Attorney Questions Use of Analogy in Proposed Manufacturing Regs

I respectfully submit this letter in response to the request for comments on the proposed regulations (REG-136459-09) under Section 199 of the Internal Revenue Code of 1986, as most recently amended (the "Code")¹ published in the Federal Register on August 27, 2015 (the "Proposed Regulations"). This letter presents the following two comments for the Internal Revenue Service (the "Service") and the U.S. Department of the Treasury ("Treasury") drafters' consideration: (1) observations with respect to the Proposed Regulations' statement that allocable contract costs for long term contracts accounted for under Section 460 are analogous to Costs of Goods Sold ("CGS") and will be treated as such for purposes of certain provisions in the Regulations under Section 199; and (2) a request for clarification regarding the effective date of the Proposed Regulations.

Comparison of Section 460 Allocable Contract Costs to Costs of Goods Sold

The Proposed Regulations provide, in pertinent part, "[i]n the case of a long-term contract accounted for under the percentage-of-completion method described in § 1.460-4(b) (PCM), or the completed-contract method described in § 1.460-4(d) (CCM), CGS for purposes of this section includes the allocable contract costs described in § 1.460-5(b) (in the case of a contract accounted for under PCM) or § 1.460-5(d) (in the case of a contract accounted for under CCM)."² The preamble to the Proposed Regulations states, "[t]he Treasury Department and the IRS recognize that allocable contract costs under PCM or CCM are analogous to CGS and should be treated in the same manner." 80 Fed. Reg. 51978, 51983. However, the preamble does not cite authority supporting this assertion or describe how the characterization of costs accounted for under the PCM as CGS follows from Section 460 or the related Treasury Regulations. The preamble also does not explain the reasons for the change in treatment of allocable contract costs under Section 460 relative to the existing Treasury Regulations under Section 199.

The assertion in the preamble seems inappropriate because allocable contract costs are not analogous to CGS. The Code does not define the term "costs of goods sold," but Treas. Reg. § 1.199-4(b)(1) is instructive. The regulation currently provides that solely for purposes of Section 199³ , "CGS is equal to the beginning inventory plus purchases and production costs incurred during the taxable year and included in inventory costs, less ending inventory. See sections 263A, 471, and 472." As evidenced by the relevant regulations, CGS is an inventory-related concept. The concept of inventory is contrary to Section 460; therefore, the concept of CGS is also contrary to and outside the scope of Section 460. Illustrations of this principle are provided below.

The Treasury Regulations establish that (1) CGS is an amount that is subtracted from gross receipts to arrive at gross income, and (2) ending inventories must be considered when determining the impact of CGS. For example, Treas. Reg. § 1.61-3(a) stipulates that "[i]n a manufacturing . . . business 'gross income' means the total sales, less the costs of goods sold." Similarly, Treas. Reg. § 1.162-1(a) explains that the "cost of goods purchased for resale, with proper adjustment for opening and closing inventories, is deducted from gross sales in computing gross income."

The above concepts have no application to contracts accounted for under Section 460. For example, CGS, generally, is subtracted from gross receipts to determine gross income. However, as an exception, under Section 460, allocable contract costs are deducted in calculating net income rather than in determining gross income. Treas. Reg. § 1.460-4(b)(1) requires taxpayers to include a portion of the total contract price in gross receipts as the taxpayer incurs allocable contract costs. Thus, allocable contract costs are not netted against gross receipts to determine gross income. Instead, the proportion of allocable contract costs incurred is used to determine the amount of gross income recognized under the PCM.

Further, generally, the change in inventory from period to period must be taken into account when determining CGS, whereas under PCM, as an exception, all costs are deducted as incurred rather than being capitalized into inventory.

The principle that inventory is not pertinent under PCM is evidenced elsewhere in the Code and Treasury Regulations. For example, Section 471 requires the use of inventories when necessary to clearly determine the taxpayer's income. Treas. Reg. § 1.471-10, which relates to the applicability of long-term contract methods, references Treas. Reg. § 1.460-2 for guidance relating to certain manufacturing contracts and Treas. Reg. § 1.460-2(a) provides that a taxpayer must use PCM if the long-term manufacturing contract involves a "unique item of a type that is not normally carried in the finished goods inventory of the taxpayer." Treas. Reg. § 1.460-2(b)(2)(iii) includes a safe harbor for "inventoried item[s]" providing that "[a] unique item ceases to be unique no later than when the taxpayer normally includes similar items in its finished goods inventory." Accordingly, upon its inclusion in finished goods inventory, an item ceases to be unique (and moves outside the scope of the Section 460 rules).

In addition, Treas. Reg. § 1.263A-1(b)(2) provides that "[e]xcept for certain home construction contracts described in section 460(e)(1), section 263A does not apply to any property produced by the taxpayer pursuant to a long-term contract as defined in section 460(f), regardless of whether the taxpayer uses an inventory method to account for such production." Thus, the concept of inventory, which is an essential element in the determination of CGS, does not apply to long-term contracts accounted for under the PCM or the costs attributable to such contracts.

The sole example provided to illustrate the new rule in Prop. Treas. Reg. § 1.199-4(b) does not address allocated contract costs subject to Section 460, but is limited to a contract for which inventory is maintained. Prop. Treas. Reg. § 1.199-4(b)(2)(iii)(B).

In summary, allocable contract costs can be distinguished from CGS in at least two critical ways. First, unlike CGS, allocable contract costs are not subtracted from gross receipts in determining gross income. Second, unlike CGS, allocable contract costs are not capitalized into inventory under PCM. Accordingly, the novel rule in Prop. Treas. Reg. § 1.199-4(b)(1) is inconsistent with the long-standing treatment of costs allocable to contracts accounted for under Section 460. The novel rule is also inconsistent with the Section 199 Regulations, which distinguish between CGS (which are allocated under Treas. Reg. § 1.199-4(b)) and other costs and deductions (which are allocated under Treas. Reg. §§ 1.199-4(c) and (d)). Costs related to contracts accounted for under PCM are appropriately allocated under Treas. Reg. §§ 1.199-4(c) and (d) because they are not CGS.

Based on the provisions cited above, I recommend that the Service and Treasury omit this proposed rule from any final regulations under Section 199. As a result, costs under contracts accounted for under PCM would continue to be treated as other costs and deductions (as opposed to CGS) for purposes of allocating costs under Treas. Reg. § 1.199-4.

Effective Date of the Proposed Regulations

The preamble to the Proposed Regulations provides in relevant part that "Section 1.199-4(b)(2)(iii)(A) of the proposed regulations clarifies that the CGS must be allocated between DPGR and non-DPGR, regardless of whether any component of the costs included in CGS can be associated with activities undertaken in an earlier taxable year." This characterization as a "clarification" could be interpreted as an indication of the drafters' intent to give the Proposed Regulations retroactive effect. Section 7805(b) generally prohibits retroactive application of regulations. Therefore, I recommend that Treasury clarify that nothing in the regulations or the preamble to the regulations is intended to give such regulations retroactive application, and that all rules in the final regulations are effective only prospectively from the date when the Proposed Regulations are published in the Federal Register in final form.

I commend the Service and the Treasury drafters for their efforts. Thank you for your consideration of this matter.

² Prop. Treas. Reg. § 1.199-4(b)(1).

³ Treas. Reg. § 1.199-4(a).