SERVICE ISSUES TEMPORARY GUIDANCE ON UNIFORM CAPITALIZATION RULES.

Notice 89-67

The purpose of this notice is to provide guidance regarding forthcoming regulations interpreting the uniform capitalization rules under section 263A of the Internal Revenue Code. Included in this notice is a discussion of the amendments to section 263A made by the Technical and Miscellaneous Revenue Act of 1988, Pub. L. No. 100-647 (the "1988 Act"). Finally, this notice, 89-67, provides clarification relating to certain issues raised in other guidance previously published under section 263A of the Code.

I. BACKGROUND

Section 263A of the Code, enacted by the Tax Reform Act of 1986, Pub. L. No. 99-514 (the "1986 Act") provides uniform capitalization rules that apply to the production of property and the acquisition of property for resale.

Proposed and temporary regulations interpreting section 263A of the Code were published in the Federal Register on March 31, 1987, and August 7, 1987 (T.D. 8131, 1987-1 C.B. 98; T.D. 8148, 1987-2 C.B. 70). A public hearing on the regulations was held on December 7, 1987. Notice 88-24, 1988-14 I.R.B. 6, contains guidance relating to the application of section 263A to property produced in the trade or business of farming. Notice 88-62, 1988-22 I.R.B. 50, provides an elective simplified method for deducting the business expenses of authors, photographers, artists, and other similarly situated persons who incur expenses in producing creative properties. Notice 88-78, 1988-28 I.R.B. 24, provides guidance to taxpayers that fail to change their method of accounting in order to conform to the uniform capitalization provisions of section 263A. Notice 88-86, 1988-34 I.R.B. 10, contains additional guidance on a number of issues that will be addressed in the final regulations under section 263A. Notice 88-99, 1988-36 I.R.B. 29, relates to the interest capitalization requirements of section 263A. Notice 88-104, 1988-38 I.R.B. 20, contains guidance relating to the application of section 263A to foreign persons.

II. AMENDMENTS TO SECTION 263A UNDER THE 1988 ACT.

(A) SIMPLIFIED RESALE METHOD.

Section 1008(b)(8) of the 1988 Act provides that, for purposes of the simplified resale method provided in the regulations under section 263A of the Code, the allocation formula used for apportioning storage costs and related handling costs may be determined by dividing the amount of such costs by the beginning inventory balances and the purchases made during the year and by multiplying the resulting allocation ratio by the amount of purchases that, under the taxpayer's method of accounting for inventories, are treated as remaining in ending inventory. The method provided in section 1.263A-lT(d)(4) of the Temporary Treasury Regulations includes in the denominator of the allocation ratio only the current year's purchases. Beginning inventory balances are excluded from the calculation of the allocation ratio in the simplified resale method contained in the temporary regulations. As discussed in the preamble to the temporary regulations (52 Fed. Reg. 10055 (1987)), because under the simplified resale method the allocation ratio is not applied to purchases in ending inventory that are not treated as acquired during the current year (i.e., beginning inventory balances), beginning inventory balances are similarly excluded from the ratio to provide consistency in the treatment of such balances for purposes of the simplified resale method.

An alternative simplified resale method was provided in Notice 88-86. Under the alternative simplified resale method, beginning inventory balances are included in the denominator of the allocation ratio, and the allocation ratio is applied to the taxpayer's total ending inventory, including amounts that were included in beginning inventory for the current year.

The temporary regulations will be amended to provide that, effective for taxable years beginning after December 31, 1986, taxpayers may elect the "modified resale" method permitted by section 1008(b)(8) of the 1988 Act. For purposes of section 263A of the Code, the election to use the modified resale method is a method of accounting and, except as provided in this notice, a change to or from the modified resale method is a change in method of accounting that requires the consent of the Commissioner. Other than the calculation of the allocation ratio, as provided herein, the application of the modified resale method shall be made in accordance with all of the provisions of section 1.263A-1T of the regulations.

In calculating the allocation ratio, for purposes of both the alternative simplified method and the modified resale method, beginning inventory amounts included in the denominator by a taxpayer using the last-in, first-out (LIFO) method of accounting for inventories are to be stated using the LIFO carrying value of such inventory and shall not be stated in current year dollars. Once the allocation ratio is determined, section 1.263A-lT(d)(4)(v) of the regulations provides that, if the taxpayer determines that there has been an inventory increment for the current year, then the taxpayer shall state the amount of the increment in current year dollars and multiply the resulting amount by the allocation ratio.

EXAMPLE.

          Base-year     LIFO      LIFO       Inflator      Current

A taxpayer electing the modified resale method for its first taxable year ending after December 5, 1989 shall effect such election by applying the modified resale method in calculating the amount of additional section 263A costs required to be capitalized beginning with the year of change on a cut-off basis; i.e., without restating beginning balances for the year of change, and without any corresponding adjustment under section 481(a) for any year, if and only if the previous method used by the taxpayer for prior taxable years for which 263A was effective was a correct method of accounting under section 263A and the regulations thereunder.

A taxpayer electing the modified resale method for its first taxable year beginning after December 31, 1986, shall effect such election by filing returns amended to reflect the election of the modified resale method, for the taxpayer's first taxable year beginning after December 31, 1986, and any subsequent year for which a Federal income tax return has already been filed. (Section III(A) of this Notice 89-67 contains the deadline for filing an amended return for any such year). In filing amended returns for the purpose of electing the modified resale method, taxpayers shall recompute the adjustment under section 481(a) of the Code determined by revaluing inventory on hand at the beginning of the year of change pursuant to the provisions of section 1.263A-1T(e) of the regulations as if the modified resale method had been applied during all relevant prior periods.

The provisions of this section apply only to any taxpayer eligible to elect the simplified resale method or the alternative simplified resale method under section 1.263A-lT of the regulations, regardless of whether the taxpayer has elected either method for any taxable year.

(B) FREE-LANCE AUTHORS, PHOTOGRAPHERS, AND ARTISTS.

The uniform capitalization rules of section 263A of the Code apply to the production of all tangible personal property and to the acquisition of property for resale. "Tangible personal property" includes a film, sound recording, video tape, book, or similar property. Thus, for example, publishers and authors must capitalize the cost of researching, preparing, and writing literary works.

In Notice 88-62, the Internal Revenue Service provided an elective safe harbor method of accounting for "qualified costs" incurred by certain authors, photographers, artists, and other similarly situated individuals who incur expenses in producing creative properties. Under this method, eligible taxpayers may aggregate and capitalize all qualified creative costs incurred during each taxable year and may deduct 50 percent of such aggregate costs in the year they are incurred and 25 percent of such costs in each of the two succeeding years.

Section 6026(a) of the 1988 Act provides an exemption from the capitalization provisions of section 263A of the Code for "qualified creative expenses" incurred by free-lance authors, photographers, and artists, in the trade or business of being a writer, author, photographer or artist. "Qualified creative expenses" are any expenses which are otherwise deductible and which are paid or incurred by an individual engaged in the business of being an author, photographer, or artist. The exemption applies to an individual whose personal efforts create (or may reasonably be expected to create) a literary manuscript, musical composition, dance score, photograph, photographic negative or transparency, picture, painting, sculpture, statue, etching, drawing, cartoon, graphic design, or original print edition. The originality and uniqueness of the item created (or to be created) and the predominance of aesthetic value over utilitarian value of the item created (or to be created) will be considered in determining whether a qualified creative expense is paid or incurred by an artist. Thus, for example, any expense that is paid or incurred in producing jewelry, silverware, pottery, furniture, and other similar household items generally will not be considered as being paid or incurred in the business of an individual being an artist.

The exemption for qualified creative expenses does not apply to any expenses incurred by an individual in his or her capacity as an employee. However, expenses paid or incurred by a personal service corporation that directly relate to the activities of a qualified employee-owner qualify for the exception to the uniform capitalization rules to the extent that expenses would qualify if paid or incurred directly by the employee-owner. The exemption under section 6026(a) of the 1988 Act does not apply to any expense that is related to printing, photographic plates, motion picture films, sound recordings, video tapes, or similar items.

The exemption provided for qualified creative expenses in section 6026(a) of the 1988 Act is retroactive and effective as if included in the Tax Reform Act of 1986. Eligible taxpayers (including taxpayers who elected the safe harbor method provided in Notice 88-62 for any taxable year) may change from the method of accounting required under section 263A of the Code to any other method of accounting permitted under the Code for the costs incurred in the trade or business of such taxpayers by either (1) applying the provisions of section 6026(a) of the 1988 Act beginning with the first taxable year for which section 263A applied to the taxpayer (Section III(A) of this Notice 89-67 contains the deadline for filing an amended return for any such year), or (2) applying the provisions of section 6026(a) of the 1988 Act for its first Federal income tax return filed after the date September 5, 1989, or, if the taxpayer wishes, with a return filed before such date]. Costs capitalized by a taxpayer described in clause (2) in any return filed before the return described in the preceding sentence shall continue to be treated as capitalized costs and shall be recovered using the taxpayer's method of accounting for the recovery of such capitalized costs, e.g., the income forecast method or, if elected, the safe harbor method provided in Notice 88-62.

(C) CERTAIN PRODUCERS OF ANIMALS IN A FARMING BUSINESS.

The uniform capitalization provisions of section 263A of the Code apply to the production, growing, or raising of property in the trade or business of farming. As enacted by the 1986 Act, the uniform capitalization rules apply to plants and animals produced by a taxpayer in a farming business if (1) the plants or animal has a preproductive period of more than two years, or (2) the taxpayer engaged in the farming business is a corporation, partnership, or tax shelter that is required to use an accrual method of accounting.

Section 6026(b) of the 1988 Act exempts from the application of the uniform capitalization rules expenses incurred by a taxpayer in connection with the production of animals in an eligible farming business. An eligible farming business is a farming business which is not a corporation, partnership, or tax shelter that is required to use an accrual method of accounting under sections 447 or 448(a)(3). This exemption is prospective and applies only to costs incurred after December 31, 1988, in taxable years ending after such date. The exemption does not apply to costs incurred with respect to plants.

In Notice 88-24, the Internal Revenue Service provided an elective simplified method for capitalizing the costs of raising female cattle that are to be used principally for purposes of breeding ("beef cattle") or for purposes of producing milk to be sold for consumption ("dairy cattle"). Under this method, available only to taxpayers other than those required to use an accrual method of accounting, a total of $340 for each beef cow, or $540 for each dairy cow, is to be capitalized over a period of three years beginning with the year in which the cow is born.

A taxpayer that elected, under section 263A(d)(3), not to apply the uniform capitalization rules to its farming business for a taxable year beginning before January 1, 1989, may, without the consent of the Commissioner, revoke such election for the taxpayer's first taxable year beginning after December 31, 1988. A taxpayer that initially elected not to apply the uniform capitalization rules for any taxable years beginning before January 1, 1989, must continue to apply the alternative depreciation method provided in section 168(g)(2) to property placed in service during such years. With respect to property placed in service in taxable years ending after December 31, 1988, an eligible taxpayer is not required to apply the alternative depreciation method, and may use any other depreciation method permissible with respect to such property, without obtaining the consent of the Commissioner. For costs incurred after December 31, 1988, the determination of whether costs are deductible shall be made under all other applicable provisions of the Code. A taxpayer that elected the safe harbor values provided in Notice 88-24 shall continue to amortize the costs capitalized in taxable years beginning before January 1, 1989, using the taxpayer's depreciation method applicable to such costs.

In the case of a taxpayer that elected the safe harbor method provided in Notice 88-24 and whose taxable year begins before December 31, 1988, and ends after January 1, 1989, the taxpayer may account for the costs incurred in such taxable year in one of two ways:

(1) The taxpayer may account for costs incurred using the safe harbor values for the entire taxable year, without regard to whether costs were incurred on, before or after January 1, 1989, or

(2) the taxpayer may account for costs incurred using the safe harbor values for the portion of its taxable year that includes only the number of months before January 1, 1989, and account for costs incurred on or after January 1, 1989, using the taxpayer's method of accounting for costs available under the applicable provisions of the Code other than section 263A. Thus, for example, a dairy farmer having a fiscal year ending on June 30, 1989, would account for costs using the safe harbor values for the first six months of its taxable year: 6/12 x $135 for each cow born during the taxpayer's current taxable year, 6/12 x $270 for each cow born in the taxpayer's taxable year ending June 30, 1988, and 6/12 x $135 for each cow born in the taxpayer's taxable year ending, June 30, 1987. Section 263A (or the safe-harbor values) would not apply to costs incurred after December 31, 1988.

III. CLARIFICATION OF ISSUES.

(A) EXTENSION OF FILING DATES FOR AMENDED RETURNS UNDER NOTICE 88-78, NOTICE 88-86, NOTICE 88-99, AND NOTICE 89-67.

In order to minimize the administrative complexities that may be involved in complying with the additional guidance issued under section 263A of the Code, the dates by which an amended return filed for the purpose of changing a method of accounting in accordance with the provisions of Notice 88-78, Notice 88-86, Notice 88-99, or this notice, Notice 89-67 shall be extended, and the same date shall apply with respect to all notices. The date by which amended Federal income tax returns, for purposes of Notice 88-78, Notice 88-86, Notice 88-99, or this notice, Notice 89-67 must be filed is the later of (i) the due date (determined with regard to extensions) of the taxpayer's income tax return for the second taxable year that begins (or is deemed to begin) after December 31, 1986, or (ii) October 16, 1989. All terms and conditions (other than the date by which an amended return must be filed) contained in each of the above notices remain in effect with respect to each particular change in method of accounting provided in the applicable notice. Except as specifically provided to the contrary, any change in method of accounting with respect to a taxpayer's inventory for the year of change (generally, its first taxable year beginning after December 31, 1986), made in accordance with the provisions of the temporary regulations or notices issued under section 263A, is to be included in the taxpayer's calculation of the adjustment under section 481(a) pursuant to the automatic change in method of accounting to comply with section 263A provided in section 1.263A-lT(e) of the temporary regulations. Any amount that is required or permitted, for purposes of section 263A, to be included in the taxpayer's calculation of the adjustment under section 481(a) shall be taken into account in accordance with the provisions of section 1.263A-lT(e). However, if the taxpayer is under examination and receives written notification from the examiner that the method to be changed is an issue under consideration, and such notice is given prior to the taxpayer's timely filing of the Federal income tax return (including an amended return) for the year of change, the provisions of section 1.263A- lT(e) may not apply. Other administrative provisions such as Rev. Proc. 84-74, 1984-2 C.B. 736, or Notice 88-78 may instead be applicable.

(B) TAXPAYERS SUBJECT TO THE COORDINATED EXAMINATION PROGRAM.

A taxpayer that is subject to the Coordinated Examination Program (CEP), for its first taxable year for which section 263A applies, and that has filed a Federal income tax return for such year will not be required to file an amended return, which, but for this paragraph (B), would be required in order to effect a change in method of accounting for purposes of Notice 88-78, Notice 88-86, Notice 88-99, Notice 88-104, or this notice, Notice 89-67, if the following conditions are met:

(i) The first taxable year for which section 263A applies shall be treated as the year of change for all purposes. Thus, in the case of inventory property, the adjustment under section 481(a) shall be redetermined as if the method of accounting adopted pursuant to one of the designated notices has been used by the taxpayer for all prior periods.

(ii) The taxpayer types or legibly prints on its timely filed (including extensions) Federal income tax return for the first taxable year after the year of change, a statement indicating that the taxpayer applied the procedures of Rev. Proc. 85-26, 1985-1 C.B. 580, (or any successor rulings or procedures), to effectuate the change in method of accounting for the preceding year (the year of change).

(iii) In its timely filed (including extensions) Federal income tax return for the first taxable year after the year of change (and any subsequent year for which the method is in effect), the taxpayer reports all items in accordance with the method of accounting adopted pursuant to one of the designated notices as if the method had been used by the taxpayer for the year of change and any subsequent year, including a redetermination of the portion of the adjustment under section 481(a) (where applicable) to be taken into account for each subsequent taxable year.

(iv) The taxpayer satisfies all requirements of Rev. Proc. 85-26 and any other administrative rules applicable to a taxpayer subject to the CEP.

(C) CAPITALIZATION OF PERIOD COSTS.

Under section IV(E) of Notice 88-86, taxpayers are permitted to capitalize costs that otherwise would be treated as period costs, if such practice does not result in a material distortion of income; such costs are included in computing beginning inventory, ending inventory, and cost of goods sold; and the taxpayer consistently capitalizes such costs, treating the practice as a method of accounting under the Code. A cost may not be capitalized under section 263A with respect to production or resale property if no portion of such cost relates to the taxpayer's production or resale activity, or if the capitalization (or deduction) of such cost is prohibited by any other section of the Code. For example, because selling expenses, losses, or other items are not ordinarily used in computing the cost of goods sold, such costs may not be included in inventoriable costs for purposes of section 1.61-3(a) of the regulations, and, accordingly, such costs may not be capitalized with respect to property for purposes of section 263A of the Code. (For an exception to this rule, see Notice 88-99, relating to the capitalization of certain costs for purposes of the substitute cost method.)

A taxpayer may capitalize certain period costs if such capitalization does not result in a material distortion. For this purpose, a period cost may not be capitalized under section 263A of the Code if such capitalization results in a material distortion of a computation under any provision of the Code, including material distortions relating to the source, character, amount, or timing of the cost capitalized. Thus, for example, a taxpayer may not capitalize a period cost under section 263A of the Code if the capitalization would result in a material change in the computation of the foreign tax credit limitation under section 904 of the Code. In addition, the capitalization of interest that is not allocable to production activities under the avoided cost method of section 263A(f) generally results in a material distortion of income.

(D) EXPEDITED PROCEDURES UNDER SECTION VI OF NOTICE 88-86.

A number of comments have been received by the Service with respect to the availability of the expedited procedures contained in section VI (Expedited Changes in Methods of Accounting), of Notice 88-86. In Notice 88-86, the expedited procedures for effecting a change in method of accounting are available only with respect to certain provisions specified in the notice. (It should be noted that Notice 88-86 does not apply to any change for which the taxpayer applies, or is required to apply, the provisions of Notice 88-78.) Paragraph (1) of Section VI of Notice 88-86 contains details regarding expedited procedures applicable to a change in method of accounting beginning with the first taxable year in which section 263A is effective and requires an adjustment to the amount calculated under section 481(a) for such year. Expedited changes made according to paragraph (2) are available for the taxable year following the year of change, on a cut-off basis, without restating beginning balances for such year and without any corresponding section 481(a) adjustment. It has been suggested that these expedited procedures be made available to additional provisions contained in Notice 88-86. In response to these comments, Notice 88-86 is modified as follows --

(i) Only paragraph (1) of section VI of Notice 88-86 (and not paragraph (2)) is available with respect to the changes to the methods of accounting described in the following sections of Notice 88-86:

III(D) SERVICES VERSUS PROPERTY ACQUIRED FOR RESALE, but only to the extent that the rules discussed in the third and fourth paragraphs of Section III(D) would require the capitalization of costs with respect to the types of property described therein.

III(E) CAPITALIZATION OF HANDLING COSTS, but only to the extent of any change in method required as a result of the application of the rule relating to costs required to be capitalized at any facility, as discussed in the third paragraph of Section III(E).

III(F) DISTRIBUTION COSTS.

III(G) $10 MILLION GROSS RECEIPTS EXCEPTION FOR CERTAIN TAXPAYERS, but only to the extent of any change in method required as a result of a determination that, due to the application of the rules discussed in Section III(G), the taxpayer is not entitled to the exception from the general rules of section 263A provided in section 263A(b)(2)(B).

IV(A) DEFERRED INTERCOMPANY TRANSACTIONS.

IV(C) INTANGIBLE AND TANGIBLE PROPERTY, but only to the extent that the taxpayer failed to apply the rules of section 263A with respect to intangible personal property acquired for resale.

IV(H) DEPLETION.

IV(I) PREPUBLICATION EXPENDITURES, but only to the extent that the taxpayer failed to capitalize payments made to authors other than payments that relate to sales of books that have already taken place.

IV(J) DUAL FUNCTION FACILITIES.

IV(K) MATERIALS AND SUPPLIES.

IV(M) STORAGE COSTS.

IV(N) LOWER OF COST OR MARKET.

(ii) In addition to the provisions for which the expedited procedures were initially available, both paragraphs (1) and (2) of section VI of Notice 88-86 shall be available with respect to the changes to the methods of accounting described in the following sections of Notice 88-86:

II(C) MANUFACTURERS AND ON-SITE STORAGE.

III(B) PROPERTY PRODUCED UNDER CONTRACT FOR SUBSEQUENT RESALE.

III(C) DE MINIMIS PRODUCTION ACTIVITIES.

III(D) SERVICES VERSUS PROPERTY ACQUIRED FOR RESALE, but only to the extent of any change in method permitted as a result of the de minimis rule provided in the second paragraph of Section III(D).

III(E) CAPITALIZATION OF HANDLING COSTS, but only to the extent of any change in method permitted as a result of the application of the rules relating to certain on-site labor costs described in the second paragraph of Section III(E).

III(G) $10 MILLION GROSS RECEIPTS EXCEPTION FOR CERTAIN TAXPAYERS, but only to the extent of any change in method of accounting resulting from a determination that, due to the application of the rules described in section III(G), the taxpayer is entitled to the exception from the general rules of section 263A provided in section 263A(b)(2)(B).

IV(C) INTANGIBLE AND TANGIBLE PROPERTIES, but only to the extent that a taxpayer applied the rules of section 263A to the production of personal property that pursuant to section IV(C) is not tangible personal property for purposes of section 263A.

IV(D) SERVICE DEPARTMENTS -- ACCOUNTS RECEIVABLE.

IV(G) WARRANTY COSTS AND PRODUCTS LIABILITY INSURANCE.

IV(I) PREPUBLICATION EXPENDITURES, but only to the extent that, for purposes of section 263A, the taxpayer capitalized payments made to authors that relate to sales of books that have already taken place.

IV(L) ALLOCATION METHODS AND DE MINIMIS RULE.

V(A) FARMERS AND CONSTRUCTIVE OWNERSHIP RULES.

(E) APPLICATION OF SECTION 263A TO FOREIGN PERSONS.

A simplified method of accounting for the additional costs required to be capitalized by foreign persons for purposes of the uniform capitalization rules of section 263A of the Code (the "U.S. ratio method") was provided in Notice 88-104. Under the U.S. ratio method, the additional costs (other than interest) required to be capitalized by the foreign person under section 263A are to be allocated to property produced or property acquired for resale by a foreign person by applying the "U.S ratio" of the "applicable U.S. trade or business" to the cost (as determined by the foreign person before the application of the rules of section 263A) of the property produced or property acquired for resale. Under the U.S. ratio method, no adjustment to the U.S. ratio of the applicable U.S. trade or business or to the costs (as determined before the application of the rules of section 263A) of property produced or property acquired for resale by the foreign person, is permitted.

Notice 88-104 limited the election of the U.S. ratio method to taxable years beginning before January 1, 1988. The provisions of Notice 88-104 are extended to taxable years beginning after December 31, 1987, and will remain in effect until further guidance under section 263A is issued. A taxpayer that did not elect the U.S. ratio method for its first taxable year for which section 263A is effective may elect to apply the U.S. ratio method: (i) on its Federal income tax return adopting the use of the U.S. ratio method (including any necessary revisions of adjustments under section 481(a)) for its first taxable year for which section 263A is effective, including a Federal income tax return amended for the purpose of electing the U.S. ratio method, or (ii) on its Federal income tax return for its second taxable year for which section 263A is effective, if and only if the previous method used by the taxpayer for the prior taxable year was a correct method of accounting under section 263A and the regulations thereunder.

It is anticipated that forthcoming regulations will permit a taxpayer to elect the U.S. ratio method as provided therein regardless of whether the U.S. ratio method was elected for previous taxable years. In addition, it is anticipated that a taxpayer that elected the U.S. ratio method prior to the publication of the regulations will be permitted to elect to discontinue use of the U.S. ratio method under rules provided in the regulations.

PROCEDURAL INFORMATION

This notice serves as an "administrative pronouncement" as that term is described in section 1.6661-3(b)(2) of the regulations and may be relied upon to the same extent as a revenue ruling or a revenue procedure.

FURTHER INFORMATION

For further information regarding this notice, please contact Ellen McElroy at (202) 566-4941 (not a toll-free call).