SERVICE PROVIDES FOREIGN PERSONS AN ELECTIVE SIMPLIFIED ACCOUNTING METHOD FOR COSTS REQUIRED TO BE CAPITALIZED.

Notice 88-104

The purpose of this notice is to advise taxpayers of forthcoming guidance that will provide an elective simplified method of accounting for the costs required to be capitalized by foreign persons under the uniform capitalization rules of section 263A of the Internal Revenue Code. The forthcoming guidance will provide a simplified method (the "U.S. ratio method") of accounting for costs other than interest that are required to be capitalized under section 263A of the Code. The U.S. ratio method, to the extent possible, will permit compliance with the rules of section 263A by making adjustments to data already compiled for financial accounting purposes.

The U.S. ratio method to be provided in the forthcoming guidance will not apply to the capitalization of interest expense that is required to be capitalized as production expenditures under section 263A(f) of the Code. A general discussion of the requirement to capitalize interest expense is contained in section 1.263A- 1T(b)(2)(iv) of the regulations. Additional guidance relating to the requirement to capitalize interest expense, including guidance with respect to related parties that are subject to the "avoided cost" concept for purposes of capitalizing interest expense, is contained in Notice 88-99, 1988-36 I.R.B.

BACKGROUND.

Section 263A, enacted by section 803 of the Tax Reform Act of 1986 (the "1986 Act") Pub. L. 99-514, 100 Stat. 2350, provides uniform capitalization rules that apply to costs incurred with respect to property produced and property acquired for resale. Temporary regulations under section 263A of the Code were published in the Federal Register on March 30, 1987, (52 FR 10052) and on August 7, 1987, (52 FR 29375).

EFFECTIVE DATE.

The preamble to the temporary regulations under section 1.263A- 1T, published on March 30, 1987, (52 FR 10059), provided that --

The provisions of section 263A (including the effective dates thereof) are applicable to all persons engaging in the production of property, or the acquisition of property for resale, including, for example, certain foreign persons which may be organized and operated exclusively outside the United States.

Thus, except as otherwise provided, such taxpayers are required to capitalize costs incurred after December 31, 1986, or, in the case of inventory property, costs incurred in taxable years beginning after December 31, 1986, in accordance with section 263A and the regulations thereunder (or, if elected, in accordance with the methods provided in this notice). Pub. L. 99-514, section 803(d), 100 Stat. 2356.

THE U.S. RATIO METHOD - GENERAL DISCUSSION.

Under the U.S. ratio method, the additional costs (other than interest) required to be capitalized by a foreign person under section 263A ("additional section 263A costs" as defined in section 1.263A-1T(b)(5)(iii)) are to be allocated to property produced or property acquired for resale by a foreign person in the same proportion that such costs are required to be allocated to property produced or property acquired for resale in the applicable U.S. trade or business of a related taxpayer (the "applicable U.S. trade or business"). For purposes of the U.S. ratio method, the term "foreign person" is any qualified business unit ("QBU") of a foreign person, as defined in section 1.989(a)-IT of the regulations, or any foreign branch of a U.S. person, provided the branch constitutes a separate QBU. Generally, the applicable U.S. trade or business is the trade or business conducted in the United States by such U.S. person or a related person (as described in section 267(b) or 707(b)) that is the same as, or most similar to, the trade or business conducted by the foreign person.

The costs (as determined before the application of the rules of section 263A) of property produced or property acquired for resale by a foreign person shall be increased by the factor, based on the costs incurred by the related taxpayer with respect to the applicable U.S. trade or business, that represents the ratio ("the U.S. ratio") of additional section 263A costs to otherwise capitalizable costs incurred by the related taxpayer in such trade or business for each particular taxable year. In the case of a foreign branch, any costs incurred by the foreign person are excluded by the related person for purposes of determining the U.S. ratio. (See section 446 of the Code, the regulations thereunder, and applicable case law for the factors to be considered in determining the existence of separate trades or businesses.) All expenses that the foreign person otherwise treats as deductible (that is, expenses other than those included in the computation of cost of goods sold or as a recovery of basis) shall be decreased ratably, to equal the amount of the increase in costs capitalized under the U.S. ratio method for the taxable year.

The appropriate ratio shall be applied to the costs of property produced or property acquired for resale incurred by the foreign person for each taxable year. A separate ratio is to be calculated for each taxable year with respect to property produced for sale, property acquired for resale, and property produced by the foreign person for use in the foreign person's trade or business ("self- constructed property") if the production or acquisition of such property constitutes a separate trade or business. The amount of costs that are properly included in the cost of goods sold or cost of sales for the taxable year and the amount of costs attributable to goods treated as remaining in ending inventor and incurred during the taxable year are determined using the foreign person's method of accounting (e.g., the last-in, first-out method -"LIFO", the first- in, first-out method - "FIFO", or a specific identification method). The additional section 263A costs included in the computation of cost of goods sold or cost of sales by a foreign person are to be sourced in the same manner as all other cost of goods sold or cost of sales. In the case of self-constructed property, the additional section 263A costs shall be allocated between (and included in the basis of) property placed in service during the taxable year and property that remains in production at the end of the taxable year.

In computing the adjustment under section 481(a) of the Code with respect to inventor on hand at the beginning of the first taxable year of the foreign person beginning after December 31, 1986, the factor to be applied shall be the ratio of (i) the additional section 263A costs that are required to be taken into account under section 481(a) by the related taxpayer with respect to the applicable U.S. trade or business determined for purposes of the change in method of accounting to comply with section 263A, to (ii) costs included in beginning inventor on hand at the beginning of the first taxable year of the related taxpayer beginning after December 31, 1986, before the application of the rules of section 263A. The ratio determined in the preceding sentence shall be applied to each layer of beginning inventor of the foreign person on hand at the beginning of its first taxable year beginning after December 31, 1986, to determine the amount of the adjustment required to be taken into account under section 481(a). The adjustment under section 481(a) of the Code is to be taken into account by the foreign person as provided in section 1.263A-1T(e) of the regulations, and is to be sourced in the same manner as any other adjustment to costs required to be included in inventory.

The U.S. ratio method, subject to the general provisions described in this notice, may be elected with respect to costs incurred after December 31, 1986 (or, in the case of inventor property, for taxable years beginning after December 31, 1986). For taxable years beginning on or after January 1, 1988, all the specific provisions contained in forthcoming guidance shall apply for purposes of the U.S. ratio method.

An election to use the U.S. ratio method with respect to a foreign QBU of a controlled foreign corporation may be made either by the controlled foreign corporation or by the controlling United States shareholders on behalf of the controlled foreign corporation. An election to use the U.S. ratio method by or on behalf of any member of a controlled group (within the meaning of section 267(f)) with respect to any QBU of such member, or with respect to any foreign QBU of a controlled foreign corporation (other than with respect to controlled foreign corporations as to which members of the group do not constitute controlling shareholders), shall be binding on all members of such controlled group with respect to any foreign qualified business unit of any such members or of any controlled foreign corporations as to which members of the group constitute controlling shareholders. Similarly, an election to use the U.S. ratio method with respect to any foreign QBU of a U.S. person other than a corporation described in the preceding sentence, shall be binding on all foreign qualified business units of the taxpayer's trade or business.

The election to apply the U.S. ratio method shall be treated as a method of accounting and, except as provided in this paragraph, a change to or from the U.S. ratio method is a change in method of accounting that requires the consent of the Commissioner. The election to use the U.S. ratio method on returns filed for the first taxable year in which the provisions of section 263A apply (including amended returns filed for the purpose of electing the U.S. ratio method) shall be included in the automatic change in method of accounting to comply with the capitalization requirements of section 263A, made in accordance with the provisions of section 1.263A(e) of the regulations.

PROCEDURAL INFORMATION

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

DRAFTING INFORMATION

The principal author of this notice is Paulette C. Galanko of the Legislation and Regulations Division. For further information regarding this notice, contact Ms. Galanko at (202) 566-3288 (not a toll-free call).