SERVICE ANNOUNCES PROCEDURES FOR AUTOMATIC CHANGE IN ACCOUNTING METHOD TO COMPLY WITH UNIFORM CAPITALIZATION RULES.

Notice 88-92

The purpose of this notice is to provide guidance to taxpayers regarding the uniform capitalization rules enacted into law by the Tax Reform Act of 1986 (Pub. L. 99-514). New section 263A of the Internal Revenue Code provides uniform capitalization rules that apply to the costs incurred with respect to property produced or 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).

BACKGROUND

Section 1.263A-1T(e)(11) of the Income Tax Regulations provides that a taxpayer required to change its method of accounting to comply with the rules under section 263A of the Code may automatically change its method of accounting, subject to procedures prescribed by the Commissioner. This notice sets forth certain of those prescribed procedures. The change in method of accounting required under section 263A of the Code consists of the changes necessary to properly capitalize and allocate costs with respect to production and resale activities in the manner prescribed in section 1.263A-1T of the regulations. The consent of the Commissioner to the change in method of accounting is granted to taxpayers changing their method of accounting as required under section 263A of the Code in accordance with the procedures contained in this notice.

SCOPE

This notice applies to changes in method of accounting required under section 263A of the Code with respect to the production of (i) inventories, (ii) property held for sale to customers in the ordinary course of business, and (iii) property to be used in the taxpayer's trade or business ("self-constructed property"), including, where applicable, property produced under contract for the taxpayer by another person. In addition, this notice applies to changes in methods of accounting required under section 263A of the Code with respect to property acquired for resale. This notice applies only to changes in methods of accounting required under section 263A of the Code. Thus, for example, this notice does not apply to changes in methods of accounting made with respect to property that is treated as substantially constructed before March 1, 1986, within the meaning of section 1.263A-1T(a)(6)(v) of the regulations. Taxpayers desiring to change their method of accounting, other than with respect to changes in method required by section 263A of the Code and the regulations thereunder (see section 1.263A-1T(e)(11) of the regulations), shall submit an application for change in accounting method under the administrative procedures applicable to such taxpayers at such time, including the applicable procedures regarding the time and place of filing the application for change in method of accounting.

"Taxpayers" to which this notice applies include any person (as defined in section 7701(a)(1) of the Code) required to change its method of accounting under section 263A, regardless of whether such person is itself required to pay Federal income taxes (e.g., a partnership).

EXCEPTIONS FROM THE FILING REQUIREMENT OF THIS NOTICE

The following taxpayers described in this section that are otherwise in compliance with the rules of section 263A are granted permission to make an automatic change in method of accounting to comply with section 263A without filing a Form 3115 or a section 263A checklist. Such change in method shall be reflected in the taxpayer's books and records.

Taxpayers that are required to change their method of accounting with respect to property produced in a farming business are not required to complete and file a Form 3115 or a section 263A checklist with respect to such change in method of accounting, notwithstanding the fact that such taxpayers are required to comply with all other applicable provisions of section 263A. Similarly, taxpayers that are required to change their method of accounting for only self- constructed property are not required to complete a Form 3115 or a section 263A checklist with respect to such change in method if the average annual gross receipts of the taxpayer for the 3-taxable year period preceding the year of change do not exceed $10 million. For purposes of this gross receipts exception to the filing requirements of this notice, the rules of section 263A(b)(2)(C) shall apply. Notwithstanding this provision, such taxpayers are required to comply with all provisions of section 263A in accounting for costs (including interest, if applicable) incurred by the taxpayer after December 31, 1986, with respect to self-constructed property.

PROCEDURE TO COMPLY WITH SECTION 263A

Taxpayers required to change their method of accounting under section 263A of the Code shall complete Section A (items la, 3a, 3b, 4a, 11, and 12) and Section D of a current Form 3115 (Rev. 11-87) and the 263A checklist required by this notice. Except as provided in the following paragraph, the Form 3115 and the 263A checklist shall be filed no later than the due date (including extensions) of the taxpayer's Federal income tax return for the year of change and shall be attached to that return. (No filing fee is required. Copies of the Form 3115 or the 263A checklist are not to be filed with the National Office.) The taxpayer shall type or legibly print the following statement at the top of page 1 of Form 3115: "Automatic Change in Accounting Method under section 263A".

A taxpayer that has (i) filed, on or before October 21, 1988 a Federal income tax return for the first taxable year of the taxpayer to which the provisions of section 263A of the Code apply; (ii) failed to file the Form 3115 (and the 263A checklist) with such return; and (ii) otherwise complied with section 263A and the regulations under section 1.263A-1T, shall attach a Form 3115 (and the 263A checklist) to the taxpayer's first Federal income tax return filed subsequent to October 21, 1988 for a taxable year to which the provisions of section 263A apply. (A taxpayer, at its option, may attach Form 3115 and the 263A checklist with a return filed before the date provided in the preceding sentence.)

In the case of a taxpayer having more than one trade or business, a separate Form 3115, including the 263A checklist, shall be filed for each trade or business the activities of which are subject to the rules of section 263A. (See section 446 of the Code, the regulations thereunder, and applicable case law for the factors to be considered in determining whether the taxpayer has separate trades or businesses.)

In completing the Form 3115, all taxpayers shall attach the 263A checklist that provides the following information, where applicable, with respect to each particular trade or business:

SECTION 263A CHECKLIST

Except where otherwise provided, all terms used in the 263A checklist are defined using the definitions and meanings provided in section 1.263A-1T of the regulations.

QUESTIONS FOR ALL TAXPAYERS

1. What activities are conducted in the trade or business that is the subject of this particular checklist?

a. The production of inventory property;

b. The production of property that is not inventory but which is held for sale to customers (for example, homes constructed for sale by a homebuilder);

c. The production of property to be used in the taxpayer's trade or business ("self-constructed property"); or

d. The acquisition by the taxpayer of property held for resale.

Please note: the treatment of costs incurred by a contractor in producing property under a long-term contract is addressed in section 460 of the Code. Such costs are not subject to section 263A or the provisions of this notice.

Please note: The costs of administrative, service, or support departments or functions (hereinafter "service departments") that benefit more than one trade or business of the taxpayer (at least one of which consists of activities to which section 263A applies) are to be allocated, using any reasonable method, between the various trades or businesses of the taxpayer for purposes of section 263A of the Code.

2. Has the taxpayer deducted the costs of temporarily idle equipment as provided in section 1.263A-1T(b)(2)(v)(F) and (b)(2)(viii) of the regulations with respect to any activity listed in question 1?

QUESTIONS FOR TAXPAYERS PRODUCING INVENTORY PROPERTY OR PRODUCING PROPERTY HELD FOR SALE TO CUSTOMERS.

1. Has the taxpayer elected to use the simplified production method?

Please note: If the answer to question (1) is yes, the requirements that must be met by the taxpayer include the following:

a. The simplified production method must be used for both allocating costs incurred after the effective date of section 263A, and for revaluing inventories on hand as of the effective date of section 263A.

b. The simplified production method must be used by the taxpayer for all activities in the entire trade or business of the taxpayer involving the production of property eligible for the method.

c. For purposes of the simplified production method, consent of the Commissioner must be obtained for any change in method of computing or determining "section 471 costs", as defined in section 1.263A-1T(b)(5)(iii) of the regulations.

d. If the trade or business includes both production and resale activities, the simplified production method must be used to account for both the production and resale activities of the trade or business. However, see section III of Notice 88-86 (1988-34 I.R.B.), relating to the availability of the simplified resale method.

e. The costs pertaining to long-term contracts and self- constructed property must be excluded from the costs allocated to production under the simplified production method. However, see section II(A) of Notice 88-86 (1988-34 I.R.B.), relating to the availability of the simplified production method.

See section 1.263A-1T(b)(5) of the regulations for additional rules relating to the simplified production method.

2. If the answer to question (1) is no, please briefly identify the methods (such as additional allocation methods) that the taxpayer has used in order to properly capitalize additional costs required to be capitalized under section 263A.

3. Has the taxpayer elected to use the simplified service cost method?

Please note: If the answer to question (3) is yes, the requirements that must be met by the taxpayer include the following:

a. The simplified service cost method must be used for both allocating costs incurred after the effective date of section 263A and for revaluing inventories on hand as of the effective date of section 263A.

b. The simplified service cost method must be used by the taxpayer for all activities in the entire trade or business of the taxpayer. However, see section II(B) of notice 88-86 (1988-34 I.R.B.), relating to the simplified service cost method.

c. The total costs of the various departments or functions performing mixed service activities must be included for purposes of the simplified service cost method.

d. The 90%-10% de minimis formula, contained in section 1.263A-1T(b)(6)(iv) of the regulations, must be used in determining whether the taxpayer's service departments are departments the activities of which are (i) solely allocable to production activities; (ii) solely allocable to "policy" activities, or (iii) mixed, i.e., consisting of both production and "policy" activities.

See section 1.263A-1T(b)(6) of the regulations for additional rules relating to the simplified service cost method.

4. If the answer to question (3) is no, please briefly identify the methods used by the taxpayer to allocate service costs to the production of inventories or property produced for sale to customers.

Please note: Taxpayers producing inventory property or property held for sale to customers are required to capitalize the costs of off- site storage, purchasing, handling, and related general and administrative services (defined in sections 1.263A-1T(b)(2)(iii)(T) and (d)(3)(ii) of the regulations) as a cost of production.

Please note: Taxpayers are required to capitalize costs with respect to property produced for taxpayers by other persons under contract with such taxpayers. See section 1.263A-1T(a)(5)(ii) of the regulations.

QUESTIONS FOR TAXPAYERS PRODUCING SELF-CONSTRUCTED PROPERTY.

1. Is the taxpayer not applying the rules of section 263A to any property produced by the taxpayer for use in its trade or business, based on the determination that substantial construction with respect to such property had occurred before March 1, 1986? (See section 1.263A-1T(a)(6)(v) of the regulations).

2. Please briefly identify the methods used by the taxpayer in order to properly capitalize additional costs, including service costs, required to be capitalized under section 263A.

Please note: Taxpayers producing self-constructed property are required to capitalize the costs of off-site storage, purchasing handling, and related general and administrative services (defined in sections 1.263A-1T(b)(2)(iii)(T) and (d)(3)(ii) of the regulations) as a cost of production.

Please note: Taxpayers are required to capitalize costs with respect to property produced for taxpayers by other persons under contract with such taxpayers. See section 1.263A-1T(a)(5)(ii) of the regulations.

QUESTIONS FOR TAXPAYERS ACQUIRING PROPERTY FOR RESALE.

1. Is the taxpayer involved in the acquisition of real property for resale? If the answer is yes, the taxpayer must capitalize the additional costs as required under section 263A with respect to this property, regardless of the amount of the taxpayer's gross receipts.

2. Is the taxpayer involved in the acquisition of personal property (tangible or intangible) for resale?

3. If the answer to question (2) is yes, are the taxpayer's average annual gross receipts (including the gross receipts of all persons treated as a single employer with the taxpayer under section 52(a) or (b), or section 414(m) or (o)) for the 3 preceding taxable years greater than $10 million? If the answer is yes, the taxpayer must capitalize the additional costs as required under section 263A with respect to this property.

4. Is the taxpayer expensing costs under the rule provided in section 1.263A-1T(d)(3)(ii)(C)(2) of the regulations for repackaging costs incurred in preparation for imminent shipment or delivery directly to a particular customer?

Please note: All taxpayers are required to capitalize the costs of the following facilities as off-site storage: (i) pooled stock facilities; (ii) catalog or mail order centers; (iii) storage or warehousing areas used with respect to wholesale sales; and (iv) storage facilities used to store goods which will be shipped by the taxpayer to a store or outlet of the taxpayer (or a related person). (See section 1.263A-1T(d)(3) of the regulations for the definitions of these terms).

Please note: Taxpayers are required to capitalize the costs of transporting items from a storage facility of the taxpayers to a store or outlet of the taxpayers (or related persons).

5. Has the taxpayer elected to use the simplified resale method?

Please note: If the answer to question (5) is yes, the requirements that must be met by the taxpayer include the following:

a. The simplified resale method must be used for both allocating costs incurred after the effective date of section 263A, and for revaluing inventories on hand as of the effective date of section 263A.

b. The simplified resale method must be used by the taxpayer for all activities in the entire trade or business of the taxpayer involving the acquisition of property for resale.

c. If the trade or business includes both production and resale activities, only the simplified production method, (and not the simplified resale method) may be used by the taxpayer and such method must be applied to the entire trade or business of the taxpayer. However, see section III of Notice 88-86 (1988-34 I.R.B.), relating to the availability of the simplified resale method.

d. The total costs of the various departments or functions performing mixed service activities must be included for purposes of multiplying such amount by the ratio of labor costs, as provided in section 1.263A-1T(d)(4)(iii) of the regulations.

e. The 90%-10% de minimis formula, contained in section 1.263A-1T(b)(6)(iv) of the regulations, must be used in determining whether the taxpayer's service departments are departments the activities of which are (i) solely allocable to resale activities; (ii) solely allocable to "policy" activities; or (iii) mixed, i.e., consisting of both resale and "policy" activities.

See section 1.263A-1T(d)(3) of the regulations for additional rules relating to the simplified resale method.

6. If the answer to question (5) is no, please briefly identify the methods the taxpayer has used in order to properly capitalize additional costs, including service costs, required to be capitalized under section 263A.

QUESTIONS FOR ALL INVENTORY TAXPAYERS (TAXPAYERS WHO PRODUCE OR ACQUIRE INVENTORY FOR RESALE)

1. Please attach a schedule setting forth the computation of the adjustment under section 481(a) of the Code (the "section 481(a) adjustment").

2. Over what period of years will the section 481(a) adjustment be taken into account?

3. Do the acceleration provisions of the "75 percent rule" (as described in section 1.263A-1T(e)(3)(ii) of the regulations) apply to the taxpayer?

4. What is the method used for identifying costs in inventory? a. Specific identification; b. LIFO; c. FIFO; or d. Other (please briefly identify).

5. Has a change in method of accounting, other than a change to comply with the rules of section 263A (as defined in section 1.263A- 1T(e)(11) of the regulations) been made or requested by the taxpayer for a taxable year during which the provisions of section 263A are first effective?

6. If the answer to question (5) is yes, has the change in method of accounting for purposes of complying with section 263A been made in the taxable year before any other changes in method of accounting were made in such year? (Taxpayers should note that the termination of the use of the LIFO method of accounting may, if the taxpayer chooses, be deemed to occur before the change in method of accounting required under section 263A is deemed to occur for the year of change. See Notice 88-23, 1988-10 I.R.B. 51.)

7. Has the taxpayer used the practical capacity concept in prior years? If so, the taxpayer's section 481(a) adjustment must include all amounts attributable to the repeal of practical capacity under section 1.263A-1T of the regulations.

8. What method was used by the taxpayer in revaluing beginning inventory amounts for purposes of section 263A of the Code? a. Facts and circumstances method; b. Weighted average method; or c. Three- year average method. See section 1.263A-1T(e)(6) of the regulations.

Please note: If the taxpayer used the facts and circumstances revaluation method, the taxpayer should note that section 1.263A- 1T(e)(6)(ii)(A) of the regulations requires that taxpayers using this method apply the capitalization rules of this section to the production and resale activities of the taxpayer with the same degree of specificity as required of inventory manufacturers under the law immediately prior to the effective date of the Tax Reform Act of 1986.

Please note: If the taxpayer used the weighted average method, the taxpayer should note that the weighted average method may only be used by a taxpayer if, and to the extent that, the taxpayer lacks sufficient data to allow for the direct revaluation of the items or layers based on its production history.

Please note: If the taxpayer used the three-year average method, the requirements that must be met by the taxpayer include the following:

a. The 3-year average method may be used only for inventories for which the dollar-value LIFO method was used.

b. The taxpayer must use the three most recent taxable years for which there is sufficient information to calculate the revaluation factor, regardless of whether increments were incurred for such years.

c. The taxpayer may use additional years (but only if such years are consecutive) beyond the three most recent years in calculating the revaluation factor.

9. Did the taxpayer adjust the revaluation factor (as defined in section 1.263A-1T(e)(7) of the regulations) with respect to amounts attributable to depreciation, practical capacity, or other items? If the answer to any of these questions is yes, then please answer the following questions.

a. Please briefly identify the types of costs for which the revaluation factor has been adjusted.

b. Did the taxpayer include any "applicable pre-cutoff years" as described in section 1.263A-1T(e)(8) of the regulations, with respect to adjustments relating to depreciation?

Please note: With respect to adjustments pertaining to practical capacity (if any), the taxpayer must make such adjustments only for consecutive years, as described in section 1.263A-1T(e)(7)(iv) of the regulations.

QUESTIONS FOR TAXPAYERS ENGAGING IN TRANSACTIONS WITH RELATED PARTIES; ALL TRADES OR BUSINESSES

1. Has the taxpayer participated in a transfer of services, labor, or property between the taxpayer and a related party? If yes, please note that the taxpayer must take into account all items transferred in an amount equal to the arm's length charge for such items as required by section 1.263A-1T(b)(2)(vi) of the regulations.

2. In computing the section 481(a) adjustment, has the taxpayer revalued the amount of deferred gain or loss resulting from the sale or exchange of inventory property in a deferred intercompany transaction, as required under section 1.263A-1T(e)(1)(ii) of the regulations?

3. Did the taxpayer transfer inventories to a related corporation in a transaction described in section 351 of the Code (i) on or before the beginning of the transferor's taxable year beginning in 1987; and (ii) after September 18, 1986? If yes, did the taxpayer comply with section 1.263A-1T(e)(10) of 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 revenue procedure.

The collection of information in this notice has been submitted to the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1980 and has been approved by OMB (Control Number 1545-0987).

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 Paulette Galanko at (202) 566-3288 or Ruth Bettinger at (202) 566-3636 (not a toll-free call).