INTEREST CAPITALIZATION 'PRODUCTION PERIOD' INCLUDES PERIOD WINE IS AGED IN ITS BOTTLES.

UIL Number(s) 0263A.03-03

                                             Date: April 30, 1993

For the purposes of determining if the taxpayer is required to capitalize interest costs under section 263A(f) of the Internal Revenue Code, whether the "production period" of certain premium red wine includes the period during which the taxpayer holds the wine while it ages in its bottle.

FACTS

Taxpayer operates a winery where it manufactures and sells various grades of wine including several premium red wines. Traditionally, premium red wine is aged in oak barrels for a period of time and then is bottle aged before being released for sale. During barrel aging, the wine may be aged naturally or certain compounds may be added to change the character of the wine. During bottle aging, the wine is merely stored in finished form in the taxpayer's warehouse. The length of time that the bottled wine is held by the winery before release to the public is influenced by many considerations in addition to allowing for a period of bottle aging. These considerations include cash flow, market trends, grape supply, inventory levels, continuity of product, and other marketing factors. However, most premium wineries attempt to maintain a consistency in their production methods and their product from year to year.

The wine at issue in this Request for Technical Advice is the taxpayer's Cabernet Sauvignon, a premium red wine. Generally, the taxpayer plans to release its Cabernet Sauvignon approximately x years from crush. Moreover, since date 1, the taxpayer's Cabernet Sauvignon has actually been released for sale x years from crush. This period includes approximately y months of barrel aging and an additional z months of bottle aging while the taxpayer continues to hold the bottled wine before it is released for sale to its customers. If this latter period is included in the production period of the taxpayer's Cabernet Sauvignon, the production period for this property will exceed 2 years.

APPLICABLE LAW

Section 263A of the Code, which sets forth the "uniform capitalization rules," requires taxpayers to capitalize all direct and certain indirect costs incurred after December 31, 1986, that are allocable to real or tangible property produced by the taxpayer. Section 263A(g)(1) specifies that for the purposes of section 263A the term "produce" includes construct, build, install, manufacture, develop, or improve.

Section 263A(f) of the Code provides special rules for the allocation of interest to property produced by the taxpayer. Specifically, section 263A(f) requires taxpayers to capitalize interest costs which are paid or incurred during the production period of certain property.

Section 263A(f)(1) of the Code describes the types of property to which this requirement applies. For example, section 263A(f)(1)(B)(ii) requires taxpayers to capitalize interest costs when such costs are allocable to tangible personal property which has an estimated production period exceeding 2 years.

Section 263A(f)(4)(B) of the Code defines "production period" as the period beginning on the date on which production of the property begins, and ending on the date on which the property is ready to be placed in service or is ready to be held for sale. The Senate Report accompanying section 263A(f) further provides that in the case of property such as wine and whiskey that is aged before it is sold, the production period includes the aging period. See S. Rep. No. 313, 99th Cong. 2d Sess. 144 (1986)

ANALYSIS

The issue in this request for technical advice involves an interpretation of the "production period" under section 263A(f) of the Code. Specifically, the taxpayer questions the length of the production period for its Cabernet Sauvignon, a premium red wine. The taxpayer and the examining agent agree that the production period of the taxpayer's Cabernet Sauvignon includes the barrel aging period. The taxpayer and agent disagree, however, on the inclusion of a "bottle aging period" in the production period of this wine. The taxpayer argues that, for the purposes of section 263A(f), the production period of its Cabernet Sauvignon ends when the wine is removed from the oak barrel and is bottled. The examining agent, on the other hand, believes that the production period of this particular varietal includes the bottle aging period and, therefore, ends when the wine is released for sale (i.e., when the wine is officially offered to the winery's distribution chain). Under the agent's analysis, the production period of the taxpayer's Cabernet Sauvignon will generally exceed 2 years. Therefore, the taxpayer would be required to capitalize interest allocable to the production of this property under section 263A(f)(1)(B)(ii).

The taxpayer argues that the production period for its Cabernet Sauvignon ends when the wine is bottled and should not include the period during which the bottled wine is held before it is released. To support its position, the taxpayer points to the language in section 263A(f)(4)(B)(ii) of the Code, which provides that the production period ends when the property is ready to be held for sale. The taxpayer argues that this section does not require that the property be actually held for sale, only that it be READY to be held for sale. The taxpayer contends that once the wine is bottled, all aging and processing are complete, and the wine is ready to be shipped to the customer. Thus, it is ready to be held for sale. Furthermore, the taxpayer contends that any change in the wine during the period that it is held in its bottle is so minor and so subjective that it should not be considered an integral part of the production. Moreover, the taxpayer claims that once the wine is bottled, the determination of how long it is held before release is not based on bottle aging considerations. Rather, the taxpayer states that the wine's release date is based on marketing considerations such as grape supply, cash flow, customer demand, continuity of product, and inventory levels. Thus, the taxpayer argues that if any aging occurs during this time, it is merely incidental.

After careful consideration, however, we believe that, for the purposes of section 263A(f) of the Code, the production period for this particular varietal, the taxpayer's Cabernet Sauvignon, ends after the bottle aging period at the time that the wine is released for sale. First, we disagree with the taxpayer's interpretation of "production period" as defined in section 263A(f)(4)(B). Because the taxpayer continues to hold the wine after bottling for an extended period while the wine continues to age, we believe that this property is not ready to be held for sale under the definition of production period in section 263A(f)(4)(B). Moreover, we believe that the legislative history of section 263A(f) is controlling. The Senate Report accompanying section 263A elaborates on the definition of production period for the purposes of interest capitalization. Specifically, the Senate Report provides that, in the case of property such as wine or whisky that is aged before it is sold, the production period includes the aging period. S. Rep. No. 313, at 144. This language clearly suggests that, in the case of wine, all aging must be included in the production period.

Furthermore, we are not convinced that the change in the wine during bottle aging is so subjective and so incidental that it should not be considered part of the production period for the purposes of section 263A(f) of the Code. Generally, section 263A(g)(1) defines "produce" to include the improvement of property. Many wine commentators have emphasized that certain premium red wines improve considerably during the first few months or years after bottling. See, e.g., Walter Schug, The Vinification of Fine Wine, in Book of California Wine 168 (Doris Muscatine, Maynard A. Amerine, Bob Thompson eds. 1984); Tim Unwin, Wine and the Vine - An Historical Geography of Viticulture and the Wine Trade 56 (1991). As such, we believe that certain premium red wine continues to improve while it is held in its bottle. Therefore, because under section 263A the production of property includes the improvement of property, we believe that the bottle aging period is properly included in the production period for purposes of section 263A(f).

In addition, we are not persuaded by the taxpayer's claim that it did not consider bottle aging in determining the length of time that its Cabernet Sauvignon was held before release for sale. Many wine commentators have indicated that bottle aging is an important consideration in the production of premium red wine, particularly Cabernet Sauvignon. See, e.g., Maynard A. Amerine & V. L. Singleton, Wine, An Introduction 131 (2d ed. 1977); Louis M. Martini, Red Wine Production, in Wine Production Technology in the United States 79 (Maynard A. Amerine ed. 1981); Serena Sutcliff, The Art of the Winemaker 210 (1981). Moreover, in their marketing materials, many wineries highlight the fact that they allow their Cabernet Sauvignon to bottle age. Thus, both wine experts and consumers appear to appreciate the benefits of bottle aging with respect to Cabernet Sauvignon. Accordingly, we believe that, in its decision to hold its wine for z months after bottling, the taxpayer did consider the benefits of bottle aging. Furthermore, even if the taxpayer did not consider bottle aging in its red wine production, the mere fact that the wine continued to improve during that period suggests that production is nevertheless occurring.

Finally, the taxpayer argues that "release date" is too uncertain a date to designate the end of the production period for the purposes of section 263A(f) of the Code. Section 263A(f) requires taxpayer to capitalize interest costs allocable to property with an ESTIMATED production period exceeding 2 years. We believe that the taxpayer can reasonably estimate the end of the production period based on the date that the wine will be officially released to the taxpayer's distribution chain. First, since date 1, the taxpayer has regularly released each vintage of its Cabernet Sauvignon approximately x years from crush. In addition, we note that the taxpayer's financial statements suggest that the year of release for each vintage is consistently planned to be x years from crush. Accordingly, we believe that the taxpayer can reasonably anticipate the length of the production period for the purposes of determining whether this period will exceed 2 years under section 263A(f)(1)(B)(ii).

CONCLUSION:

For the purposes of determining if the taxpayer is required to capitalize interest costs under section 263A(f) of the Code, the "production period" of the taxpayer's Cabernet Sauvignon includes the period during which the taxpayer holds the wine while it ages in its bottle. ¹

A copy of this Technical Advice Memorandum is to be given to the taxpayer. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent. Temporary or final regulations pertaining to one or more of the issues addressed in this memorandum have not been adopted. Therefore, this memorandum will be modified or revoked by the adoption of temporary or final regulations to the extent that the regulations are inconsistent with any conclusion in the memorandum. See section 15.04 of Rev. Proc. 93-2, 1993-1 I.R.B. 50, 65. However, a technical advice memorandum involving a continuing transaction generally is not revoked or modified retroactively if the taxpayer can demonstrate that the criteria in section 15.05 of Rev. Proc. 93-2 are satisfied.