[Federal Register Volume 64, Number 99 (Monday, May 24, 1999)]
[Proposed Rules]
[Pages 27936-27941]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-12898]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-113910-98]
RIN 1545-AW54
Special Rules Regarding the Simplified Production and Resale
Methods with Historic Absorption Ratio Election
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
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SUMMARY: This document contains proposed regulations under section 263A
that relate to accounting for costs incurred in producing property and
acquiring property for resale. The proposed regulations are necessary
to address specific problems in the current section 263A regulations
and affect persons who elect to use the simplified production or resale
methods with historic absorption ratio election. This document also
provides notice of a public hearing on these proposed regulations.
DATES: Written and electronic comments must be received by August 23,
1999. Outlines of topics to be discussed at the public hearing
scheduled for September 1, 1999, at 10 a.m., must be received by August
11, 1999.
ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-113910-98), room
5226, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered Monday through
Friday between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-
113910-98), Courier's Desk, Internal Revenue Service, 1111 Constitution
Avenue, NW., Washington, DC. Alternatively, taxpayers may submit
comments electronically via the Internet by selecting the ``Tax Regs''
option on the IRS Home Page, or by submitting comments directly to the
IRS Internet site at http://www.irs.ustreas.gov/tax__regs/
regslist.html. The public hearing will be held in room 2615, Internal
Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Jennifer
Nuding, (202) 622-4970; concerning submissions of comments, the
hearing, and/or to be placed on the building access list to attend the
hearing, LaNita Van Dyke at (202) 622-7180 (not toll-free calls).
SUPPLEMENTARY INFORMATION:
Background
Section 263A provides uniform rules for capitalization of certain
expenses. Section 263A requires the capitalization of the direct, and
an allocable portion of the indirect, costs of real or tangible
personal property produced by a taxpayer or real and personal property
described in section 1221(1) that is acquired by the taxpayer for
resale. The rules under section 263A, which were added by the Tax
Reform Act of 1986, Public Law 99-514, section 803, 100 Stat. 2085,
2350, were designed, in part, to properly match income with related
expenses and, thus, more accurately reflect income. They also were
intended to make the tax system more neutral by eliminating the
differences in capitalization rules that created distortions in the
allocation of economic resources and the manner in which certain
economic activity was organized. See S. Rep. No. 313, 99th Cong., 2d
Sess. 140 (1986), 1986-3 C.B. Vol. 3 140. However, the legislative
history provides authority to the Secretary to prescribe simplifying
methods and assumptions where the costs and other burdens of literal
compliance with section 263A may outweigh the benefits of the provision
(e.g., matching and neutrality). S. Rep. No. 313, 99th Cong., 2d Sess.
142 (1986).
Section 263A costs are the costs that a taxpayer must capitalize
under section 263A and equal the sum of a taxpayer's section 471 costs,
its additional section 263A costs, and interest capitalizable under
section 263A(f). Additional section 263A costs are the costs, other
than interest, that were not capitalized under the taxpayer's method of
accounting immediately prior to the effective date of section 263A, but
that are required to be capitalized under section 263A.
Sections 1.263A-1 through 1.263A-3 of the final regulations (T.D.
8482) were published in the Federal Register for August 9, 1993 (58 FR
42207) and amended by T.D. 8559 (59 FR 39958), T.D. 8584 (59 FR 67187),
T.D. 8597 (60 FR 36671), T.D. 8728 (62 FR 42051) and T.D. 8729 (62 FR
44542). The final regulations provide simplified methods for
determining the additional section 263A costs properly allocable to
eligible property on hand at the end of the taxable year, including
ending inventories of property produced and property acquired for
resale. The final regulations include the simplified production method
contained in the temporary regulations issued under 263A, Sec. 1.263A-
1T(b)(5), T.D. 8131 (58 FR 151), and the simplified resale method, a
redesignation of the modified resale method set forth in Notice 89-67,
1989-1 C.B. 723. A taxpayer using either the simplified production
method or the simplified resale method determines the additional
section 263A costs properly allocable to eligible property on hand at
the end of the taxable year by multiplying its absorption ratio by the
section 471 costs on hand at year-end. Under both the simplified
production method and the simplified resale method, an absorption ratio
is calculated annually and applied to determine the additional section
263A costs allocated to ending inventory.
In response to requests for additional simplification, the final
regulations provide an election to use an historic absorption ratio to
determine additional section 263A costs allocable to eligible property
on hand at year-end that may be used in connection with either the
simplified production method or the simplified resale method.
The final regulations permit a taxpayer that properly elects to use
the historic absorption ratio to determine the additional section 263A
costs allocable to eligible property on hand at the end of the taxable
year by using an historic absorption ratio in lieu of an
[[Page 27937]]
actual absorption ratio, i.e., by multiplying the historic absorption
ratio by section 471 costs on hand at year-end. The historic absorption
ratio is based on costs capitalized by a taxpayer during its test
period, generally the three taxable-year period immediately prior to
the taxable year that the taxpayer elects the historic absorption
ratio. The historic absorption ratio equals the taxpayer's additional
section 263A costs incurred during the test period divided by the
section 471 costs incurred by the taxpayer during the test period.
Under the final regulations, taxpayers are required to test the
accuracy of the historic absorption ratio every six years. If the test
of the ratio indicates more than one-half of one percentage point
difference (plus or minus) from the historic absorption ratio, the
taxpayer must redetermine its historic absorption ratio using a new
updated test period. The final regulations provide that, if elected,
the historic absorption ratio must be used for each taxable year within
the qualifying period. Generally, the qualifying period includes each
of the first five taxable years beginning with the first taxable year
after a test period (or an updated test period).
Explanation of Provisions
This document contains proposed amendments to the Income Tax
Regulations (26 CFR part 1) that relate to the capitalization of
certain costs under section 263A. More specifically, this document
contains proposed amendments with respect to the historic absorption
ratio election that are necessary to carry out the purpose of section
263A. The rules under section 263A were designed to properly match
income with related expenses by requiring all of the costs relating to
an item produced or acquired for resale to be included in the basis or
inventoriable cost of that item. The simplified production method and
the simplified resale method were included in the regulations to
provide taxpayers with a simplified method for determining the
additional section 263A costs allocable to items on hand at year end.
The historic absorption ratio election was provided in response to
commentators' concerns that computations under the simplified
production method and the simplified resale method are costly and time
consuming because taxpayers must determine absorption ratios annually,
even though there may have been little or no change in the taxpayers'
business operations that would cause the absorption ratios to vary from
year to year.
The historic absorption ratio election in the final regulations is
intended to permit taxpayers to determine additional section 263A costs
allocable to items on hand at year-end without calculating actual
absorption ratios while still capitalizing the costs properly allocable
to property produced or acquired for resale. The historic absorption
ratio was selected in lieu of an industry-based ratio because the IRS
and Treasury Department believed that a ratio based on taxpayer
specific historical data would more reasonably approximate the
taxpayer's annual absorption ratio than an industry-based ratio.
The IRS and Treasury Department have become aware that the historic
absorption ratio may become materially inaccurate generally as the
result of a significant change in a taxpayer's circumstances during the
qualifying period, thus resulting in a failure to allocate the proper
amount of additional section 263A costs to items on hand at year-end.
Although the regulations provide that a taxpayer must test its historic
absorption ratio every six years, a significant deviation from the
taxpayer's actual absorption ratio could result in a substantial
mismatching of the taxpayer's income and related expenses during the
qualifying period.
The IRS and Treasury Department considered many alternate
approaches to revising the historic absorption ratio regulations in
order to prevent a substantial mismatching of income and related
expenses. Among the approaches considered and rejected were the
following: (1) Eliminate the historic absorption ratio election
entirely; (2) limit use of the historic absorption ratio election to
small taxpayers; (3) require taxpayers to retest their historic
absorption ratio more frequently, e.g., every three years; and (4)
provide a general anti-abuse rule.
These proposed regulations provide for early termination of the
qualifying period if the taxpayer's historic absorption ratio is
materially inaccurate. In such a case, the taxpayer must calculate a
new historic absorption ratio beginning with the year in which the
taxpayer's historic absorption ratio became materially inaccurate.
Generally, a taxpayer's historic absorption ratio may become
materially inaccurate when the taxpayer experiences a significant
change in the taxpayer's normal business operations and that change has
an effect on the taxpayer's section 263A absorption ratio. For example,
the following changes may cause a taxpayer's historic absorption ratio
to become materially inaccurate: a significant change in the taxpayer's
manufacturing process, e.g. implementation of a new inventory
management system; a significant change in the taxpayer's product
offering; a significant addition or retirement of equipment used for
manufacturing; a significant change in the taxpayer's components of
cost, e.g., a manufacturing operation that becomes significantly more
or less labor intensive; a significant change in the taxpayer's
overhead costs, e.g. a new plant, building or building addition; and a
significant change in the taxpayer's trade or business, e.g., the sale
or acquisition of a division.
The proposed regulations establish a high threshold for when the
historic absorption ratio will be regarded as materially inaccurate.
The regulations provide a definition of materially inaccurate that
incorporates both a percentage test and a specific dollar amount test.
The regulations provide that the historic absorption ratio is
materially inaccurate if: (1) the taxpayer's actual absorption ratio
deviates by more than 50% and by more than one-half of one percentage
point from the taxpayer's historic absorption ratio; and (2) the amount
of additional section 263A costs capitalizable to items on hand at
year-end using the actual absorption ratio deviates by more than
$100,000 from the amount of additional section 263A costs capitalizable
to items on hand at year-end using the historic absorption ratio. This
high threshold is provided so that annual actual absorption ratio
computations will be unnecessary in the overwhelming majority of
situations. For example, the placement in service of a significant
amount of property may have a significant effect on a taxpayer's actual
absorption ratio. However, it may not be necessary for a taxpayer to
compute its actual absorption ratio for a year that the taxpayer placed
property in service if, based on the taxpayer's knowledge of the
difference between its tax depreciation and book depreciation, and its
inventory turnover, the taxpayer knows that it would be impossible for
the amount of additional section 263A costs allocable to items on hand
at year-end to increase by $100,000 if the taxpayer used the simplified
production method without the historic absorption ratio election.
Therefore, the taxpayer would not need to calculate an actual
absorption ratio for that year.
Proposed Effective Date
The provisions of these regulations are proposed to be effective
for taxable years beginning after May 24, 1999.
[[Page 27938]]
Special Analyses
It has been determined that this notice of proposed rulemaking 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) does not apply to
these regulations, and because the regulations do not impose a
collection of information on small entities, the Regulatory Flexibility
Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of
the Internal Revenue Code, this notice of proposed rulemaking will be
submitted to the Chief Counsel for Advocacy of the Small Business
Administration for comment on its impact on small business.
Comments and Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any written comments (a signed original
and eight (8) copies) and electronic comments that are submitted timely
to the IRS. The IRS and Treasury Department request comments on the
clarity of the proposed rules and how they can be made easier to
understand. All comments will be available for public inspection and
copying.
A public hearing has been scheduled for Wednesday, September 1,
1999, in room 2615, Internal Revenue Building, 1111 Constitution
Avenue, NW., Washington, DC. Due to building security procedures,
visitors must enter at the 10th Street entrance, located between
Constitution and Pennsylvania Avenues, NW. In addition, all visitors
must present photo identification to enter the building. Because of
access restrictions, visitors will not be admitted beyond the immediate
entrance area more than 15 minutes before the hearing starts. For
information about having your name placed on the building access list
to attend the hearing, see the FOR FURTHER INFORMATION CONTACT section
of this preamble.
The rules of 26 CFR 601.601(a)(3) apply to the hearing.
Persons who wish to present oral comments at the hearing must
submit written or electronic comments by August 23, 1999 and submit an
outline of the topics to be discussed and the time to be devoted to
each topic (a signed original and eight (8) copies) by August 11, 1999.
A period of 10 minutes will be allocated to each person for making
comments.
An agenda showing the scheduling of the speakers will be prepared
after the deadline for receiving outlines has passed. Copies of the
agenda will be available free of charge at the hearing.
Drafting Information: The principal author of these regulations is
Jennifer Nuding of the Office of Assistant Chief Counsel (Income Tax
and Accounting). However, other personnel from the IRS and Treasury
Department participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.263A-2 is amended as follows:
1. Paragraphs (b)(4)(ii)(C)(1) and (2) are revised;
2. New paragraphs (b)(4)(ii)(C)(3) and (4) are added;
3. Paragraph (b)(4)(vi) is amended by:
a. Revising the paragraph heading and introductory text;
b. Redesignating the Example as Example 1;
c. Adding new Example 2 and Example 3.
The revisions and additions read as follows:
Sec. 1.263A-2 Rules relating to property produced by the taxpayer.
* * * * *
(b) * * *
(4) * * *
(ii) * * *
(C) Qualifying period--(1) In general. A qualifying period
generally includes each of the first five taxable years beginning with
the first taxable year after a test period (or an updated test period).
However, a qualifying period may be extended under the provisions of
paragraph (b)(4)(ii)(C)(2) of this section or may terminate early under
the provisions of paragraph (b)(4)(ii)(C)(3) of this section.
(2) Extension of qualifying period. In the first taxable year
following the close of each qualifying period, (e.g., the sixth taxable
year following the test period), the taxpayer must compute the actual
absorption ratio under the simplified production method. If the actual
absorption ratio computed for this taxable year (the recomputation
year) is within one-half of one percentage point (plus or minus) of the
historic absorption ratio used in determining capitalizable costs for
the qualifying period (e.g., the previous five taxable years), the
qualifying period is extended to include the recomputation year and the
following five taxable years (or a shorter period if the qualifying
period is terminated early under the provisions of paragraph
(b)(4)(ii)(C)(3) of this section), and the taxpayer must continue to
use the historic absorption ratio throughout the extended qualifying
period. If, however, the actual absorption ratio computed for the
recomputation year is not within one-half of one percentage point (plus
or minus) of the historic absorption ratio, the taxpayer must use
actual absorption ratios beginning with the recomputation year under
the simplified production method and throughout the updated test
period. The taxpayer must resume using the historic absorption ratio
(determined with reference to the updated test period) in the third
taxable year following the recomputation year.
(3) Earlier termination of the qualifying period. For taxable years
beginning after May 24, 1999, a qualifying period closes immediately
prior to a taxable year in which the taxpayer's historic absorption
ratio becomes materially inaccurate (early recomputation year). If the
taxpayer's historic absorption ratio is materially inaccurate, as
defined in paragraph (b)(4)(ii)(C)(4) of this section, the taxpayer
must use its actual absorption ratios computed using the simplified
production method beginning with the early recomputation year and
throughout the updated test period. The taxpayer must resume using the
historic absorption ratio (determined with reference to the updated
test period) in the third taxable year following the early
recomputation year.
(4) Materially inaccurate. For purposes of this paragraph (b)(4), a
historic absorption ratio becomes materially inaccurate in a taxable
year that--
(i) The taxpayer's actual absorption ratio computed using the
simplified production method deviates by more than 50 percent and by
more than one-half of one percentage point from the taxpayer's historic
absorption ratio for that year; and
(ii) The amount of additional section 263A costs capitalizable to
eligible property remaining on hand at the close of that year under the
simplified production method (using the taxpayer's actual absorption
ratio) deviates by more than $100,000 from the amount of
[[Page 27939]]
additional section 263A costs capitalizable to that property under the
simplified production method with historic absorption ratio election
for that year.
* * * * *
(vi) Examples. The provisions of this paragraph (b)(4) are
illustrated by the following examples:
Example 1. * * *
Example 2. (i) Taxpayer K uses the FIFO method of accounting for
inventories and properly elects to use the historic absorption ratio
with the simplified production method for 1998. K identifies the
following costs incurred during the test period:
1995:
Add'l section 263A costs--$3,500,000 Section 471 costs--
$75,000,000
1996:
Add'l section 263A costs--$4,000,000 Section 471 costs--
$80,000,000
1997:
Add'l section 263A costs--$4,500,000 Section 471 costs--
$85,000,000
(ii) Therefore, K computes a 5% historic absorption ratio as
follows:
[GRAPHIC] [TIFF OMITTED] TP24MY99.000
(iii) In 1998, K incurs $90,000,000 of section 471 costs of
which $15,000,000 remain in inventory at the end of the year. In
addition, K places $50,000,000 of plant and equipment into service.
K's book depreciation on the new plant and equipment is $5,000,000,
while K's tax depreciation on the new plant and equipment is
$10,000,000. K's book depreciation is a section 471 cost as
described in Sec. 1.263A-1(d)(2) and the excess of K's tax
depreciation over K's book depreciation, $5,000,000, is an
additional section 263A cost. K also has $4,500,000 in other
additional section 263A costs.
(iv) K must determine whether K's historic absorption ratio is
materially inaccurate in 1998. Under the simplified production
method without the historic absorption ratio election, K determines
its actual absorption ratio for 1998 as follows:
[GRAPHIC] [TIFF OMITTED] TP24MY99.001
(v) The difference between K's actual absorption ratio (10%)
under the simplified production method for 1998 and K's historic
absorption ratio (5%) is 5%, which is greater than 50 percent of K's
historic absorption ratio for that year (5% x 50% = 2.5%). Under the
simplified production method without the historic absorption ratio
election, K determines the additional section 263A costs allocable
to its ending inventory by multiplying its actual absorption ratio
(10%) by the section 471 costs remaining in its ending inventory as
follows:
Add'l section 263A costs = 10% x $15,000,000 = $1,500,000
(vi) Under the simplified production method using the historic
absorption ratio, K determines the additional section 263A costs
allocable to its ending inventory by multiplying its historic
absorption ratio (5%) by the section 471 costs remaining in its
ending inventory as follows:
Add'l section 263A costs = 5% x $15,000,000 = $750,000
(vii) The difference between the amount of additional section
263A costs allocable to eligible property remaining on hand at the
close of 1998 under the simplified production method using the
taxpayer's actual absorption ratio and the amount of additional
section 263A costs allocable to that property under the simplified
production method with historic absorption ratio election
($1,500,000-$750,000 = $750,000) exceeds $100,000. Accordingly, K's
historic absorption ratio is materially inaccurate for 1998.
(viii) Since K's historic absorption ratio is materially
inaccurate in 1998, K's qualifying period closes immediately prior
to the beginning of K's 1998 taxable year. Therefore, K must update
its test period beginning in 1998. K must use actual absorption
ratios under the simplified production method beginning in 1998 and
throughout the updated test period (1999 and 2000). K must resume
using the historic absorption ratio (determined with reference to
the updated test period) in 2001, the third taxable year following
1998.
Example 3. (i) Taxpayer L properly elects to use the historic
absorption ratio with the simplified production method for 1999. L
computes a 10% historic absorption ratio. On average, L's inventory
turns over approximately fifteen times a year.
(ii) In 1999, L incurs $8,000,000 of section 471 costs of which
$500,000 remain in inventory at the end of the year. In addition, L
places $5,000,000 of plant and equipment into service. The
difference between L's tax depreciation on the new plant and
equipment and L's book depreciation on that plant and equipment for
1999 is $500,000, which is an additional section 263A cost. There
were no other changes in L's additional 263A costs.
(iii) L can determine, without calculating an actual absorption
ratio, that its historic absorption ratio is not materially
inaccurate for 1999. The difference between the amount of additional
section 263A costs allocated to its ending inventory using its
actual absorption ratio and the amount of additional section 263A
costs allocated to its ending inventory using its historic
absorption ratio will not exceed $100,000 and, therefore, L does not
fall within the specific dollar amount test of paragraph
(b)(4)(ii)(C)(4)(ii) of this section. Although L's additional
section 263A costs increased by over $100,000 in 1999 (they
increased by $500,000) as a result of placing the plant and
equipment into service, only a portion of that amount will be
allocated to ending inventory. L's inventory turns over
approximately fifteen times a year. Of the $500,000 of additional
section 263A costs incurred as the result of placing the plant and
equipment into service in 1999, only about $33,000 ($500,000
15) will be allocated to ending inventory. Since $33,000 is
well below the $100,000 threshold, L can determine without
calculating an actual absorption ratio for 1999 that its historic
absorption ratio is not materially inaccurate. Since L's historic
absorption ratio is not materially inaccurate in 1999, L's
qualifying period does not terminate early.
* * * * *
Par. 3. Section 1.263A-3 is amended as follows:
1. Paragraphs (d)(4)(ii)(C)(1) and (2) are revised;
2. New paragraphs (d)(4)(ii)(C)(3) and (4) are added;
3. Paragraph (d)(4)(vi) is amended by:
a. Revising the paragraph heading and introductory text;
b. Redesignating the Example as Example 1;
c. Adding new Example 2.
The revisions and additions read as follows:
Sec. 1.263A-3 Rules relating to property acquired for resale.
* * * * *
(d) * * *
(4) * * *
(ii) * * *
(C) Qualifying period--(1) In general. A qualifying period
generally includes each of the first five taxable years beginning with
the first taxable year after a test period (or an updated test period).
However, a qualifying period may be extended under the provisions of
paragraph (d)(4)(ii)(C)(2) of this section or may terminate early under
the provisions of paragraph (d)(4)(ii)(C)(3) of this section.
[[Page 27940]]
(2) Extension of qualifying period. In the first taxable year
following the close of each qualifying period, (e.g., the sixth taxable
year following the test period), the taxpayer must compute the actual
combined absorption ratio under the simplified resale method. If the
actual combined absorption ratio computed for this taxable year (the
recomputation year) is within one-half of one percentage point (plus or
minus) of the historic absorption ratio used in determining
capitalizable costs for the qualifying period (e.g., the previous five
taxable years), the qualifying period is extended to include the
recomputation year and the following five taxable years (or a shorter
period if the qualifying period is terminated early under the
provisions of paragraph (d)(4)(ii)(C)(3) of this section), and the
taxpayer must continue to use the historic absorption ratio throughout
the extended qualifying period. If, however, the actual combined
absorption ratio computed for the recomputation year is not within one-
half of one percentage point (plus or minus) of the historic absorption
ratio, the taxpayer must use actual combined absorption ratios
beginning with the recomputation year under the simplified resale
method and throughout the updated test period. The taxpayer must resume
using the historic absorption ratio (determined with reference to the
updated test period) in the third taxable year following the
recomputation year.
(3) Earlier termination of the qualifying period. For taxable years
beginning after May 24, 1999, a qualifying period closes immediately
prior to a taxable year in which the taxpayer's historic absorption
ratio becomes materially inaccurate (early recomputation year). If the
taxpayer's historic absorption ratio is materially inaccurate, as
defined in paragraph (d)(4)(ii)(C)(4) of this section, the taxpayer
must use its actual combined absorption ratios computed using the
simplified resale method beginning with the early recomputation year
and throughout the updated test period. The taxpayer must resume using
the historic absorption ratio (determined with reference to the updated
test period) in the third taxable year following the early
recomputation year.
(4) Materially inaccurate. For purposes of this paragraph (d)(4), a
historic absorption ratio becomes materially inaccurate in a taxable
year that--
(i) The taxpayer's actual combined absorption ratio computed using
the simplified resale method deviates by more than 50 percent and by
more than one-half of one percentage point from the taxpayer's historic
absorption ratio for that year; and
(ii) The amount of additional section 263A costs capitalizable to
eligible property remaining on hand at the close of that year under the
simplified resale method (using the taxpayer's actual combined
absorption ratio) deviates by more than $100,000 from the amount of
additional section 263A costs capitalizable to that property under the
simplified resale method with historic absorption ratio election for
that year.
* * * * *
(vi) Examples. The provisions of this paragraph (d)(4) are
illustrated by the following examples:
Example 1. * * *
Example 2. (i) Taxpayer W operates a mail-order retail business
and uses the FIFO method of accounting for inventories. In 1996,
1997 and 1998, W used the simplified resale method without the
historic absorption ratio election with the variation permitted in
paragraph (d)(3)(iii)(A) of this section, exclusion of beginning
inventories from the denominator in the storage and handling costs
absorption ratio formula. Taxpayer W elects to use the historic
absorption ratio with the simplified resale method for 1999. W
identifies the following costs incurred during the test period:
1996:
Add'l section 263A costs--$2,000,000 Section 471 costs--
$45,000,000
1997:
Add'l section 263A costs--$2,500,000 Section 471 costs--
$50,000,000
1998:
Add'l section 263A costs--$3,000,000 Section 471 costs--
$55,000,000
(ii) Therefore, W computes a 5% historic absorption ratio as
follows:
[GRAPHIC] [TIFF OMITTED] TP24MY99.002
(iii) In 1999, W decides to automate part of its repackaging
activities. Accordingly, W places new repackaging equipment into
service. The repackaging equipment has a basis of $15,000,000 for
tax purposes. W's tax depreciation on the new equipment for 1999 is
$3,000,000. This depreciation allowance is an additional section
263A cost and is a handling cost as defined in paragraph (c)(4) of
this section. As a result of the new equipment, W's direct labor
costs with respect to its repackaging activities decrease by
$500,000 during 1999. In 1999, W incurs $60,000,000 of section 471
costs, of which $6,000,000 remain on hand at the end of the year. W
identifies $6,000,000 of storage and handling costs, including W's
tax depreciation on the new equipment and taking into account the
reduction in direct labor costs, and $450,000 of purchasing costs
incurred in 1999.
(iv) W must determine whether W's historic absorption ratio is
materially inaccurate in 1999. In order to do so, W calculates W's
actual combined absorption ratio for 1999 as follows:
[GRAPHIC] [TIFF OMITTED] TP24MY99.003
Combined absorption ratio = 10% + 0.75% = 10.75%
(v) The difference between W's actual combined absorption ratio
(10.75%) under the simplified resale method for 1999 and W's
historic absorption ratio (5%) is 5.75%, which is greater than 50
percent of W's historic absorption ratio for that year (5% x 50% =
2.5%). Under the simplified resale method without the historic
absorption ratio election, W determines the additional section 263A
costs allocable to its ending inventory by multiplying its actual
combined absorption ratio (10.75%) by the section 471 costs
remaining in its ending inventory as follows:
Add'l section 263A costs = 10.75% x $6,000,000 = $645,000
(vi) Under the simplified resale method using the historic
absorption ratio, W determines the additional section 263A costs
allocable to its ending inventory by multiplying its historic
absorption ratio (5%) by the section 471 costs remaining in its
ending inventory as follows:
Add'l section 263A costs = 5% x $6,000,000 = $300,000
(vii) The difference between the amount of additional section
263A costs allocable to eligible property remaining on hand at the
close of 1999 under the simplified resale
[[Page 27941]]
method using the taxpayer's actual combined absorption ratio and the
amount of additional section 263A costs allocable to that property
under the simplified resale method with historic absorption ratio
election ($645,000-$300,000 = $345,000) exceeds $100,000.
Accordingly, W's historic absorption ratio is materially inaccurate
for 1999.
(viii) Since W's historic absorption ratio was materially
inaccurate in 1999, W's qualifying period closes immediately prior
to the beginning of W's 1999 taxable year. Therefore, W must update
its test period beginning in 1999. W must use actual combined
absorption ratios under the simplified resale method beginning in
1999 and throughout the updated test period (2000 and 2001). W must
resume using the historic absorption ratio (determined with
reference to the updated test period) in 2002, the third taxable
year following 1999.
* * * * *
Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 99-12898 Filed 5-21-99; 8:45 am]
BILLING CODE 4830-01-U
