustrations of interest capitalization in other guidance.
Related Person Rules
In General
Section 263A(i) provides that the Secretary shall prescribe such
regulations as may be necessary or appropriate to carry out the
purposes of the uniform capitalization rules, including regulations to
prevent the use of related persons, pass-through entities, or
intermediaries to avoid these rules.
Notice 88-99, issued August 17, 1998, provides the principal source
of guidance concerning the application of related person rules under
section 263A(f). Notice 88-99 generally provides that if a taxpayer is
producing designated property and has accumulated production
expenditures that exceed the total amount of its eligible debt, one or
more related persons (generally members of the same parent-subsidiary
controlled group as defined in section 1563(a)(1), whether or not
filing consolidated returns) must capitalize interest with respect to
the excess expenditures. Under Notice 88-99, the related persons, in
effect, capitalize interest with respect to the excess expenditures as
if the related persons had incurred those expenditures directly. The
notice provides similar rules in the case of flow through entities
(i.e., partnerships or S corporations).
The proposed regulations also provide certain related person rules
and direct taxpayers to follow applicable administrative pronouncements
in applying the rules. More comprehensive related person rules will be
proposed at a future date under a separate regulations project. Until
more specific rules are provided under related person regulations,
however, Notice 88-99 generally indicates the position of the IRS with
respect to the application of related persons rules under section
263A(f). To the extent that Notice 88-99 rules are modified by specific
provisions in, or principles of, these final regulations, the rules and
principles of the final regulations are controlling.
Consolidated Return Interest Rule
Consistent with the purposes of section 263A(f), the proposed
regulations provide that to the extent of a consolidated group's
outside interest deduction, the consolidated group must currently
report, rather than defer, the interest income on intragroup debt on
which it capitalizes interest (consolidated section 263A(f) interest
rule). Without this rule, a consolidated group could effectively avoid
capitalizing interest under section 263A(f) if the group were to
capitalize interest intragroup debt, but at the same time defer
reporting the associated interest income and deduct outside interest
equal to or less than the interest capitalized.
Certain taxpayers believed that the consolidated section 263A(f)
interest rule does not apply unless and until final regulations are
issued under section 263A or section 1502. The IRS and Treasury
believe, however, that a consolidated group that effectively deducts
interest by capitalizing interest on intragroup debt under section
263A(f) and deferring the associated interest income on the debt adopts
an unreasonable interpretation of the statute and legislative history
of section 263A(f) to the extent the associated interest income on the
intragroup debt is less than or equal to the group's outside interest
expense deductions.
Comments on Related Person Rules
Commentators submitted comments on certain related persons issues.
In particular, commentators believed that, under Notice 88-99 and the
proposed rules, capitalizing interest on the intragroup debt of an
affiliated group that is not a consolidated group may create an
overcapitalization of interest. According to the commentators,
overcapitalization may occur, for example, if two or more members
capitalize interest with respect to the same debt (e.g., back-to-back
loans). Additionally, one commentator believed that interest on debt
owed to a producing member by a nonproducing member should not be
subject to capitalization.
In response to commentator concerns, the IRS and Treasury are
studying whether the amount of interest capitalized by the related
person members of an affiliated group should be limited to the interest
incurred by all affiliated group members on outside debt, less any
interest capitalized by the producing member on outside and intragroup
debt. It is generally the intent of Rev. Proc. 88-99 and the final
regulations to prevent taxpayers from avoiding the purposes of interest
capitalization through the use of related persons. The IRS and Treasury
welcome additional comments on this and other related person issues
that should be addressed in future related person regulations.
Accounting Method Changes
The final section 263A(f) regulations are generally effective for
taxable years beginning on or after January 1, 1995. Taxpayers that
have previously adopted methods of accounting under section 263A(f) may
be required to change their methods of accounting under section 263A(f)
to comply with the final regulations. Within 30 days, the IRS will
issue a revenue procedure prescribing the procedures, terms, and
conditions for effecting method changes necessary due to the
promulgation of these regulations.
The revenue procedure will facilitate election of early application
of the regulations to the first taxable year beginning on or after
January 1, 1994 so that taxpayers may combine, within the same taxable
year, changes under the final section 263A(f) regulations and changes
under the final general section 263A regulations.
Clarification of Mixed Service Costs De Minimis Rules
The final regulations clarify the application of the 90 percent de
minimis rule for mixed service department costs contained in the final
main section 263A regulations. Under that rule, an electing taxpayer is
not required to allocate any portion of a mixed service department's
costs to property produced or acquired for resale if 90 percent or more
of the department's costs are deductible service costs. The final
regulations clarify that if this election is made, the taxpayer must
also allocate all of a mixed service department's costs to property
produced or acquired for resale if 90 percent or more of the
department's costs are capitalizable service costs.
Special Analyses
It has been determined that this Treasury decision is not a
significant regulatory action as defined in EO 12866. 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)
and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to
these regulations, and, therefore, a Regulatory Flexibility Analysis is
not required. Pursuant to section 7805(f) of the Internal Revenue Code,
the notice of proposed rulemaking preceding these regulations was
submitted to the Small Business Administration for comment on its
impact on small business.
Drafting Information
The principal author of these final regulations is Mary E. Goode of
the Office of Assistant Chief Counsel, Internal Revenue Service.
However, personnel from other offices of the Internal Revenue Service
and Treasury Department participated in their development.
List of Subjects
26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
26 CFR Part 602
Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR parts 1 and 602 are amended as follows:
Paragraph 1. The authority citation for part 1 is amended by adding
the following citation:
Authority: 26 U.S.C. 7805 * * * Sections 1.263A-8 through
1.263A-15 also issued under 26 U.S.C. 263A(i).
Par. 2. Section 1.263A-0 is amended by revising the introductory
text, removing the word ``Reserved'' after Sec. 1.263A-
2(a)(1)(ii)(B)(2), removing the word ``Reserved'' after Secs. 1.263A-
3(c)(4)(vi) (A) through (C) to reflect issuance of T.D. 8559 on August
5, 1994, and adding the following headings for Secs. 1.263A-8 through
1.263A-15 to read as follows:
Sec. 1.263A-0 Outline of regulations under section 263A.
This section lists the paragraphs in Secs. 1.263A-1 through 1.263A-
3 and Secs. 1.263A-8 through 1.263A-15.
* * * * *
Sec. 1.263A-8 Requirement to capitalize interest.
(a) In general.
(1) General rule.
(2) Treatment of interest required to be capitalized.
(3) Methods of accounting under section 263A(f).
(4) Special definitions.
(i) Related person.
(ii) Placed in service.
(b) Designated property.
(1) In general.
(2) Special rules.
(i) Application of thresholds.
(ii) Relevant activities and costs.
(iii) Production period and cost of production.
(3) Excluded property.
(4) De minimis rule.
(i) In general.
(ii) Determination of total production expenditures.
(c) Definition of real property.
(1) In general.
(2) Unsevered natural products of land.
(3) Inherently permanent structures.
(4) Machinery.
(i) Treatment.
(ii) Certain factors not determinative.
(d) Production.
(1) Definition of produce.
(2) Property produced under a contract.
(i) Customer.
(ii) Contractor.
(iii) Definition of a contract.
(iv) Determination of whether thresholds are satisfied.
(A) Customer.
(B) Contractor.
(v) Exclusion for property subject to long-term contract rules.
(3) Improvements to existing property.
(i) In general.
(ii) Real property.
(iii) Tangible personal property.
Sec. 1.263A-9 The avoided cost method.
(a) In general.
(1) Description.
(2) Overview.
(i) In general.
(ii) Rules that apply in determining amounts.
(3) Definitions of interest and incurred.
(4) Definition of eligible debt.
(b) Traced debt amount.
(1) General rule.
(2) Identification and definition of traced debt.
(3) Example.
(c) Excess expenditure amount.
(1) General rule.
(2) Interest required to be capitalized.
(3) Example.
(4) Treatment of interest subject to a deferral provision.
(5) Definitions.
(i) Nontraced debt.
(A) Defined.
(B) Example.
(ii) Average excess expenditures.
(A) General rule.
(B) Example.
(iii) Weighted average interest rate.
(A) Determination of rate.
(B) Interest incurred on nontraced debt.
(C) Average nontraced debt.
(D) Special rules if taxpayer has no nontraced debt or rate is
contingent.
(6) Examples.
(7) Special rules where the excess expenditure amount exceeds
incurred interest.
(i) Allocation of total incurred interest to units.
(ii) Application of related person rules to average excess
expenditures.
(iii) Special rule for corporations.
(d) Election not to trace debt.
(1) General rule.
(2) Example.
(e) Election to use external rate.
(1) In general.
(2) Eligible taxpayer.
(f) Selection of computation period and measurement dates and
application of averaging conventions.
(1) Computation period.
(i) In general.
(ii) Method of accounting.
(iii) Production period beginning or ending during the computation
period.
(2) Measurement dates.
(i) In general.
(ii) Measurement period.
(iii) Measurement dates on which accumulated production
expenditures must be taken into account.
(iv) More frequent measurement dates.
(3) Examples.
(g) Special rules.
(1) Ordering rules.
(i) Provisions preempted by section 263A(f).
(ii) Deferral provisions applied before this section.
(2) Application of section 263A(f) to deferred interest.
(i) In general.
(ii) Capitalization of deferral amount.
(iii) Deferred capitalization.
(iv) Substitute capitalization.
(A) General rule.
(B) Capitalization of amount carried forward.
(C) Method of accounting.
(v) Examples.
(3) Simplified inventory method.
(i) In general.
(ii) Segmentation of inventory.
(A) General rule.
(B) Example.
(iii) Aggregate interest capitalization amount.
(A) Computation period and weighted average interest rate.
(B) Computation of the tentative aggregate interest capitalization
amount.
(C) Coordination with other interest capitalization computations.
(1) In general.
(2) Deferred interest.
(3) Other coordinating provisions.
(D) Treatment of increases or decreases in the aggregate interest
capitalization amount.
(E) Example.
(iv) Method of accounting.
(4) Financial accounting method disregarded.
(5) Treatment of intercompany transactions.
(i) General rule.
(ii) Special rule for consolidated group with limited outside
borrowing.
(iii) Example.
(6) Notional principal contracts and other derivatives.
(7) 15-day repayment rule.
Sec. 1.263A-10 Unit of property.
(a) In general.
(b) Units of real property.
(1) In general.
(2) Functional interdependence.
(3) Common features.
(4) Allocation of costs to unit.
(5) Treatment of costs when a common feature is included in a unit
of real property.
(i) General rule.
(ii) Production activity not undertaken on benefitted property.
(A) Direct production activity not undertaken.
(1) In general.
(2) Land attributable to a benefitted property.
(B) Suspension of direct production activity after clearing and
grading undertaken.
(1) General rule.
(2) Accumulated production expenditures.
(iii) Common feature placed in service before the end of production
of a benefitted property.
(iv) Benefitted property sold before production completed on common
feature.
(v) Benefitted property placed in service before production
completed on common feature.
(6) Examples.
(c) Units of tangible personal property.
(d) Treatment of installations.
Sec. 1.263A-11 Accumulated production expenditures.
(a) General rule.
(b) When costs are first taken into account.
(1) In general.
(2) Dedication rule for materials and supplies.
(c) Property produced under a contract.
(1) Customer.
(2) Contractor.
(d) Property used to produce designated property.
(1) In general.
(2) Example.
(3) Excluded equipment and facilities.
(e) Improvements.
(1) General rule.
(2) De minimis rule.
(f) Mid-production purchases.
(g) Related person costs.
(h) Installation.
Sec. 1.263A-12 Production period.
(a) In general.
(b) Related person activities.
(c) Beginning of production period.
(1) In general.
(2) Real property.
(3) Tangible personal property.
(d) End of production period.
(1) In general.
(2) Special rules.
(3) Sequential production or delivery.
(4) Examples.
(e) Physical production activities.
(1) In general.
(2) Illustrations.
(f) Activities not considered physical production.
(1) Planning and design.
(2) Incidental repairs.
(g) Suspension of production period.
(1) In general.
(2) Special rule.
(3) Method of accounting.
(4) Example.
Sec. 1.263A-13 Oil and gas activities.
(a) In general.
(b) Generally applicable rules.
(1) Beginning of production period.
(i) Onshore activities.
(ii) Offshore activities.
(2) End of production period.
(3) Accumulated production expenditures.
(i) Costs included.
(ii) Improvement unit.
(c) Special rules when definite plan not established.
(1) In general.
(2) Oil and gas units.
(i) First productive well unit.
(ii) Subsequent units.
(3) Beginning of production period.
(i) First productive well unit.
(ii) Subsequent wells.
(4) End of production period.
(5) Accumulated production expenditures.
(i) First productive well unit.
(ii) Subsequent well unit.
(6) Allocation of interest capitalized with respect to first
productive well unit.
(7) Examples.
Sec. 1.263A-14 Rules for related persons.
Sec. 1.263A-15 Effective dates, transitional rules, and anti-abuse
rule.
(a) Effective dates.
(b) Transitional rule for accumulated production expenditures.
(1) In general.
(2) Property used to produce designated property.
(c) Anti-abuse rule.
Par. 3. Section 1.263A-1 is amended by revising the third sentence
of paragraph (g)(4)(ii) to read as follows:
Sec. 1.263A-1 Uniform capitalization of costs.
* * * * *
(g) * * *
(4) * * *
(ii) * * * Under this election, however, if 90 percent or more of a
mixed service department's costs are capitalizable service costs, a
taxpayer must allocate 100 percent of the department's costs to the
production or resale activity benefitted. * * *
* * * * *
Par. 4. Section 1.263A-2 is amended by revising paragraph
(a)(1)(ii)(B)(2) to read as follows:
Sec. 1.263A-2 Rules relating to property produced by the taxpayer.
(a) * * *
(1) * * *
(ii) * * *
(B) * * *
(2) Definition of a contract--(i) General rule. Except as provided
under paragraph (a)(1)(ii)(B)(2)(ii) of this section, a contract is any
agreement providing for the production of property if the agreement is
entered into before the production of the property to be delivered
under the contract is completed. Whether an agreement exists depends on
all the facts and circumstances. Facts and circumstances indicating an
agreement include, for example, the making of a prepayment, or an
arrangement to make a prepayment, for property prior to the date of the
completion of production of the property, or the incurring of
significant expenditures for property of specialized design or
specialized application that is not intended for self-use.
(ii) Routine purchase order exception. A routine purchase order for
fungible property is not treated as a contract for purposes of this
section. An agreement will not be treated as a routine purchase order
for fungible property, however, if the contractor is required to make
more than de minimis modifications to the property to tailor it to the
customer's specific needs, or if at the time the agreement is entered
into, the customer knows or has reason to know that the contractor
cannot satisfy the agreement within 30 days out of existing stocks and
normal production of finished goods.
* * * * *
Par. 5. Section 1.263A-7 is added and reserved and Sections 1.263A-
8 through 1.263A-15 are added reading as follows:
Sec. 1.263A-8 Requirement to capitalize interest.
(a) In general--(1) General rule. Capitalization of interest under
the avoided cost method described in Sec. 1.263A-9 is required with
respect to the production of designated property described in paragraph
(b) of this section.
(2) Treatment of interest required to be capitalized. In general,
interest that is capitalized under this section is treated as a cost of
the designated property and is recovered in accordance with
Sec. 1.263A-1(c)(4). Interest capitalized by reason of assets used to
produce designated property (within the meaning of Sec. 1.263A-11(d))
is added to the basis of the designated property rather than the bases
of the assets used to produce the designated property. Interest
capitalized with respect to designated property that includes both
components subject to an allowance for depreciation or depletion and
components not subject to an allowance for depreciation or depletion is
ratably allocated among, and is treated as a cost of, components that
are subject to an allowance for depreciation or depletion.
(3) Methods of accounting under section 263A(f). Except as
otherwise provided, methods of accounting and other computations under
Secs. 1.263A-8 through 1.263A-15 are applied on a taxpayer, as opposed
to a separate and distinct trade or business, basis.
(4) Special definitions--(i) Related person. Except as otherwise
provided, for purposes of Secs. 1.263A-8 through 1.263A-15, a person is
related to a taxpayer if their relationship is described in section
267(b) or 707(b).
(ii) Placed in service. For purposes of Secs. 1.263A-8 through
1.263A-15, placed in service has the same meaning as set forth in
Sec. 1.46-3(d).
(b) Designated property--(1) In general. Except as provided in
paragraphs (b)(3) and (b)(4) of this section, designated property means
any property that is produced and that is either:
(i) Real property; or
(ii) Tangible personal property (as defined in Sec. 1.263A-2(a)(2))
which meets any of the following criteria:
(A) Property with a class life of 20 years or more under section
168 (long-lived property), but only if the property is not property
described in section 1221(l) in the hands of the taxpayer or a related
person,
(B) Property with an estimated production period (as defined in
Sec. 1.263A-12) exceeding 2 years (2-year property), or
(C) Property with an estimated production period exceeding 1 year
and an estimated cost of production exceeding $1,000,000 (1-year
property).
(2) Special rules--(i) Application of thresholds. The thresholds
described in paragraphs (b)(l)(ii)(A), (B), and (C) of this section are
applied separately for each unit of property (as defined in
Sec. 1.263A-10).
(ii) Relevant activities and costs. For purposes of determining
whether property is designated property, all activities and costs are
taken into account if they are performed or incurred by, or for, the
taxpayer or any related persons and they directly benefit or are
incurred by reason of the production of the property.
(iii) Production period and cost of production. For purposes of
applying the thresholds under paragraphs (b)(l)(ii) (B) and (C) of this
section to a unit of property, the taxpayer is required, at the
beginning of the production period, to reasonably estimate the
production period and the total cost of production for the unit of
property. The taxpayer must maintain contemporaneous written records
supporting the estimates and classification. If the estimates are
reasonable based on the facts in existence at the beginning of the
production period, the taxpayer's classification of the property is not
modified in subsequent periods, even if the actual length of the
production period or the actual cost of production differs from the
estimates. To be considered reasonable, estimates of the production
period and the total cost of production must include anticipated
expense and time for delay, rework, change orders, and technological,
design or other problems. To the extent that several distinct
activities related to the production of the property are expected to
occur simultaneously, the period during which these distinct activities
occur is not counted more than once. The bases of assets used to
produce a unit of property (within the meaning of Sec. 1.263A-11(d))
and any interest that would be required to be capitalized if a unit of
property were designated property are disregarded in making estimates
of the total cost of production for purposes of this paragraph
(b)(2)(iii).
(3) Excluded property. Designated property does not include:
(i) Timber and evergreen trees that are more than 6 years old when
severed from the roots, or
(ii) Property produced by the taxpayer for use by the taxpayer
other than in a trade or business or an activity conducted for profit.
(4) De minimis rule--(i) In general. Designated property does not
include property for which--
(A) The production period does not exceed 90 days; and
(B) The total production expenditures do not exceed $1,000,000
divided by the number of days in the production period.
(ii) Determination of total production expenditures. For purposes
of determining whether the condition of paragraph (b)(4)(i)(B) of this
section is met with respect to property, the cost of land, the adjusted
basis of property used to produce property, and interest that would be
capitalized with respect to property if it were designated property are
excluded from total production expenditures.
(c) Definition of real property--(1) In general. Real property
includes land, unsevered natural products of land, buildings, and
inherently permanent structures. Any interest in real property of a
type described in this paragraph (c), including fee ownership, co-
ownership, a leasehold, an option, or a similar interest is real
property under this section. Real property includes the structural
components of both buildings and inherently permanent structures, such
as walls, partitions, doors, wiring, plumbing, central air conditioning
and heating systems, pipes and ducts, elevators and escalators, and
other similar property. Tenant improvements to a building that are
inherently permanent or otherwise classified as real property within
the meaning of this paragraph (c)(1) are real property under this
section. However, property produced for sale that is not real property
in the hands of the taxpayer or a related person, but that may be
incorporated into real property by an unrelated buyer, is not treated
as real property by the producing taxpayer (e.g., bricks, nails, paint,
and windowpanes.)
(2) Unsevered natural products of land. Unsevered natural products
of land include growing crops and plants, mines, wells, and other
natural deposits. Growing crops and plants, however, are real property
only if the preproductive period of the crop or plant exceeds 2 years.
(3) Inherently permanent structures. Inherently permanent
structures include property that is affixed to real property and that
will ordinarily remain affixed for an indefinite period of time, such
as swimming pools, roads, bridges, tunnels, paved parking areas and
other pavements, special foundations, wharves and docks, fences,
inherently permanent advertising displays, inherently permanent outdoor
lighting facilities, railroad tracks and signals, telephone poles,
power generation and transmission facilities, permanently installed
telecommunications cables, broadcasting towers, oil and gas pipelines,
derricks and storage equipment, grain storage bins and silos. For
purposes of this section, affixation to real property may be
accomplished by weight alone. Property may constitute an inherently
permanent structure even though it is not classified as a building for
purposes of former section 48(a)(1)(B) and Sec. 1.48-1. Any property
not othewise described in this paragraph (c)(3) that constitutes other
tangible property under the principles of former section 48(a)(1)(B)
and Sec. 1.48-1(d) is treated for the purposes of this section as an
inherently permanent structure.
(4) Machinery--(i) Treatment. A structure that is property in the
nature of machinery or is essentially an item of machinery or equipment
is not an inherently permanent structure and is not real property. In
the case, however, of a building or inherently permanent structure that
includes property in the nature of machinery as a structural component,
the property in the nature of machinery is real property.
(ii) Certain factors not determinative. A structure may be an
inherently permanent structure, and not property in the nature of
machinery or essentially an item of machinery, even if the structure is
necessary to operate or use, supports, or is otherwise associated with,
machinery.
(d) Production--(1) Definition of produce. Produce is defined as
provided in section 263A(g) and Sec. 1.263A-2(a)(1)(i).
(2) Property produced under a contract--(i) Customer. A taxpayer is
treated as producing any property that is produced for the taxpayer
(the customer) by another party (the contractor) under a contract with
the taxpayer or an intermediary. Property produced under a contract is
designated property to the customer if it is real property or tangible
personal property that satisfies the classification thresholds
described in paragraph (b)(1)(ii) of this section. If property produced
under a contract will become part of a unit of designated property
produced by the customer in the customer's hands, the property produced
under the contract is designated property to the customer.
(ii) Contractor. Property produced under a contract is designated
property to the contractor if it is real property, 2-year property, or
1-year property and the property produced under the contract is not
excluded by reason of paragraph (d)(2)(v) of this section.
(iii) Definition of a contract. For purposes of this paragraph
(d)(2), contract has the same meaning as under Sec. 1.263A-
2(a)(1)(ii)(B)(2).
(iv) Determination of whether thresholds are satisfied. In the case
of tangible personal property produced under a contract, the customer
and the contractor each determine under this paragraph (d)(2), whether
the property satisfies the classification thresholds described in
paragraph (b)(1)(ii) of this section. Thus, tangible personal property
may be designated property with respect to either, or both, the
customer and the contractor. The provisions of paragraph (b)(2)(iii) of
this section are modified as set forth in this paragraph (d)(2)(iv) for
purposes of determining whether tangible personal property produced
under a contract is 2-year property or 1-year property.
(A) Customer. In determining a customer's estimated cost of
production, the customer takes into account costs and payments that are
reasonably expected to be incurred by the customer, but does not take
into account costs incurred (or to be incurred) by an unrelated
contractor. In determining the customer's estimated length of the
production period, the production period is treated as beginning on the
earlier of the date the contract is executed or the date that the
customer's accumulated production expenditures for the unit are at
least 5 percent of the customer's total estimated production
expenditures for the unit. The customer, however, may elect to treat
the production period as beginning on the date the sum of the
accumulated production expenditures of the contractor (or contractors
if more than one contractor is producing components for the unit of
property) and of the customer are at least 5 percent of the customer's
estimated production expenditures for the unit.
(B) Contractor. In determining a contractor's estimated cost of
production, the contractor takes into account only the costs that are
reasonably expected to be incurred by the contractor, without any
reduction for payments from the customer. In determining the
contractor's estimated length of the production period, the production
period is treated as beginning on the date the contractor's accumulated
production expenditures (without any reduction for payments from the
customer) are at least 5 percent of the contractor's total estimated
accumulated production expenditures.
(v) Exclusion for property subject to long-term contract rules.
Property described in paragraph (b) of this section is designated
property with respect to a contractor only if--
(A) The contract is not a long-term contract (within the meaning of
section 460(f)); or
(B) The contract is a home construction contract (within the
meaning of section 460(e)(6)(A) with respect to which the requirements
of section 460(d)(1)(B) (i) and (ii) are not met.
(3) Improvements to existing property--(i) In general. Any
improvement to property described in Sec. 1.263(a)-1(b) constitutes the
production of property. Generally, any improvement to designated
property constitutes the production of designated property. An
improvement is not treated as the production of designated property,
however, if the de minimis exception described in paragraph (b)(4) of
this section applies to the improvement. In addition, paragraph
(d)(3)(iii) of this section provides an exception for certain
improvements to tangible personal property. Incidental maintenance and
repairs are not treated as improvements under this paragraph (d)(3).
See Sec. 1.162-4.
(ii) Real property. The rehabilitation or preservation of a
standing building, the clearing of raw land prior to sale, and the
drilling of an oil well are activities constituting improvements to
real property and, therefore, the production of designated property.
Similarly, the demolition of a standing building generally constitutes
an activity that is an improvement to real property and, therefore, the
production of designated property. See the exceptions, however, in
paragraphs (b)(3) and (b)(4) of this section.
(iii) Tangible personal property. If the taxpayer has treated a
unit of tangible personal property as designated property under this
section, an improvement to such property constitutes the production of
designated property regardless of the remaining useful life of the
improved property (or the improvement) and, except as provided in
paragraph (b)(4) of this section, regardless of the estimated length of
the production period or the estimated cost of the improvement. If the
taxpayer has not treated a unit of tangible personal property as
designated property under this section, an improvement to such property
constitutes the production of designated property only if the
improvement independently meets the classification thresholds described
in paragraph (b)(1)(ii) of this section.
Sec. 1.263A-9 The avoided cost method.
(a) In general--(1) Description. The avoided cost method described
in this section must be used to calculate the amount of interest
required to be capitalized under section 263A(f). Generally, any
interest that the taxpayer theoretically would have avoided if
accumulated production expenditures (as defined in Sec. 1.263A-11) had
been used to repay or reduce the taxpayer's outstanding debt must be
capitalized under the avoided cost method. The application of the
avoided cost method does not depend on whether the taxpayer actually
would have used the amounts expended for production to repay or reduce
debt. Instead, the avoided cost method is based on the assumption that
debt of the taxpayer would have been repaid or reduced without regard
to the taxpayer's subjective intentions or to restrictions (including
legal, regulatory, contractual, or other restrictions) against
repayment or use of the debt proceeds.
(2) Overview--(i) In general. For each unit of designated property
(within the meaning of Sec. 1.263A-8(b)), the avoided cost method
requires the capitalization of--
(A) The traced debt amount under paragraph (b) of this section, and
(B) The excess expenditure amount under paragraph (c) of this
section.
(ii) Rules that apply in determining amounts. The traced debt and
excess expenditure amounts are determined for each taxable year or
shorter computation period that includes the production period (as
defined in Sec. 1.263A-12) of a unit of designated property. Paragraph
(d) of this section provides an election not to trace debt to specific
units of designated property. Paragraph (f) of this section provides
rules for selecting the computation period, for calculating averages,
and for determining measurement dates within the computation period.
Special rules are in paragraph (g) of this section.
(3) Definitions of interest and incurred. Except as provided in the
case of certain expenses that are treated as a substitute for interest
under paragraphs (c)(2)(iii) and (g)(2)(iv) of this section, interest
refers to all amounts that are characterized as interest expense under
any provision of the Code, including, for example, sections 482, 483,
1272, 1274, and 7872. Incurred refers to the amount of interest that is
properly accruable during the period of time in question determined by
taking into account the loan agreement and any applicable provisions of
the Internal Revenue laws and regulations such as section 163,
Sec. 1.446-2, and sections 1271 through 1275.
(4) Definition of eligible debt. Except as provided in this
paragraph (a)(4), eligible debt includes all outstanding debt (as
evidenced by a contract, bond, debenture, note, certificate, or other
evidence of indebtedness). Eligible debt does not include--
(i) Debt (or the portion thereof) bearing interest that is
disallowed under a provision described in Sec. 1.163-8T(m)(7)(ii);
(ii) Debt, such as accounts payable and other accrued items, that
bears no interest, except to the extent that such debt is traced debt
(as defined in paragraph (b)(2) of this section);
(iii) Debt that is borrowed directly or indirectly from a person
related to the taxpayer and that bears a rate of interest that is less
than the applicable Federal rate in effect under section 1274(d) on the
date of issuance;
(iv) Debt (or the portion thereof) bearing personal interest within
the meaning of section 163(h)(2);
(v) Debt (or the portion thereof) bearing qualified residence
interest within the meaning of section 163(h)(3);
(vi) Debt incurred by an organization that is exempt from Federal
income tax under section 501(a), except to the extent interest on such
debt is directly attributable to an unrelated trade or business of the
organization within the meaning of section 512;
(vii) Reserves, deferred tax liabilities, and similar items that
are not treated as debt for Federal income tax purposes, regardless of
the extent to which the taxpayer's applicable financial accounting or
other regulatory reporting principles require or support treating these
items as debt; and
(viii) Federal, State, and local income tax liabilities, deferred
tax liabilities under section 453A, and hypothetical tax liabilities
under the look-back method of section 460(b) or similar provisions.
(b) Traced debt amount--(1) General rule. Interest must be
capitalized with respect to a unit of designated property in an amount
(the traced debt amount) equal to the total interest incurred on the
traced debt during each measurement period (as defined in paragraph
(f)(2)(ii) of this section) that ends on a measurement date described
in paragraph (f)(2)(iii) of this section. See the example in paragraph
(b)(3) of this section. If any interest incurred on the traced debt is
not taken into account for the taxable year that includes the
measurement period because of a deferral provision, see paragraph
(g)(2) of this section for the time and manner for capitalizing and
recovering that amount. This paragraph (b)(1) does not apply if the
taxpayer elects under paragraph (d) of this section not to trace debt.
(2) Identification and definition of traced debt. On each
measurement date described in paragraph (f)(2)(iii) of this section,
the taxpayer must identify debt that is traced debt with respect to a
unit of designated property. On each such date, traced debt with
respect to a unit of designated property is the outstanding eligible
debt (as defined in paragraph (a)(4) of this section) that is
allocated, on that date, to accumulated production expenditures with
respect to the unit of designated property under the rules of
Sec. 1.163-8T Traced debt also includes unpaid interest that has been
capitalized with respect to such unit under paragraph (b)(1) of this
section and that is included in accumulated production expenditures on
the measurement date.
(3) Example. The provisions of paragraphs (b)(1) and (b)(2) of this
section are illustrated by the following example.
Example. Corporation X, a calendar year taxpayer, is engaged in
the production of a single unit of designated property during 1995
(unit A). Corporation X adopts a taxable year computation period and
quarterly measurement dates. Production of unit A starts on January
14, 1995, and ends on June 16, 1995. On March 31, 1995 and on June
30, 1995, Corporation X has outstanding a $1,000,000 loan that is
allocated under the rules of Sec. 1.163-8T to production
expenditures with respect to unit A. During the period January 1,
1995, through June 30, 1995, Corporation X incurs $50,000 of
interest related to the loan. Under paragraph (b)(1) of this
section, the $50,000 of interest Corporation X incurs on the loan
during the period January 1, 1995, through June 30, 1995, must be
capitalized with respect to
unit A.
(c) Excess expenditure amount--(1) General Rule. If there are
accumulated production expenditures in excess of traced debt with
respect to a unit of designated property on any measurement date
described in paragraph (f)(2)(iii) of this section, the taxpayer must,
for the computation period that includes the measurement date,
capitalize with respect to this unit the excess expenditure amount
calculated under this paragraph (c)(1). However, if the sum of the
excess expenditure amounts for all units of designated property of a
taxpayer exceeds the total interest described in paragraph (c)(2) of
this section, only a prorata amount (as determined under paragraph
(c)(7) of this section) of such interest must be capitalized with
respect to each unit. For each unit of designated property, the excess
expenditure amount for a computation period equals the production of--
(i) The average excess expenditures (as determined under paragraph
(c)(5)(ii) of this section) for the unit of designated property for
that period, and
(ii) The weighted average interest rate (as determined under
paragraph (c)(5)(iii) of this section) for that period.
(2) Interest required to be capitalized. With respect to an excess
expenditure amount, interest incurred during the computation period is
capitalized from the following sources and in the following sequence
but not in excess of the excess expenditure amount for all units of
designated property:
(i) Interest incurred on nontraced debt (as defined in paragraph
(c)(5)(i) of this section);
(ii) Interest incurred on borrowings described in paragraph
(a)(4)(iii) of this section (relating to certain borrowings from
related persons); and
(iii) In the case of a partnership, guaranteed payments for the use
of capital (within the meaning of section 707(c)) that would be
deductible by the partnership if section 263A(f) did not apply.
(3) Example. The provisions of paragraph (c)(1) and (2) of this
section are illustrated by the following example.
Example. (i) P, a partnership owned equally by Corporation A and
Individual B, is engaged in the construction of an office building
during 1995. Average excess expenditures for the office building for
1995 are $2,000,000. When P was formed, A and B agreed that A would
be entitled to an annual guaranteed payment of $70,000 in exchange
for A's capital contribution. The only borrowing of P, A, and B for
1995 is a loan to P from an unrelated lender of $1,000,000 (loan #).
The loan is nontraced debt and bears interest at an annual rate of
10 percent. Thus, P's weighted average interest rate (determined
under paragraph (c)(5)(iii) of this section) is 10 percent and
interest incurred during 1995 is $100,000.
(ii) In accordance with paragraph (c)(1) of this section, the
excess expenditure amount is $200,000 ($2,000,000 x 10%). The
interest capitalized under paragraph (c)(2) of this section is
$170,000 ($100,000 of interest plus $70,000 of guaranteed payments).
(4) Treatment of interest subject to a deferral provision. If any
interest described in paragraph (c)(2) of this section is not taken
into account for the taxable year that includes the computation period
because of a deferral provision described in paragraph (g)(1)(ii) of
this section, paragraph (c)(2) of this section is first applied without
regard to the amount of the deferred interest. After applying paragraph
(c)(2) without regard to the deferred interest, if the amount of
interest capitalized with respect to all units of designated property
for the computation period is less than the amount that would have been
capitalized if a deferral provision did not apply, see paragraph (g)(2)
of this section for the time and manner for capitalizing and recovering
the difference (the shortfall amount).
(5) Definitions--(i) Nontraced debt--(A) Defined. Nontraced debt
means all eligible debt on a measurement date other than any debt that
is treated as traced debt with respect to any unit of designated
property on that measurement date. For example, nontraced debt includes
eligible debt that is allocated to expenditures that are not
capitalized under section 263A(a) (e.g., expenditures deductible under
section 174(a) or 263(c)). Similarly, even if eligible debt is
allocated to a production expenditure for a unit of designated
property, the debt is included in nontraced debt on measurement dates
before the first or after the last measurement date for that unit of
designated property. Thus, nontraced debt may include debt that was
previously treated as traced debt or that will be treated as traced
debt on a future measurement date.
(B) Example. The provisions of paragraph (c)(5)(i)(A) of this
section are illustrated by the following example.
Example. In 1995, Corporation X begins, but does not complete,
the construction of two office buildings that are separate units of
designated property as defined in Sec. 1.263A-10 (Property D and
Property E). At the beginning of 1995, X borrows $2,500,00 (the
$2,500,000 loan), which will be used exclusively to finance
production expenditures for Property D. Although interest is paid
currently, the entire principal amount of the loan remains
outstanding at the end of 1995. Corporation X also has outstanding
during all of 1995 a long-term loan with a principal amount of
$2,000,000 (the $2,000,000 loan). The proceeds of the $2,000,000
loan were used exclusively to finance the production of Property C,
a unit of designated property that was completed in 1994. Under the
rules of paragraph (b)(2) of this section, the portion of the
$2,500,000 loan allocated to accumulated production expenditures for
property D at each measurement date during 1995 is treated as traced
debt for that measurement date. The excess, if any, of $2,500,000
over the amount treated as traced debt at each measurement date
during 1995 is treated as nontraced debt for that measurement date,
even though it is expected that the entire $2,500,000 will be
treated as traced debt with respect to Property D on subsequent
measurement dates as more of the proceeds of the loan are used to
finance additional production expenditures. In addition, the entire
principal amount of the $2,000,000 loan is treated as nontraced debt
for 1995, even though it was treated as traced debt with respect to
Property C in a previous period.
(ii) Average excess expenditures--(A) General rule. The average
excess expenditures for a unit of designated property for a computation
period are computed by--
(1) Determining the amount (if any) by which accumulated production
expenditures exceed traced debt at each measurement date during the
computation period; and
(2) Dividing the sum of these amounts by the number of measurement
dates during the computation period.
(B) Example. The provisions of paragraph (c)(5)(ii)(A) of this
section are illustrated by the following example.
Example. Corporation X, a calendar year taxpayer, is engaged in
the production of a single unit of designated property during 1995
(unit A). Corporation X adopts the taxable year as the computation
period and quarterly measurement dates. The production period for
unit A begins on January 14, 1995, and ends on June 16, 1995. On
March 31, 1995, and on June 30, 1995, Corporation X has outstanding
$1,000,000 of traced debt with respect to unit A. Accumulated
production expenditures for unit A on March 31, 1995, are $1,400,000
and on June 30, 1995, are $1,600,000. Accumulated production
expenditures in excess of traced debt for unit A on March 31, 1995,
are $400,000 and on June 30, 1995, are $600,000. Average excess
expenditures for unit A during 1995 are therefore $250,000
([$400,000 + $600,000 + $0 +$0] 4).
(iii) Weighted average interest rate--(A) Determination of rate.
The weighted average interest rate for a computation period is
determined by dividing interest incurred on nontraced debt during the
period by average nontraced debt for the period.
(B) Interest incurred on nontraced debt. Interest incurred on
nontraced debt during the computation period is equal to the total
amount of interest incurred during the computation period on all
eligible debt minus the amount of interest incurred during the
computation period on traced debt. Thus, all interest incurred on
nontraced debt during the computation period is included in the
numerator of the weighted average interest rate, even if the underlying
nontraced debt is repaid before the end of a measurement period and
excluded from nontraced debt outstanding for measurement dates after
repayment, in determining the denominator of the weighted average
interest rate. However, see paragraph (g)(7) of this section for an
election to treat eligible debt that is repaid within the 15-day period
immediately preceding a quarterly measurement date as outstanding on
that measurement date. See paragraph (a)(3) of this section for the
definitions of interest and incurred.
(C) Average nontraced debt. The average nontraced debt for a
computation period is computed by--
(1) Determining the amount of nontraced debt outstanding on each
measurement date during the computation period; and
(2) Dividing the sum of these amounts by the number of measurement
dates during the computation period.
(D) Special rules if taxpayer has no nontraced debt or rate is
contingent--If the taxpayer does not have nontraced debt outstanding
during the computation period, the weighted average interest rate for
purposes of applying paragraphs (c)(1) and (c)(2) of this section is
the highest applicable Federal rate in effect under section 1274(d)
during the computation period. If interest is incurred at a rate that
is contingent at the time the return for the year that includes the
computation period is filed, the amount of interest is determined using
the higher of the fixed rate of interest (if any) on the underlying
debt or the applicable Federal rate in effect under section 1274(d) on
the date of issuance.
(6) Examples. The following examples illustrate the principles of
this paragraph (c):
Example 1. (i) W, a calendar year taxpayer, is engaged in the
production of a unit of designated property during 1995. For
purposes of applying the avoided cost method of this section, W uses
the taxable year as the computation period. During 1995, W's only
debt is a $1,000,000 loan bearing interest at a rate of 7 percent
from Y, a person that is related to W. Assuming the applicable
Federal rate in effect under section 1274(d) on the date of issuance
of the loan is 10 percent, the loan is not eligible debt under
paragraph (a)(4) of this section. However, even though W has no
eligible debt, W incurs $70,000 ($1,000,000 x 7%) of interest during
the computation period. This interest is described in paragraph
(c)(2) of this section and must be capitalized under paragraph
(c)(1) of this section to the extent it does not exceed W's excess
expenditure amount for the unit of property.
(ii) W determines, under paragraph (c)(5)(ii) of this section,
that average excess expenditures for the unit of property are
$600,000. Assuming the highest applicable Federal rate in effect
under section 1274(d) during the computation period is 10 percent, W
uses 10 percent as the weighted average interest rate for purposes
of determining the excess expenditure amount. See paragraph
(c)(5)(iii)(D) of this section. In accordance with paragraph (c)(1)
of this section, the excess expenditure amount is therefore $60,000.
Because this amount does not exceed the total amount of interest
described in paragraph (c)(2) of this section ($70,000), W is
required to capitalize $60,000 of interest with respect to the unit
of designated property for the 1995 computation period.
Example 2. (i) Corporation X, a calendar year taxpayer, is
engaged in the production of a single unit of designated property
during 1955 (unit A). Corporation X adopts the taxable year as the
computation period and quarterly measurement dates. Production of
unit A begins in 1994 and ends on June 30, 1995. On March 31, 1995,
and on June 30, 1995, Corporation X has outstanding $1,000,000 of
eligible debt (loan #1) that is allocated under the rules of
Sec. 1.163-8T to production expenditures for unit A. During each of
the first two quarters of 1995, $30,000 of interest is incurred on
loan #1. The loan is repaid on July 1, 1995. Throughout 1995,
Corporation X also has outstanding $2,000,000 of eligible debt (loan
#2) which is not allocated under the rules of Sec. 1.163-8T to the
production of unit A. During 1995, $200,000 of interest is incurred
on this nontraced debt. Accumulated production expenditures on March
31, 1995, are $1,400,000 and on June 30, 1995, are $1,600,000.
Accumulated production expenditures in excess of traced debt on
March 31, 1995, are $400,000 and on June 30, 1995, are $600,000.
(ii) Under paragraph (b)(1) of this section, the amount of
interest capitalized with respect to traced debt is $60,000 ($30,000
for the measurement period ending March 31, 1995, and $30,000 for
the measurement period ending June 30, 1995). Under paragraph
(c)(5)(ii) of this section, average excess expenditures for unit A
are $250,000 ([$1,400,000-$1,000,000) + ($1,600,000-$1,000,000) + $0
+ $0]4). Under paragraph (c)(5)(iii)(C) of this section,
average nontraced debt is $2,000,000 ([$2,000,000 + $2,000,000 +
$2,000,000 + $2,000,000]4). Under paragraph (c)(5)(iii)(B)
of this section, interest incurred on nontraced debt is $200,000
($260,000 of interest incurred on all eligible debt less $60,000 of
interest incurred on traced debt). Under paragraph (c)(5)(iii)(A) of
this section, the weighted average interest rate is 10 percent
($200,000$2,000,000). Under paragraph (c)(1) of this
section, Corporation X capitalizes the excess expenditure amount of
$25,000 ($250,000 x 10%), because it does not exceed the total
amount of interest subject to capitalization under paragraph (c)(2)
of this section ($200,000). Thus, the total interest capitalized
with respect to unit A during 1995 is $85,000 ($60,000+$25,000).
(7) Special rules where the excess expenditure amount exceeds
incurred interest.--(i) Allocation of total incurred interest to units.
For a computation period in which the sum of the excess expenditure
amounts under paragraph (c)(1) of this section for all units of
designated property exceeds the total amount of interest (including
deferred interest) available for capitalization, as determined under
paragraph (c)(2) of this section, the amount of interest that is
allocated to a unit of designated property is equal to the product of--
(A) The total amount of interest (including deferred interest)
available for capitalization, as determined under paragraph (c)(2) of
this section; and
(B) A fraction, the numerator of which is the average excess
expenditures for the unit of designated property and the denominator of
which is the sum of the average excess expenditures for all units of
designated property.
(ii) Application of related person rules to average excess
expenditures. Certain excess expenditures must be taken into account by
the persons (if any) required to capitalize interest with respect to
production expenditures of the taxpayer under applicable related person
rules. For each computation period, the amount of average excess
expenditures that must be taken into account by such persons for each
unit of the taxpayer's property is computed by--
(A) Determining, for the computation period, the amount (if any) by
which the excess expenditures amount for the unit exceeds the amount of
interest allocated to the unit under paragraph (c)(7)(i) of this
section; and
(B) Dividing the excess by the weighted average interest rate for
the period.
(iii) Special rule for corporations. If a corporation is related to
another person for the purposes of the applicable related party rules,
the District Director upon examination may require that the corporation
apply this paragraph (c)(7) and other provisions of the regulations by
excluding deferred interest from the total interest available for
capitalization.
(d) Election not to trace debt.--(1) General rule. Taxpayers may
elect not to trace debt. If the election is made, the average excess
expenditures and weighted average interest rate under paragraph (c)(5)
of this section are determined by treating all eligible debt as
nontraced debt. For this purpose, debt specified in paragraph
(a)(4)(ii) of this section (e.g., accounts payable) may be included in
eligible debt, provided it would be treated as traced debt but for an
election under this paragraph (d). The election not to trace debt is a
method of accounting that applies to the determination of capitalized
interest for all designated property of the taxpayer. The making or
revocation of the election is a change in method of accounting
requiring the consent of the Commissioner under section 446(e) and
Sec. 1.446-1(e).
(2) Example. The provisions of paragraph (d)(1) of this section are
illustrated by the following example.
Example. (i) Corporation X, a calendar year taxpayer, is engaged
in the production of a single unit of designated property during
1995 (unit A). Corporation X adopts the taxable year as the
computation period and quarterly measurement dates. At each
measurement date (March 31, June 30, September 30, and December 31)
Corporation X has the following outstanding indebtedness:
Noninterest-bearing accounts payable traced to unit A........ $100,000
Noninterest-bearing accounts payable that are not traced to
unit A...................................................... $300,000
Interest-bearing loans that are eligible debt within the
meaning of paragraph (a)(4) of this section................. $900,000
(ii) Corporation X elects under this paragraph (d) not to trace
debt. Eligible debt at each measurement date for purposes of
calculating the weighted average interest rate under paragraph
(c)(5)(iii) of this section is $1,000,000 ($100,000 + $900,000).
(e) Election to use external rate--(1) In general. An eligible
taxpayer may elect to use the highest applicable Federal rate (AFR)
under section 1274(d) in effect during the computation period plus 3
percentage points (AFR plus 3) as a substitute for the weighted average
interest rate determined under paragraph (c)(5)(iii) of this section. A
taxpayer that makes this election may not trade debt. The use of the
AFR plus 3 as provided under this paragraph (e)(1) constitutes a method
of accounting. A taxpayer makes the election to use the AFR plus 3
method by using the AFR plus 3 as the taxpayer's weighted average
interest rate, and any change to the AFR plus 3 method by a taxpayer
that has never previously used the method does not require the consent
of the Commissioner. Any other change to or from the use of the AFR
plus 3 method under this paragraph (e)(1) (other than by reason of a
taxpayer ceasing to be an eligible taxpayer) is a change in method of
accounting requiring the consent of the Commissioner under section
446(e) and Sec. 1.446-1(e). All changes to or from the AFR plus 3
method are effected on a cut-off basis.
(2) Eligible taxpayer. A taxpayer is an eligible taxpayer for a
taxable year for purposes of this paragraph (e) if the average annual
gross receipts of the taxpayer for the three previous taxable years do
not exceed $10,000,000 (the $10,000,000 gross receipts test for all
prior taxable years beginning after December 31, 1994. For purposes of
this paragraph (e)(2), the principles of section 263A(b)(2)(B) and (C)
and Sec. 1.263A-3(b) apply in determining whether a taxpayer is an
eligible taxpayer for a taxable year.
(f) Selection of computation period and measurement dates and
application of averaging conventions.--(1) Computation period--(i) In
general. A taxpayer may (but is not required to) make the avoided cost
calculation on the basis of a full taxable year. If the taxpayer uses
the taxable year as the computation period, a single avoided cost
calculation is made for each unit of designated property for the entire
taxable year. If the taxpayer uses a computation period that is shorter
than the full taxable year, an avoided cost calculation is made for
each unit of designated property for each shorter computation period
within the taxable year. If the taxpayer uses a shorter computation
period, the computation period may not include portions of more than
one taxable year and, except as provided in the case of short taxable
years, each computation period within a taxable year must be the same
length. In the case of a short taxable year, a taxpayer may treat a
period shorter than the taxpayer's regular computation period as the
first or last computation period, or as the only computation period for
the year if the year is shorter than the taxpayer's regular computation
period. A taxpayer must use the same computation periods for all
designated property produced during a single taxable year.
(ii) Method of accounting. The choice of a computation period is a
method of accounting. Any change in the computation period is a change
in method of accounting requiring the consent of the Commissioner under
section 446(e) and Sec. 1.446-1(e).
(iii) Production period beginning or ending during the computation
period. The avoided cost method applies to the production of a unit of
designated property on the basis of a full computation period,
regardless of whether the production period for the unit of designated
property begins or ends during the computation period.
(2) Measurement dates--(i) In general. If a taxpayer uses the
taxable year as the computation period, measurement dates must occur at
quarterly or more frequent regular intervals. If the taxpayer uses
computation periods that are shorter than the taxable year, measurement
dates must occur at least twice during each computation period and at
least four times during the taxable year (or consecutive 12-month
period in the case of a short taxable year). The taxpayer must use the
same measurement dates for all designated property produced during a
computation period. Except in the case of a computation period that
differs from the taxpayer's regular computation period by reason of a
short taxable year (see paragraph (f)(1)(i) of this section),
measurement dates must occur at equal intervals during each computation
period that falls within a single taxable year. For any computation
period that differs from the taxpayer's regular computation period by
reason of a short taxable year, the measurement dates used by the
taxpayer during that period must be consistent with the principles and
purposes of section 263A(f). A taxpayer is permitted to modify the
frequency of measurement dates from year to year.
(ii) Measurement period. For purposes of this section, measurement
period means the period that begins on the first day following the
preceding measurement date and that ends on the measurement date.
(iii) Measurement dates on which accumulated production
expenditures must be taken into account. The first measurement date on
which accumulated production expenditures must be taken into account
with respect to a unit of designated property is the first measurement
date following the beginning of the production period for the unit of
designated property. The final measurement date on which accumulated
production expenditures with respect to a unit of designated property
must be taken into account is the first measurement date following the
end of the production period for the unit of designated property.
Accumulated production expenditures with respect to a unit of
designated property must also be taken into account on all intervening
measurement dates. See Sec. 1.263A-12 to determine when the production
period begins and ends.
(iv) More frequent measurement dates. When in the opinion of the
District Director more frequent measurement dates are necessary to
determine capitalized interest consistent with the principles and
purposes of section 263A(f) for a particular computation period, the
District Director may require the use of more frequent measurement
dates. If a significant segment of the taxpayer's production activities
(the first segment) requires more frequent measurement dates than
another significant segment of the taxpayer's production activities,
the taxpayer may request a ruling from the Internal Revenue Service
permitting, for a taxable year and all subsequent taxable years, a
segregation of the two segments and, notwithstanding paragraph
(f)(2)(i) of this section, the use of the more frequent measurement
dates for only the first segment. The request for a ruling must be made
in accordance with any applicable rules relating to submissions of
ruling requests. The request must be filed on or before the due date
(including extensions) of the original Federal income tax return for
the first taxable year to which it will apply.
(3) Examples. The following examples illustrate the principles of
this paragraph (f):
Example 1. Corporation X, a calendar year taxpayer, is engaged
in the production of designated property during 1995. Corporation X
adopts the taxable year as the computation period and quarterly
measurement dates. Corporation X must identify traced debt,
accumulated production expenditures, and nontraced debt at each
quarterly measurement date (March 31, June 30, September 30, and
December 31). Under paragraph (c)(5)(ii) of this section,
Corporation X must calculate average excess expenditures for each
unit of designated property by determining the amount by which
accumulated production expenditures exceed traced debt for each unit
at the end of each quarter and dividing the sum of these amounts by
four. Under paragraph (c)(5)(iii) (C) of this section, Corporation X
must calculate average nontraced debt by determining the amount of
nontraced debt outstanding at the end of each quarter and dividing
the sum of these amounts by four.
Example 2. Corporation X, a calendar year taxpayer, is engaged
in the production of designated property during 1995. Corporation X
adopts a 6-month computation period with two measurement dates
within each computation period. Corporation X must identify traced
debt, accumulated production expenditures, and nontraced debt at
each measurement date (March 31 and June 30 for the first
computation period and September 30 and December 31 for the second
computation period). Under paragraph (c)(5)(ii) of this section,
Corporation X must, for each computation period, calculate average
excess expenditures for each unit of designated property by
determining the amount by which accumulated production expenditures
exceed traced debt for each unit at each measurement date during the
period and dividing the sum of these amounts by two. Under paragraph
(c)(5)(iii)(C) of this section, Corporation X must calculate average
nontraced debt for each computation period by determining the amount
of nontraced debt outstanding at each measurement date during the
period and dividing the sum of these amounts by two.
Example 3. (i) Corporation X, a calendar year taxpayer, is
engaged in the production of two units of designated property during
1995. Production of Unit A starts in 1994 and ends on June 20, 1995.
Production of Unit B starts on April 15, 1995, but does not end
until 1996. Corporation X adopts the taxable year as its computation
period and does not elect under paragraph (d) of this section not to
trace debt. Corporation X uses quarterly measurement dates and pays
all interest on eligible debt in the quarter in which the interest
is incurred. During 1995, Corporation X has two items of eligible
debt. The debt and the manner in which it is used are as follows:
------------------------------------------------------------------------
Annual
No. Principal rate Period Use of proceeds
(percent) outstanding
------------------------------------------------------------------------
1......... $1,000,000 9 1/01-9/01 Unit A.
2......... 2,000,000 11 6/01-12/31 Nontrace.
------------------------------------------------------------------------
(ii) Based on the annual 9 percent rate of interest, Corporation
X incurs $7,500 of interest during each month that Loan #1 is
outstanding.
(iii) Accumulated production expenditures at the end of each
quarter during 1995 are as follows:
------------------------------------------------------------------------
Measurement date Unit A Unit B
------------------------------------------------------------------------
March 31................................ $1,200,000 $0
June 30................................. 1,800,000 500,000
Sept. 30................................ 0 1,000,000
Dec. 31................................. 0 1,600,000
------------------------------------------------------------------------
(iv) Corporation X must first determine the amount of interest
incurred on traced debt and capitalize the interest incurred on this
debt (the traced debt amount). Loan #1 is allocated to Unit A on the
March 31 and June 30 measurement dates. Accordingly, Loan #1 is
treated as traced debt with respect to unit A for the measurement
periods beginning January 1 and ending June 30. The interest
incurred on Loan #1 during the period that Loan #1 is treated as
traced debt must be capitalized with respect to Unit A. Thus,
$45,000 ($7,500 per month for 6 months) is capitalized with respect
to Unit A.
(v) Second, Corporation X must determine average excess
expenditures for Unit A and Unit B. For Unit A, this amount is
$250,000 ([$200,000 + $800,000 + $0 +$0] 4). For Unit B,
this amount is $775,000 ([$0 + $500,000 + $1,000,000 + $1,600,000
4).
(vi) Third, Corporation X must determine the weighted average
interest rate and apply that rate to the average excess expenditures
for Units A and B. The rate is equal to the total amount of interest
incurred on nontraced debt (i.e., interest incurred on all eligible
debt reduced by interest incurred on traced debt) divided by the
average nontraced debt. The interest incurred on nontraced debt
equals $143,333 ([$1,000,000 x 9% x \8/12\] + [$2,000,000 x
11% x \7/12\] - $45,000). The average nontraced debt equals
$1,500,000 ([$0 + $2,000,000 + $2,000,000 + $2,000,000] 4).
The weighted average interest rate of 9.56 percent ($143,333 '
$1,500,000), is then applied to average excess expenditures for
Units A and B. Accordingly, Corporation X capitalizes an additional
$23,900 ($250,000 x 9.56%) with respect to Unit A and $74,090
($775,000 x 9.56%) with respect to Unit B (the excess expenditure
amounts).
(g) Special rules--(1) Ordering rules--(i) Provisions preempted by
section 263A(f). Interest must be capitalized under section 263A(f)
before the application of section 163(d) (regarding the investment
interest limitation), section 163(j) (regarding the limitation on
interest paid to a tax-exempt related person), section 266 (regarding
the election to capitalize carrying charges), section 469 (regarding
the limitation on passive losses), and section 861 (regarding the
allocation of interest to United States sources). Any interest that is
capitalized under section 263A(f) is not taken into account as interest
under those sections. However, in applying section 263A(f) with respect
to the excess expenditure amount, the taxpayer must capitalize all
interest that is neither investment interest under section 163(d),
exempt related person interest under section 163(j), nor passive
interest under section 469 before capitalizing any interest that is
either investment interest, exempt related person interest, or passive
interest. Any interest that is not required to be capitalized after the
application of section 263A(f) is then taken into account as interest
subject to sections 163(d), 163(j), 266, 469, and 861. If, after the
application of section 263A(f), interest is deferred under sections
163(d), 163(j), 266, or 469, that interest is not subject to
capitalization under section 263A(f) in any subsequent taxable year.
(ii) Deferral provisions applied before this section. Interest
(including contingent interest) that is subject to a deferral provision
described in this paragraph (g)(1)(ii) is subject to capitalization
under section 263A(f) only in the taxable year in which it would be
deducted if section 263A(f) did not apply. Deferral provisions include
sections 163(e)(3), 267, 446, and 461, and all other deferral or
limitation provisions that are not described in paragraph (g)(1)(i) of
this section. In contrast to the provisions of paragraph (g)(1)(i) of
this section, deferral provisions are applied before the application of
section 263A(f).
(2) Application of section 263A(f) to deferred interest--(i) In
general. This paragraph (g)(2) describes the time and manner of
capitalizing and recovering the deferral amount. The deferral amount
for any computation period equals the sum of--
(A) The amount of interest that is incurred on traced debt that is
deferred during the computation period and is not deductible for the
taxable year that includes the computation period because of a deferral
provision described in paragraph (g)(1)(ii) of this section, and
(B) The shortfall amount described in paragraph (c)(4) of this
section.
(ii) Capitalization of deferral amount. The rules described in
paragraph (g)(2)(iii) of this section apply to the deferral amount
unless the taxpayer elects under paragraph (g)(2)(iv) of this section
to capitalize substitute costs.
(iii) Deferred capitalization. If the taxpayer does not elect under
paragraph (g)(2)(iv) of this section to capitalize substitute costs,
deferred interest to which the deferral amount is attributable
(determined under any reasonable method) is capitalized in the year or
years in which the deferred interest would have been deductible but for
the application of section 263A(f) (the capitalization year). For this
purpose, any interest that is deferred from a prior computation period
is taken into account in subsequent capitalization years in the same
order in which the interest was deferred. If a unit of designated
property to which previously deferred interest relates is sold before
the capitalization year, the deferred interest applicable to that unit
of property is taken into account in the capitalization year and
treated as if recovered from the sale of the property. If the taxpayer
continues to hold, throughout the capitalization year, a unit of
depreciable property to which previously deferred interest relates, the
adjusted basis and applicable recovery percentages for the unit of
property are redetermined for the capitalization year and subsequent
years so that the increase in basis is accounted for over the remaining
recovery periods beginning with the capitalization year. See Example 2
of paragraph (g)(2)(v) of this section.
(iv) Substitute capitalization--(A) General rule. In lieu of
deferred capitalization under paragraph (g)(2)(iii) of this section,
the taxpayer may elect the substitute capitalization method described
in this paragraph (g)(2)(iv). Under this method, the taxpayer
capitalizes for the computation period in which interest is incurred
and deferred (the deferral period) costs that would be deducted but for
this paragraph (g)(2)(iv) (substitute costs). The taxpayer must
capitalize an amount of substitute costs equal to the deferral amount
for each unit of designated property, or if less, a prorata amount
(determined in accordance with the principles of paragraph (c)(7)(i) of
this section) of the total substitute costs that would be deducted but
for this paragraph (g)(2)(iv) during the deferral period. If the entire
deferral amount is capitalized pursuant to this paragraph (g)(2)(iv) in
the deferral period, any interest incurred and deferred in the deferral
period is neither capitalized nor deducted during the deferral period
and, unless subsequently capitalized as a substitute cost under this
paragraph (g)(2)(iv), is deductible in the appropriate subsequent
period without regard to section 263A(f).
(B) Capitalization of amount carried forward. If the taxpayer has
an insufficient amount of substitute costs in the deferral period, the
amount by which substitute costs are insufficient with respect to each
unit of designated property is a deferral amount carryforward to
succeeding computation periods beginning with the next computation
period. In any carryforward year, the taxpayer must capitalize an
amount of substitute costs equal to the deferral amount carryforward
or, if less, a prorata amount (determined in accordance with the
principles of paragraph (c)(7)(i) of this section) of the total
substitute costs that would be deducted during the carryforward year or
years (the carryforward capitalization year) but for this paragraph
(g)(2)(iv) (after applying the substitute cost method of this paragraph
(g)(2)(iv) to the production of designated property in the carryforward
period). If a unit of designated property to which the deferral amount
carryforward relates is sold prior to the carryforward capitalization
year, substitute costs applicable to that unit of property are taken
into account in the carryforward capitalization year and treated as if
recovered from the sale of the property. If the taxpayer continues to
hold, throughout the capitalization year, a unit of depreciable
property to which a deferral amount carryforward relates, the adjusted
basis and applicable recovery percentages for the unit of property are
redetermined for the carryforward capitalization year and subsequent
years so that the increase in basis is accounted for over the remaining
recovery periods beginning with the carryforward capitalization year.
See Example 2 of paragraph (g)(2)(v) of this section.
(c) Method of accounting. The substitute capitalization method
under this paragraph (g)(2)(iv) is a method of accounting that applies
to all designated property of the taxpayer. A change to or from the
substitute capitalization method is a change in method of accounting
requiring the consent of the Commissioner under section 446(e) and
Sec. 1.446-1(e).
(v) Examples. The following examples illustrate the application of
the avoided cost method when interest is subject to a deferral
provisions:
Example 1. (i) Corporation X is a calendar year taxpayer and
uses the taxable year as it computation period. During 1995, X is
engaged in the construction of a warehouse which X will use in its
storage business. The warehouse is completed and placed in service
in December 1995. X's average excess expenditures for 1995 equal
$1,000,000. Throughout 1995, X's only outstanding debt is nontraced
debt of $900,000 and $1,200,000, bearing interest at 15 percent and
9 percent, respectively, per year. Of the $243,000 interest incurred
during the year ([$900,000 x 15%] + [$1,200,000 x 9%] =
[$135,000 x $108,000]), $75,000 is deferred under section 267(a)(2).
(ii) X must first determine the amount of interest required to
be capitalized under paragraph (c)(1) of this section for 1995 (the
deferral period) without applying section 267(a)(2). The weighted
average interest rate is 11.6 percent ([$135,000 x $108,000]
$2,100,000), and the excess expenditure amount under paragraph
(c)(1) of this section is $116,000 ($1,000,000 x 11.6%). Under
paragraph (c)(4) of this section, X must then determine the amount
of interest that would be capitalized by applying paragraph (c)(2)
of this section without regard to the amount of deferred interest.
Disregarding deferred interest, the amount of interest available for
capitalization is $168,000 ([$900,000 x 15%] + [$1,200,000 x 9%]-
$75,000). Thus, the full excess expenditure amount ($116,000) is
capitalized from interest that is not deferred under section
267(a)(2) and there is no shortfall amount.
Example 2. (i) The facts are the same as in Example 1, except
that $140,000 of interest is deferred under section 267 (a)(2) in
1995. The taxpayer does not elect to use the substitute
capitalization method. This interest is also deferred in 1996 but
would be deducted in 1997 if section 263A(f) did not apply. As in
Example 1, the excess expenditure amount is $116,000. However, the
amount of interest available for capitalization after excluding the
amount of deferred interest is $103,000 ([$900,000 x 15%] +
[$1,200,000 x 9%]- $140,000). Thus, only $103,000 of interest is
capitalized with respect to the warehouse in 1995. Since $116,000 of
interest would be capitalized if section 267(a)(2) did not apply,
the deferral amount determined under paragraphs (c)(2) and (g)(2)(i)
of this section is $13,000 ($116,000 -$103,000), and $13,000 of
deferred interest must be capitalized in the year in which it would
be deducted if section 263A(f) did not apply.
(ii) The $140,000 of interest deferred under section 267(a)(2)
in 1995 would be deducted in 1997 if section 263A(f) did not apply.
X is therefore required to capitalize an additional $13,000 of
interest with respect to the warehouse in 1997 and must redetermine
its basis and recovery percentage.
(3) Simplified inventory method--(i) In general. This paragraph
(g)(3) provides a simplified method of capitalizing interest expense
with respect to designated property that is inventory. Under this
method, the taxpayer determines beginning and ending inventory and cost
of goods sold applying all other capitalization provisions, including,
for example, the simplified production method of Sec. 1.263A-2(b), but
without regard to the capitalization of interest with respect to
inventory. The taxpayer must establish a separate capital asset,
however, in an amount equal to the aggregate interest capitalization
amount (as defined in paragraph (g)(3)(iii)(C) of this section). Under
the simplified inventory method, increases in the aggregate interest
capitalization amount from one year to the next generally are treated
as reductions in interest expense, and decreases in the aggregate
interest capitalization amount from one year to the next are treated as
increases to cost of goods sold.
(ii) Segmentation of inventory--(A) General rule. Under the
simplified inventory method, the taxpayer first separates its total
ending inventory value into segments that are equal to the total ending
inventory value divided by the inverse inventory turnover rate. Each
inventory segment is then assigned an age starting with one year and
increasing by one year for each additional segment. The inverse
inventory turnover rate is determined by finding the average of
beginning and ending inventory, dividing the average by the cost of
goods sold for the year, and rounding the result to the nearest whole
number. Beginning and ending inventory amounts are determined using
total current cost of inventory for the year (rather than carrying
value). Cost of goods sold, however, may be determined using either
total current cost or the taxpayer's inventory method. In addition, for
purposes of this paragraph (g)(3)(ii), current costs for a year (and,
if applicable, the cost of goods sold for the year under the taxpayer's
inventory method) are determined without regard to the capitalization
of interest with respect to inventory.
(B) Example. The provisions of paragraph (g)(3)(ii)(A) of this
section are illustrated by the following example.
Example. X, a taxpayer using the FIFO inventory method,
determines that total cost of goods sold for 1995 equals $900, and
the cost of both beginning and ending inventory equals $3,000. Thus,
X's inverse inventory turnover rate equals 3 (3.33 rounded to the
nearest whole number). Total ending inventory of $3,000 is divided
into three segments of $1,000 each. One segment is treated as 3-
year-old inventory, one segment is treated as 2-year-old inventory,
and one segment is treated as 1-year-old inventory.
(iii) Aggregate interest capitalization amount--(A) Computation
period and weighted average interest rate. If a taxpayer elects the
simplified inventory method, the taxpayer must use the taxable year as
its computation period and use the weighted average interest rate
determined under this paragraph (g)(3)(iii)(A) in determining the
aggregate interest capitalization amount defined in paragraph
(g)(3)(iii)(C) of this section and in determining the amount of
interest capitalized with respect to any designated property that is
not inventory. Under the simplified inventory method, the taxpayer
determines the weighted average interest rate in accordance with
paragraph (c)(5)(iii) of this section, treating all eligible debt
(other than debt traced to noninventory property in the case of a
taxpayer tracing debt) as nontraced debt (i.e., without tracing debt to
inventory). A taxpayer that has elected under paragraph (e) of this
section to use an external rate as a substitute for the weighted
average interest rate determined under paragraph (c)(5)(iii) of this
section uses the rate described in paragraph (e)(1) as the weighted
average interest rate.
(B) Computation of the tentative aggregate interest capitalization
amount. The weighted average interest rate is compounded annually by
the number of years assigned to a particular inventory segment to
produce an interest factor (applicable interest factor) for that
segment. The amounts determined by multiplying the value of each
inventory segment by its applicable interest factor are then combined
to produce a tentative aggregate interest capitalization amount.
(C) Coordination with other interest capitalization computations--
(1) In general. If the tentative aggregate interest capitalization
amount for a year exceeds the aggregate interest capitalization amount
(defined in paragraph (g)(3)(iii)(D) of this section) as of the close
of the preceding year, then, for purposes of applying the rules of
paragraph (c)(7) of this section, the excess is treated as an excess
expenditure amount and the inventory to which the simplified inventory
method of this paragraph (g)(3) applies is treated as a single unit of
designated property. If, after these modifications, no paragraph (c)(7)
interest allocation is necessary (i.e., the excess expenditure amounts
for all units of designated property do not exceed the total amount of
interest (including deferred interest) available for capitalization),
the aggregate interest capitalization amount generally equals the
tentative aggregate interest capitalization amount. If, on the other
hand, a paragraph (c)(7) allocation is necessary, the tentative
aggregate interest capitalization amount is generally adjusted to
reflect the results of that allocation (i.e., the increase in the
aggregate interest capitalization amount is limited to the amount of
interest allocated to inventory, reduced, however, by any substitute
costs that are capitalized with respect to inventory under applicable
related party rules).
(2) Deferred interest. In determining the aggregate interest
capitalization amount, the tentative aggregate interest capitalization
amount is adjusted (after the application of paragraph (c)(7) of this
section) as appropriate to reflect the deferred interest rules of
paragraph (g)(2) of this section. The tentative aggregate interest
capitalization amount would be reduced, for example, by the amount of a
taxpayer's deferred interest for a taxable year unless the taxpayer has
elected the substitute capitalization method under paragraph
(g)(2)(iv).
(3) Other coordinating provisions. The Commissioner may prescribe,
by revenue ruling or revenue procedure, additional provisions to
coordinate the election and use of the simplified inventory method with
other interest capitalization requirements and methods. See
Sec. 601.601(d)(2)(ii)(b) of this chapter.
(D) Treatment of increases or decreases in the aggregate interest
capitalization amount. Except as otherwise provided in this paragraph
(g)(3)(iii)(D), increases in the aggregate interest capitalization
amount from one year to the next are treated as reductions in interest
expense, and decreases in the aggregate interest capitalization amount
from one year to the next are treated as increases to cost of goods
sold. To the extent a taxpayer capitalizes substitute costs under
either applicable related party rules or the deferred interest rules in
paragraph (g)(2) of this section, increases in the aggregate interest
capitalization amount are treated as reductions in applicable
substitute costs, rather than interest expense.
(E) Example. The provisions of this paragraph (g)(3)(iii) are
illustrated by the following example.
Example. The facts are the same as in the example in paragraph
(g)(3)(ii)(B) of this section, and, in addition, X determines that
its weighted average interest rate for 1995 is 10 percent.
Additionally, assume that X has no deferred interest in 1995 or 1996
and no deferral amount carryforward to either 1995 or 1996. (See
paragraph (g)(2) of this section.) Also assume that no allocation is
necessary under paragraph (c)(7) of this section in either 1995 or
1996. Under the rules of paragraph (g)(3)(ii) of this section, S
divides ending inventory into segments of $1,000 each. One segment
is 1-year old inventory, one segment is 2-year old inventory, and
one segment is 3-year inventory. Under paragraph (g)(3)(iii)(B) of
this section, X must compute the applicable interest factor for each
segment. The applicable interest factor for the 1-year old inventory
is not compounded. The applicable interest factor for the 2-year old
inventory is compounded for 1 year. The applicable interest factor
for the 3-year old inventory is compounded for 2 years. The interest
factor applied to the 1-year old inventory segment is .1. The
interest factor applied to the 2-year old inventory segment is .21
[(1.1 x 1.1)-1]. The interest factor applied to the 3-year old
inventory is .331 [(1.1 x 1.1 x 1.1)-1]. Thus, the tentative
aggregate interest capitalization amount for 1995 is $641 (1,000 x
[.1 + .21 + .331]). Because X has no deferred interest in 1995, no
deferral amount carryforward to 1995, and no required allocation
under paragraph (c)(7) of this section in 1995, X's aggregate
interest capitalization amount equals its $641 tentative aggregate
interest capitalization amount. If, in 1996, X computes an aggregate
interest capitalization amount of $750, the $109 increase in the
amount from 1995 to 1996 would be treated as a reduction in interest
expense for 1996.
(iv) Method of accounting. The simplified inventory method is a
method of accounting that must be elected for and applied to all
inventory within a single trade or business of the taxpayer (within
the meaning of section 446(d) and Sec. 1.446-1(d)). This method may
be elected only if the inventory in that trade or business consists
only of designated property and only if the taxpayer's inverse
inventory turnover rate for that trade or business (as defined in
paragraph (g)(3)(ii)(A) of this section) is greater than or equal to
one. A change from or to the simplified inventory method is a change
in method of accounting requiring the consent of the Commissioner
under section 446(e) and Sec. 1.446-(1)(e).
(4) Financial accounting method disregarded. The avoided cost
method is applied under this section without regard to any financial or
regulatory accounting principles for the capitalization of interest.
For example, this section determines the amount of interest that must
be capitalized without regard to Financial Accounting Standards Board
(FASB) Statement Nos. 34, 71, and 90, issued by the Financial
Accounting Standards Board, Norwalk, CT 06856-5116. Similarly,
taxpayers are not permitted to net interest income and interest expense
in determining the amount of interest that must be capitalized under
this section with respect to certain restricted tax-exempt borrowings
even though netting is permitted under FASB Statement No. 62.
(5) Treatment of intercompany transactions--(i) General rule. If
interest capitalized under section 263A(f) by a member of a
consolidated group (within the meaning of Sec. 1.1502-1(h)) with
respect to a unit of designated property is attributable to a loan from
another member of the group (the lending member), the intercompany
transaction provisions of the consolidated return regulations do not
apply to the lending member's interest income with respect to that
loan, except as provided in paragraph (g)(5)(ii) of this section. For
this purpose, the capitalized interest expense that is attributable to
a loan from another member is determined under any method that
reasonably reflects the principles of the avoided cost method,
including the traced and nontraced concepts. For purposes of this
paragraph (g)(5)(i) and paragraph (g)(5)(ii) of this section, in order
for a method to be considered reasonable it must be consistently
applied.
(ii) Special rule for consolidated group with limited outside
borrowing. If, for any year, the aggregate amount of interest income
described in paragraph (g)(5)(i) of this section for all members of the
group with respect to all units of designated property exceeds the
total amount of interest that is deductible for that year by all
members of the group with respect to debt of a member owed to
nonmembers (group deductible interest) after applying section 263A(f),
the intercompany transaction provisions of the consolidated return
regulations are applied to the excess, and the amount of interest
income that must be taken into account by the group under paragraph
(g)(5)(i) of this section is limited to the amount of the group
deductible interest. The amount to which the intercompany transaction
provisions of the consolidated return regulations apply by reason of
this paragraph (g)(5)(ii) is allocated among the lending members under
any method that reasonably reflects each member's share of interest
income described in paragraph (g)(5)(i) of this section. If a lending
member has interest income that is attributable to more than one unit
of designated property, the amount to which the intercompany
transaction provisions of the consolidated return regulations apply by
reason of this paragraph (g)(5)(ii) with respect to the member is
allocated among the units in accordance with the principles of
paragraph (c)(7)(i) of this section.
(iii) Example. The provisions of paragraph (g)(5)(ii) of this
section are illustrated by the following example.
Example. (i) P and S1 are the members of a consolidated group.
In 1995, S1 begins and completes the construction of a shopping
center and is required to capitalize interest with respect to the
construction. S1's average excess expenditures for 1995 are
$5,000,000. Throughout 1995, S1's only borrowings include a
$6,000,000 loan from P bearing interest at an annual rate of 10
percent ($600,000 per year). Under the avoided cost method, S1 is
required to capitalize interest in the amount of $500,000
([$600,000$6,000,000] x 5,000,000).
(ii) P's only borrowing from unrelated lenders is a $2,000,000
loan bearing interest at an annual rate of 10 percent ($200,000 per
year). Under the principles of paragraph (g)(5)(ii) of this section,
because the aggregate amount of interest described in paragraph
(g)(5)(i) of this section ($500,000) exceeds the aggregate amount of
currently deductible interest of the group ($200,000), the
intercompany transaction provisions of the consolidated return
regulations apply to the excess of $300,000 and the amount of P's
interest income that is subject to current inclusion by reason of
paragraph (g)(5)(i) of this section is limited to $200,000.
(6) Notional principal contracts and other derivatives.
[Reserved]
(7) 15-day repayment rule. A taxpayer may elect to treat any
eligible debt that is repaid within the 15-day period immediately
preceding a quarterly measurement date as outstanding as of that
measurement date for purposes of determining traced debt, average
nontraced debt, and the weighted average interest rate. This election
may be made or discontinued for any computation period and is not a
method of accounting.
Sec. 1.263-10 Unit of property.
(a) In general. The unit of property as defined in this section is
used as the basis to determine accumulated production expenditures
under Sec. 1.263A-11 and the beginning and end of the production period
under Sec. 1.263A-12. Whether property is 1-year or 2-year property
under Sec. 1.263A-8(b)(1)(ii) is also determined separately with
respect to each unit of property as defined in this section.
(b) Units of real property--(1) In general. A unit of real property
includes any components of real property owned by the taxpayer or a
related person that are functionally interdependent and an allocable
share of any common feature owned by the taxpayer or a related person
that is real property even though the common feature does not meet the
functional interdependence test. When the production period begins with
respect to any functionally interdependent component or any common
feature of the unit of real property, the production period has begun
for the entire unit of real property. See, however, paragraph (b)(5) of
this section for rules under which the costs of a common feature or
benefitted property are excluded from accumulated production
expenditures for one or more measurement dates. The portion of land
included in a unit of real property includes land on which real
property (including a common feature) included in the unit is situated,
land subject to setback restrictions with respect to such property, and
any other contiguous portion of the tract of land other than land that
the taxpayer holds for a purpose unrelated to the unit being produced
(e.g., investment purposes, personal use purposes, or specified future
development as a separate unit of real property).
(2) Functional interdependence. Components of real property
produced by, or for, the taxpayer, for use by the taxpayer or a related
person are functionally interdependent if the placing in service of one
component is dependent on the placing in service of the other component
by the taxpayer or a related person. In the case of property produced
for sale, components of real property are functionally interdependent
if they are customarily sold as a single unit. For example, the real
property components of a single-family house (e.g., the land,
foundation, and walls) are functionally interdependent. In contrast,
components of real property that are expected to be separately placed
in service or held for resale are not functionally interdependent.
Thus, dwelling units within a multi-unit building that are separately
placed in service or sold (within the meaning of Sec. 1.263A-12(d)(1))
are treated as functionally independent of any other units, even though
the units are located in the same building.
(3) Common features. For purposes of this section, a common feature
generally includes any real property (as defined in Sec. 1.263A-8(c))
that benefits real property produced by, or for, the taxpayer or a
related person, and that is not separately held for the production of
income. A common feature need not be physically contiguous to the real
property that it benefits. Examples of common features include streets,
sidewalks, playgrounds, clubhouses, tennis courts, sewer lines, and
cables that are not held for the production of income separately from
the units of real property that they benefit.
(4) Allocation of costs to unit. Except as provided in paragraph
(b)(5) of this section, the accumulated production expenditures for a
unit of real property include, in all cases, the costs that directly
benefit, or are incurred by reason of the production of, the unit of
real property. Accumulated production expenditures also include the
adjusted basis of property used to produce the unit of real property.
The accumulated costs of a common feature or land that benefits more
than one unit of real property, or that benefits designated property
and property other than designated property, is apportioned among the
units of designated property, or among the designated property and
property other than designated property, in determining accumulated
production expenditures. The apportionment of the accumulated costs of
the common feature (allocable share) or land (attributable land costs)
generally may be made using any method that is applied on a consistent
basis and that reasonably reflects the benefits provided. For example,
an apportionment based on relative costs to be incurred, relative space
to be occupied, or relative fair market values may be reasonable.
(5) Treatment of costs when a common feature is included in a unit
of real property--(i) General rule. Except as provided in this
paragraph (b)(5), the accumulated production expenditures of a unit of
real property include the costs of functionally interdependent
components (benefitted property) and an allocable share of the cost of
common features throughout the entire production period of the unit.
See Sec. 1.263A-12, relating to the production period of a unit of
property.
(ii) Production activity not undertaken on benefitted property--(A)
Direct production activity not undertaken--(1) In general. The costs of
land attributable to a benefitted property may be treated as not
included in accumulated production expenditures for a unit of real
property for measurement dates prior to the first date a production
activity (direct production activity), including the clearing and
grading of land, has been undertaken with respect to the land
attributable to the benefitted property. Thus, the costs of land
attributable to a benefitted property (as opposed to land attributable
to the common features) with respect to which no direct production
activities have been undertaken may be treated as not included in the
accumulated production expenditures of a unit of real property even
though a production activity has begun on a common feature allocable to
the unit.
(2) Land attributable to a benefitted property. For purposes of
this paragraph (b)(5)(ii), land attributable to a benefitted property
includes all land in the unit of real property that includes the
benefitted property other than land for a common feature. (Thus, land
attributable to a benefitted property does not include land
attributable to a common feature.)
(B) Suspension of direct production activity after clearing and
grading undertaken--(1) General rule. This paragraph (b)(5)(ii)(B) may
be used to determine the accumulated production expenditures for a unit
of real property, if the only production activity with respect to a
benefitted property has been clearing and grading and no further direct
production activity is undertaken with respect to the benefitted
property for at least 120 consecutive days (i.e., direct production
activity has ceased). Under this paragraph (b)(5)(ii)(B), the
accumulated production expenditures attributable to a benefitted
property qualifying under this paragraph (b)(5)(ii)(B) may be excluded
from the accumulated production expenditures of the unit of real
property even though production continues on a common feature allocable
to the unit. For purposes of this paragraph (b)(5)(ii)(B), production
activity is considered to occur during any time which would not qualify
as a cessation of production activities under the suspension period
rules of Sec. 1.263A-12(g).
(2) Accumulated production expenditures. If this paragraph
(b)(5)(ii)(B) applies, accumulated production expenditures attributable
to the benefitted property of the unit of real property may be treated
as not included in the accumulated production expenditures for the unit
starting with the first measurement period beginning after the first
day of the 120 consecutive day period, but must be included in the
accumulated production expenditures for the unit beginning in the
measurement period in which direct production activity has resumed on
the benefitted property. Accumulated production expenditures with
respect to common features allocable to the unit of real property may
not be excluded under this paragraph (b)(5)(ii)(B).
(iii) Common feature placed in service before the end of production
of a benefitted property. To the extent that a common feature with
respect to which all production activities to be undertaken by, or for,
a taxpayer or a related person are completed is placed in service
before the end of the production period of a unit that includes an
allocable share of the costs of the common feature, the costs of the
common feature are not treated as included in accumulated production
expenditures of the unit for measurement periods beginning after the
date the common feature is placed in service.
(iv) Benefitted property sold before production completed on common
feature. If a unit of real property is sold before common features
included in the unit are completed, the production period of the unit
ends on the date of sale. Thus, common feature costs actually incurred
and properly allocable to the unit as of the date of sale are excluded
from accumulated production expenditures for measurement period
beginning after the date of sale. Common feature costs properly
allocable to the unit and actually incurred after the sale are not
taken into account in determining accumulated production expenditures.
(v) Benefitted property placed in service before production
completed on common feature. Where production activities remain to be
undertaken on a common feature allocable to a unit of real property
that includes benefitted property, the costs of the benefitted property
are not treated as included in the accumulated production expenditures
for the unit for measurement periods beginning after the date the
benefitted property is placed in service and all production activities
reasonably expected to be undertaken by, or for, the taxpayer or a
related person with respect to the benefitted property are completed.
(6) Examples. The principles of paragraph (b) of this section are
illustrated by the following examples:
Example 1. B, an individual, is in the trade or business of
constructing custom-built houses for sale. B owns a 10-acre tract
upon which B intends to build four houses on 2-acre lots. In
addition, on the remaining 2 acres B plans to construct a perimeter
road that benefits the four houses and is not held for the
production of income separately from the sale of the houses. In
1995, B begins constructing the perimeter road and clears the land
for one house. Under the principles of paragraph (b)(1) of this
section, each planned house (including attributable land) is part of
a separate unit of real property (house unit). Under the principles
of paragraph (b)(3) of this section, the perimeter road (including
attributable land) constitutes a common feature with respect to each
planned house (i.e., benefitted property). In accordance with
paragraph (b)(1), the production period for all four house units
begins when production commences on the perimeter road in 1995. In
addition, under the principles of paragraph (b)(4) of this section,
the accumulated production expenditures for the four house units
include the allocable costs of the road. In addition, for the house
with respect to which B has cleared the land, the accumulated
production expenditures for the house unit include the land costs
attributable to the house. See paragraph (b)(5)(i) of this section.
However, the accumulated production expenditures for each of the
three house units that include a house for which B has not yet
undertaken a direct production activity do not include the land
costs attributable to the house. See paragraph (b)(5)(ii) of this
section.
Example 2. Assume the same facts as Example 1, except that B
undertakes no further direct production activity with respect to the
house for which the land was cleared for a period of at least 120
days but continues constructing the perimeter road during this
period. In accordance with paragraph (b)(5)(ii)(B) of this section,
B may exclude the accumulated production expenditures attributable
to the benefitted property from the accumulated production
expenditures of the house unit starting with the first measurement
period that begins after the first day of the 120 consecutive day
period. B must include the accumulated production expenditures
attributable to the benefitted property in the accumulated
production expenditures for the house unit beginning with the
measurement period in which direct production resumes on the
benefitted property. The house unit will continue to include the
accumulated production expenditures attributable to the perimeter
road during the period in which direct production activity was
suspended on the benefitted property.
Example 3. (i) D, a corporation, is in the trade or business of
developing commercial real property. D owns a 20-acre tract upon
which D intends to build a shopping center with 150 stores. D
intends to lease the stores. D will also provide on the 20 acres a
1500-car parking lot, which is not held by D for the production of
income separately from the stores in the shopping center.
Additionally, D will not produce any other common features as part
of the project. D intends to complete the shopping center in phases
and expects that each store will be placed in service independently
of any other store.
(ii) Under paragraphs (b)(1) and (b)(2) of this section, each
store (including attributable land) is part of a separate unit of
real property (store unit). The 1500-car parking lot is a common
feature benefitting each store, and D must include an allocable
share of the parking lost in each store unit. See paragraph (b)(1)
and (b)(3). In accordance with paragraph (b)(5)(i), D includes in
the accumulated production expenditures for each store unit during
each store unit's production period: the costs capitalized with
respect to the store (including attributable land costs in
accordance with paragraph (b)(5) of this section) and an allocable
share of the parking lot costs (including attributable land costs in
accordance with paragraph (b)(5) of this section. Under paragraph
(b)(4), the portion of the parking lot costs that is included in the
accumulated production expenditures of a store unit is determined
using a reasonable method of allocation.
Example 4. X, a real estate developer, begins a project to
construct a condominium building and a convenience store for the
benefit of the condominium. X intends to separately lease the
convenience store. Because the convenience store is held for the
production of income separately from the condominium units that it
benefits, the convenience store is not a common feature with respect
to the condominium building. Instead, the convenience store is a
separate unit of property with a separate production period and for
which a separate determination of accumulated production
expenditures must be made.
Example 5. (i) In 1995, X, a real estate developer, begins a
project consisting of a condominium building and a common swimming
pool that is not held for the production of income separately from
the condominium sales. The condominium building consists of 10
stories, and each story is occupied by a single condominium.
Production of the swimming pool begins in January. No direct
production activity is undertaken on any condominium until
September, when direct production activity commences on each
condominium. On December 31, 1995, 1 condominium that was completed
in December has been sold, 3 condominiums that were completed in
December have not been sold, and 6 condominiums are only partially
complete; additionally, the swimming pool is completed. X is a
calendar year taxpayer that uses a full taxable year as the
computation period, and quarterly measurement dates.
(ii) Under paragraphs (b)(1) and (b)(2) of this section, each
condominium (including attributable land) is part of a separate unit
of real property. Under the principles of paragraph (b)(3) of this
section, the swimming pool is a common feature with respect to each
condominium and under paragraph (b)(4) of this section the cost of
the swimming pool is allocated equally among the condominiums.
(iii) Under paragraph (b)(1) of this section, the production
period of each of the 10 condominium units begins in January when
production of the swimming pool begins. On X's March 31, 1995, and
June 30, 1995, measurement dates, the accumulated production
expenditures for each condominium unit include the allocable costs
of the swimming pool, but not the land costs attributable to the
condominium because no direct production activity has been
undertaken on the condominium. See paragraph (b)(5)(ii)(A) of this
section. On X's September 30, 1995, and December 31, 1995,
measurement dates, the accumulated production expenditures for each
unit include the allocable costs of the swimming pool, and the costs
of the condominium (including attributable land costs) because a
direct production activity has commenced on the condominium. See
paragraph (b)(5)(i) of this section.
(iv) The production period for the condominium unit that
includes the condominium that is sold as of the end of 1995 ends on
the date the condominium is sold. See paragraph (b)(5)(iv) of this
section. The production period of each unit that is ready to be held
for sale ends when all production activities have been completed on
the unit, in this case on December 31, 1995, the date that the
swimming pool included in the unit is completed. See Sec. 1.263A-
12(d). Accordingly, interest capitalization ceases for each such
unit that is sold or ready to be held for sale as of the end of 1995
(including each unit's allocable share of the completed swimming
pool).
(v) The production periods for the condominium units that
include the condominiums that are only partially complete at the end
of 1995 continue after 1995. The accumulated production expenditures
for each partially completed condominium unit continue to include
the costs of the condominium (including attributable land costs) in
addition to the costs of an allocable share of the completed
swimming pool (including attributable land costs).
Example 6. Assume the same facts as in Example 5, except that
the swimming pool is only partially complete as of the end of 1995.
Under these facts, X capitalizes no interest during 1996 for the 1
unit that includes the condominium sold during 1995 (including the
costs of the allocable share of swimming pool). See paragraph
(b)(5)(iv) of this section. However, with respect to the 6
condominiums that are partially complete and the 3 condominiums that
are completed but unsold, interest capitalization continues after
the end of 1995. The accumulated production expenditures for each of
these 9 units include the costs of an allocable share of the
swimming pool. See paragraph (b)(5)(i) of this section. In
determining the costs of an allocable share of the swimming pool
included in the accumulated production expenditures for each of the
9 units, X includes all costs of the swimming pool properly
allocable to each unit, including those cost incurred as of the date
of the sale of unit 1 that may have been used under applicable
administrative procedures (e.g., Rev. Proc. 92-29, 1992-1 C.B. 748)
in determining the basis of unit 1 solely for purposes of computing
gain or loss on the sale of unit 1. See Sec. 601.601(d)(2)(ii)(b) of
this chapter.
Example 7. (i) Assume the same facts as in Example 5, except
that X intends to lease rather than sell the condominiums and the
completed swimming pool is placed in service for depreciation
purposes on December 31, 1995. Additionally, assume that all 10
condominiums are partially completed at the end of 1995.
(ii) Under these facts, because the swimming pool is a common
feature that is placed in service separately from the condominiums
that it benefits, under paragraph (b)(5)(iii) of this section, the
accumulated production expenditures of each of the condominium units
do not include the costs of the allocable share of the swimming pool
after 1995.
(c) Units of tangible personal property. Components of tangible
personal property are a single unit of property if the components are
functionally interdependent. Components of tangible personal property
that are produced by, or for, the taxpayer, for use by the taxpayer or
a related person, are functionally interdependent if the placing in
service of one component is dependent on the placing in service of the
other component by the taxpayer or a related person. In the case of
tangible personal property produced for sale, components of tangible
personal property are functionally interdependent if they are
customarily sold as a single unit. For example, if an aircraft
manufacturer customarily sells completely assembled aircraft, the unit
of property includes all components of a completely assembled aircraft.
If the manufacturer also customarily sells aircraft engines separately,
any engines that are reasonably expected to be sold separately are
treated as single units of property.
(d) Treatment of installations. If the taxpayer produces or is
treated as producing any property that is installed on or in other
property, the production activity and installation activity relating to
each unit of property generally are not aggregated for purposes of this
section. However, if the taxpayer is treated as producing and
installing any property for use by the taxpayer or a related person or
if the taxpayer enters into a contract requiring the taxpayer to
install property for use by a customer, the production activity and
installation activity are aggregated for purposes of this section.
Sec. 1.263A-11 Accumulated production expenditures.
(a) General rule. Accumulated production expenditures generally
means the cumulative amount of direct and indirect costs described in
section 263A(a) that are required to be capitalized with respect to the
unit of property (as defined in Sec. 1.263A-10), including interest
capitalized in prior computation periods, plus the adjusted bases of
any assets described in paragraph (d) of this section that are used to
produce the unit of property during the period of their use.
Accumulated production expenditures may also include the basis of any
property received by the taxpayer in a nontaxable transaction.
(b) When costs are first taken into account--(1) In general. Except
as provided in paragraph (c)(1) of this section, costs are taken into
account in the computation of accumulated production expenditures at
the time and to the extent they would otherwise be taken into account
under the taxpayer's method of accounting (e.g., after applying the
requirements of section 461, including the economic performance
requirement of section 461(h)). Costs that have been incurred and
capitalized with respect to a unit of property prior to the beginning
of the production period are taken into account as accumulated
production expenditures beginning on the date on which the production
period of the property begins (as defined in Sec. 1.263A-12(c)). Thus,
for example, the cost of raw land acquired for development, the cost of
a leasehold in mineral properties acquired for development, and the
capitalized cost of planning and design activities are taken into
account as accumulated production expenditures beginning on the first
day of the production period. For purposes of determining accumulated
production expenditures on any measurement date during a computation
period, the interest required to be capitalized for the computation
period is deemed to be capitalized on the day immediately following the
end of the computation period. For any subsequent measurement dates and
computation periods, that interest is included in accumulated
production expenditures. If the cost of land or common features is
allocated among planned units of property that are completed in phases,
any portion of the cost properly allocated to completed units is not
reallocated to any incomplete units of property.
(2) Dedication rule for materials and supplies. The costs of raw
materials, supplies, or similar items are taken into account as
accumulated production expenditures when they are incurred and
dedicated to production of a unit of property. Dedicated means the
first date on which the raw materials, supplies, or similar items are
specifically associated with the production of any unit of property,
including by record, assignment to the specific job site, or physical
incorporation. In contrast, in the case of a component or subassembly
that is reasonably expected to be become a part of (e.g., be
incorporated into) any unit of property, costs incurred (including
dedicated raw materials) for the component or subassembly are taken
into account as accumulated production expenditures during the
production of any portion of the component or subassembly and prior to
its connection with (e.g., incorporation into) any specific unit of
property. For purposes of the preceding sentence, components and
subassemblies must be aggregated at each measurement date in a
reasonable manner that is consistent with the purposes of section
263A(f).
(c) Property produced under a contract--(1) Customer. If a unit of
property produced under a contract is designated property under
Sec. 1.263A-8(d)(2)(i) with respect to the customer, the customer's
accumulated production expenditures include any payments under the
contract that represent part of the purchase price of the unit of
designated property or, to the extent costs are incurred earlier than
payments are made (determined on a cumulative basis for each unit of
designated property), any part of such price for which the requirements
of section 461 have been satisfied. The customer has made a payment
under this section if the transaction would be considered a payment by
a taxpayer using the cash receipts and disbursements method of
accounting. The customer's accumulated production expenditures also
include any other costs incurred by the customer, such as interest, or
any other direct or indirect costs that are required to be capitalized
under section 263A(a) and the regulations thereunder with respect to
the production of the unit of designated property.
(2) Contractor. If a unit of property produced under a contract is
designated property under Sec. 1,263A-8(d)(2)(ii) with respect to the
contractor, the contractor must treat the cumulative amount of payments
made by the customer under the contract attributable to the unit of
property as a reduction in the contractor's accumulated production
expenditures. The customer has made a payment under this section if the
transaction would be considered a payment by a taxpayer using the cash
receipts and disbursements method of accounting.
(d) Property used to produce designated property--(1) In general.
Accumulated production expenditures include the adjusted bases (or
portion thereof) of any equipment, facilities, or other similar assets,
used in a reasonably proximate manner for the production of a unit of
designated property during any measurement period in which the asset is
so used. Examples of assets used in a reasonably proximate manner
include machinery and equipment used directly or indirectly in the
production process, such as assembly-line structures, cranes,
bulldozers, and buildings. A taxpayer apportions the adjusted basis of
an asset used in the production of more than one unit of designated
property in a measurement period among such units of designated
property using reasonable criteria corresponding to the use of the
asset, such as machine hours, mileage, or units of production, If an
asset used in a reasonably proximate manner for the production of a
unit of designated property is temporarily idle (within the meaning of
Sec. 1.263A-1(e)(3)(iii)(E)) for an entire measurement period, the
adjusted basis of the asset is excluded from the accumulated production
expenditures for the unit during that measurement period.
Notwithstanding this paragraph (d)(1), the portion of the depreciation
allowance for equipment, facilities, or any other asset that is
capitalized with respect to a unit of designated property in accordance
with Sec. 1.263A-1(e)(3)(ii)(I) is included in accumulated production
expenditures without regard to the extent of use under this paragraph
(d)(1) (i.e., without regard to whether the asset is used in a
reasonably proximate manner for the production of the unit of
designated property).
(2) Example. The following example illustrates how the basis of an
asset is allocated on the basis of time:
Example. In 1995, X uses a bulldozer exclusively to clear the
land on several adjacent real estate development projects, A, B, and
C. A, B, and C are treated as separate units of property under the
principles of Sec. 1.263A-10. X decides to allocate the basis of the
bulldozer among the three projects on the basis of time. At the end
of the first quarter of 1995, the production period has commenced
for all three projects. The bulldozer was operated for 30 hours on
project A, 80 hours on project B, and 10 hours on project C, for a
total of 120 hours for the entire period. For purposes of
determining accumulated production expenditures as of the end of the
first quarter, \1/4\ of the adjusted basis of the bulldozer is
allocated to project A, \2/3\ to project B, and \1/12\ to project C.
Nonworking hours, regularly scheduled nonworking days, or other
periods in which the bulldozer is temporarily idle (within the
meaning of Sec. 1.263A-1(e)(3)(iii)(E)) during the measurement
period are not taken into account in allocating the basis of the
bulldozer.
(3) Excluded equipment and facilities. The adjusted bases of
equipment, facilities, or other assets that are not used in a
reasonably proximate manner to produce a unit of property are not
included in the computation of accumulated production expenditures. For
example, the adjusted bases of equipment and facilities, including
buildings and other structures, used in service departments performing
administrative, purchasing, personnel, legal, accounting, or similar
functions, are excluded from the computation of accumulated production
expenditures under this paragraph (d)(3).
(e) Improvements--(1) General rule. If an improvement constitutes
the production of designated property under $1.263A-8(d)(3),
accumulated production expenditures with respect to the improvement
consist of--
(i) All direct and indirect costs required to be capitalized with
respect to the improvement,
(ii) In the case of an improvement to a unit of real property
(A) An allocable portion of the cost of land, and
(B) For any measurement period, the adjusted basis of any existing
structure, common feature, or other property that is not placed in
service or must be temporarily withdrawn from service to complete the
improvement (associated property) during any part of the measurement
period if the associated property directly benefits the property being
improved, the associated property directly benefits from the
improvement, or the improvement was incurred by reason of the
associated property. See, however, the de minimis rule under paragraph
(e)(2) of this section that applies in the case of associated property.
(iii) In the case of an improvement to a unit of tangible personal
property, the adjusted basis of the asset being improved if the asset
either is not placed in service or must be temporarily withdrawn from
service to complete the improvement.
(2) De minimis rule. For purposes of paragraph (e)(1)(ii) of this
section, the total costs of all associated property for an improvement
unit (associated property costs are excluded from the accumulated
production expenditures for the improvement unit during its production
period if, on the date the production period of the unit begins, the
taxpayer reasonably expects that at no time during the production
period of the unit will the accumulated production expenditures for the
unit, determined without regard to the associated property costs,
exceed 5 percent of the associated property costs.
(f) Mid-production purchases. If a taxpayer purchases a unit of
property for further production, the taxpayer's accumulated production
expenditures include the full purchase price of the property plus, in
accordance with the principles of paragraph (e) of this section,
additional direct and indirect costs incurred by the taxpayer.
(g) Related person costs. The activities of a related person are
taken into account in applying the classification thresholds under
Sec. 1.263A-8(b)(1)(ii)(B) and (C), and in determining the production
period of a unit of designated property under Sec. 1.263A-12. However,
only those costs incurred by the taxpayer are taken into account in the
taxpayer's accumulated production expenditures under this section
because the related person includes its own capitalized costs in the
related person's accumulated production expenditures with respect to
any unit of designated property upon which the parties engage in mutual
production activities. For purposes of the preceding sentence, the
accumulated production expenditures of any property transferred to a
taxpayer in a nontaxable transaction are treated as accumulated
production expenditures incurred by the taxpayer.
(h) Installation. If the taxpayer installs property that is
purchased by the taxpayer, accumulated production expenditures include
the cost of the property that is installed in addition to the direct
and indirect costs of installation.
Sec. 1.263A-12 Production period.
(a) In general. Capitalization of interest is required under
Sec. 1.263A-9 for computation periods (within the meaning of
Sec. 1.263A-9(f)(1)) that include the production period of a unit of
designated property. In contrast, section 263A(a) requires the
capitalization of all other direct or indirect costs, such as
insurance, taxes, and storage, that directly benefit or are incurred by
reason of the production of property without regard to whether they are
incurred during a period in which production activity occurs.
(b) Related person activities. Activities performed and costs
incurred by a person related to the taxpayer that directly benefit or
are incurred by reason of the taxpayer's production of designated
property are taken into account in determining the taxpayer's
production period (regardless of whether the related person is
performing only a service or is producing a subassembly or component
that the related person is required to treat as an item of designated
property). These activities and the related person's costs are also
taken into account in determining whether tangible personal property
produced by the taxpayer is 1-year or 2-year property under
Sec. 1.263A-8(b)(1)(ii) (B) and (C).
(c) Beginning of production period--(1) In general. A separate
production period is determined for each unit of property defined in
Sec. 1.263A-10. The production period begins on the date that
production of the unit of property begins.
(2) Real property. The production period of a unit of real property
begins on the first date that any physical production activity (as
defined in paragraph (e) of this section) is performed with respect to
a unit of real property. See Sec. 1.263A-10(b)(1). The production
period of a unit of real property produced under a contract begins for
the contractor on the date the contractor begins physical production
activity on the property. The production period of a unit of real
property produced under a contract begins for the customer on the date
either the customer or the contractor begins physical production
activity on the property.
(3) Tangible personal property. The production period of a unit of
tangible personal property begins on the first date by which the
taxpayer's accumulated production expenditures, including planning and
design expenditures, are at least 5 percent of the taxpayer's total
estimated accumulated production expenditures for the property unit.
Thus, the beginning of the production period is determined without
regard to whether physical production activity has commenced. The
production period of a unit of tangible personal property produced
under a contract begins for the contractor when the contractor's
accumulated production expenditures, without any reduction for payments
from the customer, are at least 5 percent of the contractor's total
estimated accumulated production expenditures. The production period
for a unit of tangible personal property produced under a contract
begins for the customer when the customer's accumulated production
expenditures are at least 5 percent of the customer's total estimated
accumulated production expenditures.
(d) End of production period--(1) In general. The production period
for a unit of property produced for self use ends on the date that the
unit is placed in service and all production activities reasonably
expected to be undertaken by, or for, the taxpayer or a related person
are completed. The production period for a unit of property produced
for sale ends on the date that the unit is ready to be held for sale
and all production activities reasonably expected to be undertaken by,
or for, the taxpayer or a related person are completed. See, however,
Sec. 1.263A-10(b)(5)(iv) providing an exception for common features in
the case of a benefitted property that is sold. In the case of a unit
of property produced under a contract, the production period for the
customer ends when the property is placed in service by the customer
and all production activities reasonably expected to be undertaken are
complete (i.e., generally, no earlier than when the customer takes
delivery). In the case of property that is customarily aged (such as
tobacco, wine, or whiskey) before it is sold, the production period
includes the aging period.
(2) Special rules. The production period does not end for a unit of
property prior to the completion of physical production activities by
the taxpayer even though the property is held for sale or lease, since
all production activities reasonably expected to be undertaken by the
taxpayer with respect to such property have not in fact been completed.
See, however, Sec. 1.263A-10(b)(5) regarding separation of certain
common features.
(3) Sequential production or delivery. The production period ends
with respect to each unit of property (as defined in Sec. 1.263A-10)
and its associated accumulated production expenditures as the unit of
property is completed within the meaning of paragraph (d)(1) of this
section, without regard to the production activities or costs of any
other units of property. Thus, for example, in the case of separate
apartments in a multi-unit building, each of which is a separate unit
of property within the meaning of Sec. 1.263A-10, the production period
ends for each separate apartment when it is ready to be held for sale
or placed in service within the meaning of paragraph (d)(1) of this
section. In the case of a single unit of property that merely undergoes
separate and distinct stages of production, the production period ends
at the same time (i.e., when all separate stages of production are
completed with respect to the entire amount of accumulated production
expenditures for the property).
(4) Examples. The provisions of paragraph (d) of this section are
illustrated by the following example:
Example 1. E is engaged in the original construction of a high-
rise office building with two wings. At the end of 1995, Wing #1,
but not Wing #2, is placed in service. Moreover, at the end of 1995,
all production activities reasonably expected to be undertaken on
Wing #1 are completed. In accordance with Sec. 1.263A-10(b)(1), Wing
#1 and Wing #2 are separate units of designated property. E may stop
capitalizing interest on Wing #1 but not on Wing #2.
Example 2. F is in the business of constructing finished houses.
F generally paints and finishes the interior of the house, although
this does not occur until a potential buyer is located. Because F
reasonably expects to undertake production activity (painting and
finishing), the production period of each house does not end until
these activities are completed.
(e) Physical production activities--(1) In general. The term
physical production activities includes any physical activity that
constitutes production within the meaning of Sec. 1.263A-8(d)(1). The
production period begins and interest must be capitalized with respect
to real property if any physical production activities are undertaken,
whether alone or in preparation for the construction of buildings or
other structures, or with respect to the improvement of existing
structures. For example, the clearing of raw land constitutes the
production of designated property, even if only cleared prior to
resale.
(2) Illustrations. THe following is a partial list of activities
any one of which constitutes a physical production activity with
respect to the production of real property:
(i) Clearing, grading, or excavating of raw land;
(ii) Demolishing a building or gutting a standing building;
(iii) Engaging in the construction of infrastructure, such as
roads, sewers, sidewalks, cables, and wiring;
(iv) Undertaking structural, mechanical, or electrical activities
with respect to a building or other structure; or
(v) Engaging in landscaping activities.
(f) Activities not considered physical production. The activities
described in paragraphs (f)(1) and (f)(2) of this section are not
considered physical production activities:
(1) Planning and design. Soil testing, preparing architectural
blueprints or models, or obtaining building permits.
(2) Incidental repairs. Physical activities of an incidental nature
that may be treated as repairs under Sec. 1.162-4.
(g) Suspension of production period--(1) In general. If production
activities related to the production of a unit of designated property
cease for at least 120 consecutive days (cessation period), a taxpayer
may suspend the capitalization of interest with respect to the unit of
designated property starting with the first measurement period that
begins after the first day in which production ceases. The taxpayer
must resume the capitalization of interest with respect to a unit
beginning with the measurement period during which production
activities resume. In addition, production activities are not
considered to have ceased if they cease because of circumstances
inherent in the production process, such as normal adverse weather
conditions, scheduled plant shutdowns, or delays due to design or
construction flaws, the obtaining of a permit or license, or the
settlement of groundfill to construct property. Interest incurred on
debt that is traced debt with respect to a unit of designated property
during the suspension period is subject to capitalization with respect
to the production of other units of designated property as interest on
nontraced debt. See Sec. 1.263A-9(c)(5)(i) of this section. For
applications of the avoided cost method after the end of the suspension
period, the accumulated production expenditures for the unit include
the balance of accumulated production expenditures as of the beginning
of the suspension period, plus any additional capitalized costs
incurred during the suspension period. No further suspension of
interest capitalization may occur unless the requirements for a new
suspension period are satisfied.
(2) Special rule. If a cessation period spans more than one taxable
year, the taxpayer may suspend the capitalization of interest with
respect to a unit beginning with the first measurement period of the
taxable year in which the 120-day period is satisfied.
(3) Method of accounting. An election to suspend interest
capitalization under paragraph (g)(1) of this section is a method of
accounting that must be consistently applied to all units that satisfy
the requirements of paragraph (g)(1) of this section. However, the
special rule in paragraph (g)(2) of this section is applied on an
annual basis to all units of an electing taxpayer that satisfy the
requirements of paragraph (g)(2) of this section.
(4) Example. The provisions of paragraph (g)(1) of this section are
illustrated by the following example.
Example. (i) D, a calendar-year taxpayer, began production of a
residential housing development on January 1, 1995. D, in applying
the avoided cost method, chose a taxable year computation period and
quarterly measurement dates. On April 10, 1995, all production
activities ceased with respect to the units in the development until
December 1, 1996. The cessation, which occurred for a period of at
least 120 consecutive days, was not attributable to circumstances
inherent in the production process. With respect to the units in the
development, D incurred production expenditures of $2,000,000 from
January 1, 1995 through April 10, 1995. D incurred interest of
$100,000 on traced debt with respect to the units for the period
beginning January 1, 1995, and ending June 30, 1995. D did not incur
any production expenditures for the more than 20-month cessation
beginning April 10, 1995, and ending December 1, 1996, but incurred
$200,000 of production expenditures from December 1, 1996, through
December 31, 1996.
(ii) D is required to capitalize the $100,000 interest on traced
debt incurred during the two measurement periods beginning January
1, 1995, and ending June 30, 1995. Because D satisfied the 120-day
rule under this paragraph (g), D is not required to capitalize
interest with respect to the accumulated production expenditures for
the units for the measurement period beginning July 1, 1995, and
ending September 30, 1995, which is the first measurement period
that begins after the date production activities cease. D is rquired
to resume interest capitalization with respect to the $2,300,000
(2,000,000+100,000+200,000) of accumulated production expenditures
for the units for the measurement period beginning October 1, 1996,
and ending December 31, 1996 (the measurement period during which
production activities resume). Accordingly, D may suspend the
capitalization of interest with respect to the units from July 1,
1995, through September 30, 1996.
Sec. 1.263A-13 Oil and gas activities.
(a) In general. This section provides rules that are to be applied
in tandem with Secs. 1.263A-8 through 1.263A-12, 1.263A-14, and 1.263A-
15 in capitalizing interest with respect to the development (within the
meaning of section 263A(g)) of oil or gas property. For this purpose,
oil or gas property consists of each separate operating mineral
interest in oil or gas as defined in section 614(a), or, if a taxpayer
makes an election under section 614(b), the aggregate of two or more
separate operating mineral interests in oil or gas as described in
section 614(b) (section 614 property). Thus, an oil or gas property is
designated property unless the de minimis rule applies. A taxpayer must
apply the rules in paragraph (c) of this section if the taxpayer cannot
establish, at the beginning of the production period of the first well
drilled on the property, a definite plan that identifies the number and
location of other wells planned with respect to the property. If a
taxpayer can establish such a plan at the beginning of the production
period of the first well drilled on the property, the taxpayer may
either apply the rules of paragraph (c) of this section or treat each
of the planned wells as a separate unit and partition the leasehold
acquisition costs and costs of features based on the number of planned
well units.
(b) Generally applicable rules--(1) Beginning of production
period--(i) Onshore activities. In the case of onshore oil or gas
development activities, the production period for a unit begins on the
first date physical site preparation activities (such as building an
access road, leveling a site for a drilling rig, or excavating a mud
pit) are undertaken with respect to the unit.
(ii) Offshore activities. In the case of offshore development
activities, the production period for a unit begins on the first date
physical site preparation activities, other than activities undertaken
with respect to expendable wells, are undertaken with respect to the
unit. For purposes of the preceding sentence, the first physical site
preparation activity undertaken with respect to a section 614 property
is generally the first activity undertaken with respect to the
anchoring of a platform (e.g., drilling to drive the piles). For
purposes of this section, an expendable well is a well drilled solely
to determine the location and delineation of offshore hydrocarbon
deposits.
(2) End of production period. The production period ends for a
productive well unit on the date the well is placed in service and all
production activities reasonably expected to be undertaken by, or for,
the taxpayer or a related person are completed. See Sec. 1.263A-12(d).
(3) Accumulated production expenditures--(i) Costs included.
Accumulated production expenditures for a well unit include the
following costs (to the extent they are not intangible drilling and
development costs allowable as a deduction under section 263(c),
263(i), or 291(b)(2)): the costs of acquiring the section 614 leasehold
and the costs of taxes and similar items that are required to be
capitalized under section 263A(a) with respect to the section 614
leasehold; the cost of real property associated with developing the
section 614 property (e.g., casing); the basis of real property that
constitutes a common feature within the meaning of Sec. 1.263A-
10(b)(3); and the adjusted basis of property used to produce property
(such as a mobile rig, drilling ship, or an offshore drilling
platform).
(ii) Improvement unit. To the extent section 614 costs are
allocated to a well unit, the undepleted portion of those section 614
costs must also be included in the accumulated production expenditures
for any improvement unit (within the meaning of Sec. 1.263A-8(d)(3))
with respect to that well unit.
(c) Special rules when definite plan not established--(1) In
general. The special rules of this paragraph (c) must be applied by a
taxpayer that cannot establish, at the beginning of the production
period of the first well drilled on the property, a definite plan that
identifies the number and location of the wells planned with respect to
the property. A taxpayer than can establish such a plan is permitted,
but not required, to apply the rules of this paragraph (c), provided
the rules of this paragraph (c) are consistently applied for all the
taxpayer's oil or gas properties for which a definite plan can be
established.
(2) Oil and gas units--(i) First productive well unit. Until the
first productive well is placed in service and all production
activities reasonably expected to be undertaken by, or for, the
taxpayer or a related person are completed, a first productive well
unit includes the section 614 property and all real property associated
with the development of the section 614 property. Thus, for example, a
first productive well unit includes the section 614 property and real
property associated with any nonproductive well drilled on the section
614 property on or before the date the first productive well is placed
in service and all production activities reasonably expected to be
undertaken by, or for, the taxpayer or a related person are completed.
For purposes of this section, a productive well is a well that produces
in commercial quantities. See paragraph (c)(5) of this section, which
provides a special rule whereby the costs of a section 614 property and
common feature costs for a section 614 property generally are included
only in the accumulated production expenditures for the first
productive well unit.
(ii) Subsequent units. Generally, real property associated with
each productive or nonproductive well with respect to which production
activities begin after the date the first productive well is placed in
service and all production activities reasonably expected to be
undertaken by, or for, the taxpayer or a related person are completed,
constitutes a unit of real property. Additionally, a productive or
nonproductive well that is included in a first productive well unit and
for which development continues after the date the first productive
well is placed in service and all production activities reasonably
expected to be undertaken by, or for, the taxpayer or a related person
are completed, generally is treated as a separate unit of property
after that date. See, however, paragraph (c)(5) of this section, which
provides rules for the treatment of costs included in the accumulated
production expenditures of a first productive well unit.
(3) Beginning of production period--(i) First productive well unit.
The beginning of the production period of the first productive well
unit is determined as provided in paragraph (b) of this section.
(ii) Subsequent wells. In applying paragraph (b) of this section to
subsequent well units (as described in paragraph (c)(2)(ii) of this
section), any activities occurring prior to the date the production
period ends for the first productive well unit are not taken into
account in determining the beginning of the production period for the
subsequent well units.
(4) End of production period. The end of the production period for
both the first productive well unit and subsequent productive well
units is determined as provided in paragraph (b)(2) of this section.
See Sec. 1.263A-12(d). Nonproductive wells included in the first
productive well unit need not be plugged and abandoned for the
production period to end for a first productive well unit.
(5) Accumulated production expenditures--(i) First productive well
unit. The accumulated production expenditures for a first productive
well unit include all costs incurred with respect to the section 614
property and associated real property at any time through the end of
the production period for the first productive well unit. Thus, the
costs of acquiring the section 614 property, the costs of taxes and
similar items that are required to be capitalized under section 263A(a)
with respect to the section 614 property, and the costs of common
features, that are incurred at any time through the end of the
production period of the first productive well unit (section 614 costs)
are included in the accumulated production expenditures for the first
productive well unit.
(ii) Subsequent well unit. The accumulated production expenditures
for a subsequent well do not include any costs included in the
accumulated production expenditures for a first productive well unit.
In the event that section 614 costs or common feature costs with
respect to a section 614 property are incurred subsequent to the end of
the production period of the first productive well unit, those common
feature costs and undepleted section 614 costs are allocated among the
accumulated production expenditures of wells being drilled as of the
date such costs are incurred.
(6) Allocation of interest capitalized with respect to first
productive well unit. Interest attributable to any productive or
nonproductive well included in the first productive well unit (within
the meaning of paragraph (c)(2)(ii) of this section) is allocated among
and capitalized to the basis of the property associated with the first
productive well unit. See Sec. 1.263A-8(a)(2).
(7) Example. The provisions of this paragraph (c) are illustrated
by the following example.
Example. (i) Corporation Z, an oil company, acquired a section
614 property in an onshore tract, Tract B, for development. In 1995,
Corporation Z began site preparation activities on Tract B and also
commenced drilling Well 1 on Tract B. Corporation Z was unable to
establish, as provided in paragraph (a) of this section, a definite
plan identifying the number and location of other wells planned on
Tract B. In 1996, Corporation Z began drilling Well 2. On May 1,
1997, Well 2, a productive well, was placed in service and all
production activities reasonably expected to be undertaken with
respect to Well 2 were completed. By that date, also, Well 1 was
abandoned.
(ii) Well 2 is a first productive well (within the meaning of
paragraph (c)(2)(i)) of this section). Well 1 is a nonproductive
well drilled prior to a first productive well. Under paragraph (c)
of this section, Corporation Z must treat both Well 1 and Well 2 as
part of the first productive well unit on the section 614 property.
In accordance with paragraphs (c)(3) and (c)(4) of this section, the
production period of the first productive well unit begins on the
date physical site preparation activities are undertaken with
respect to Well 1 in 1995 and ends on May 1, 1997, the date that
Well 2 is placed in service and all production activities reasonably
expected to be undertaken are completed. In accordance with
paragraph (c)(5) of this section, the accumulated production
expenditures for the first productive well unit include, among other
capitalized costs, the entire section 614 property costs capitalized
with respect to Tract B and all common feature costs incurred with
respect to the section 614 property through May 1, 1997.
(iii) Any well that Corporation Z begins after May 1, 1997, is a
separate unit of property. See paragraph (c)(2)(ii) of this section.
Under paragraph (c)(3)(ii) of this section, the production period
for any such well unit begins on the first day after May 1, 1997, on
which Corporation Z undertakes physical site preparation activities
with respect to the well unit. Moreover, Corporation Z does not
include any of the section 614 property costs in the accumulated
production expenditures for any well unit begun after May 1, 1997.
Sec. 1.263A-14 Rules for related persons.
Taxpayers must account for average excess expenditures allocated to
related persons under applicable administrative pronouncements
interpreting section 263A(f). See Sec. 601.601(d)(2)(ii)(b) of this
chapter.
Sec. 1.263A-15 Effective dates, transitional rules, and anti-abuse
rule.
(a) Effective dates--(1) Sections 1.263A-8 through 1.263A-15
generally apply to interest incurred in taxable years beginning on or
after January 1, 1995. In the case of property that is inventory in the
hands of the taxpayer, however, these sections are effective for
taxable years beginning on or after January 1, 1995. Changes in methods
of accounting necessary as a result of the rules in Secs. 1.263A-8
through 1.263A-15 must be made under the terms and conditions
prescribed by the Commissioner. Under these terms and conditions, the
principles of Sec. 1.263A-7T(e) generally must be applied in revaluing
inventory property.
(2) For taxable years beginning before January 1, 1995, taxpayers
must take reasonable positions on their federal income tax returns when
applying section 263A(f). For purposes of this paragraph (a)(2), a
reasonable position is a position consistent with the temporary
regulations, revenue rulings, revenue procedures, notices, and
announcements concerning section 263A applicable in taxable years
beginning before January 1, 1995. See Sec. 601.601(d)(2)(ii)(b) of this
chapter. For this purpose, Notice 88-99, 1988-2 C.B. 422, applies to
taxable years beginning after August 17, 1988, in the case of
inventory, and to interest incurred in taxable years beginning after
August 17, 1988, in all other cases. Finally, under administrative
procedures issued by the Commissioner, taxpayers may elect early
application of Secs. 1.263A-8 through 1.263A-15 to taxable years
beginning on or after January 1, 1994, in the case of inventory
property, and to interest incurred in taxable years beginning on or
after January 1, 1994, in the case of property that is not inventory in
the hands of the taxpayer.
(b) Transitional rule for accumulated production expenditures--(1)
In general. Except as provided in paragraph (b)(2) of this section,
costs incurred before the effective date of section 263A are included
in accumulated production expenditures (within the meaning of
Sec. 1.263A-11) with respect to noninventory property only to the
extent those costs were required to be capitalized under section 263
when incurred and would have been taken into account in determining the
amount of interest required to be capitalized under former section 189
(relating to the capitalization of real property interest and taxes) or
pursuant to an election that was in effect under section 266 (relating
to the election to capitalize certain carrying charges).
(2) Property used to produce designated property. The basis of
property acquired prior to 1987 and used to produce designated
noninventory property after December 31, 1986, is included in
accumulated production expenditures in accordance with Sec. 1.263A-
11(d) without regard to whether the basis would have been taken into
account under former section 189 or section 266.
(c) Anti-abuse rule. The interest capitalization rules contained in
Secs. 1.263A-8 through 1.263A-15 must be applied by the taxpayer in a
manner that is consistent with and reasonably carries out the purposes
of section 263A(f). For example, in applying Sec. 1.263A-10, regarding
the definition of a unit of property, taxpayers may not divide a single
unit of property to avoid property classifying the property as
designated property. Similarly, taxpayers may not use loans in lieu of
advance payments, tax-exempt parties, loan restructurings at
measurement dates, or obligations bearing an unreasonably low rate of
interest (even if such rate equals or exceeds the applicable Federal
rate under section 1274(d)) to avoid the purposes of section 263A(f).
For purposes of this paragraph (c), the presence of back-to-back loans
with different rates of interest, and other uses of related parties to
facilitate an avoidance of interest capitalization, evidences abuse. In
such cases, the District Director may, based upon all the facts and
circumstances, determine the amount of interest that must be
capitalized in a manner that is consistent with and reasonably carries
out the purposes of section 263A(f).
Par. 6. Section 1.266-1(a) is redesignated as Sec. 1.266-1(a)(1)
and Sec. 1.266-1(a)(2) is added to read as follows:
Sec. 1.266-1 Taxes and carrying charges chargeable to capital account
and treated as capital items.
(a) * * *
(1) * * *
(2) See Secs. 1.263A-8 through 1.263A-15 for rules regarding the
requirement to capitalize interest, that apply prior to the application
of this section. After applying Secs. 1.263A-8 through 1.263A-15, a
taxpayer may elect to capitalize interest under section 266 with
respect to designated property within the meaning of Sec. 1.263A-8(b),
provided a computation under any provision of the Internal Revenue Code
is not thereby materially distorted, including computations relating to
the source of deductions.
* * * * *
Par. 7. Section 1.1502-13 is amended by adding a sentence to the
end of paragraph (c)(1)(i), and by adding a sentence to the end of
paragraph (c)(2), to read as follows:
Sec. 1.1502-13 Intercompany transactions.
* * * * *
(c) * * *
(1) * * * (i) * * * See, however, paragraph (c)(2) of this section
for determining the amount of deferred gain or loss on a deferred
intercompany transaction that involves interest capitalized under
section 263A(f).
* * * * *
(2) * * * Additionally, see section 263A(f) and the regulations
thereunder to determine the amount of deferred gain or loss on a
deferred intercompany transaction that involves interest capitalized
under section 263A(f).
* * * * *
PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT
Par. 8. The authority citation for part 602 continues to read as
follows:
Authority: 26 U.S.C. 7805.
Par. 9. Section 602.101(c) is amended by adding entries in
numerical order to the table to read as follows:
Sec. 1.602.101 OMB Control numbers.
* * * * *
(c) * * *
------------------------------------------------------------------------
Current OMB
CRF part or section where identified and described control No.
------------------------------------------------------------------------
*****
1.263A-8(b)(2)(iii)..................................... 1545-1265
1.263A-9(d)(1).......................................... 1545-1265
1.263A-9(f)(1)(ii)...................................... 1545-1265
1.263A-9(f)(2)(iv)...................................... 1545-1265
1.263A-9(g)(2)(iv)(C)................................... 1545-1265
1.263A-9(g)(3)(iv)...................................... 1545-1265
*****
------------------------------------------------------------------------
Dated: December 13, 1994.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved:
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 94-31431 Filed 12-28-94; 8:45 am]
BILLING CODE 4830-01-P-M
