IRS TO CHANGE PORTIONS OF UNIFORM CAPITALIZATION REGULATIONS.

Notice 88-86

The purpose of this notice is to provide guidance to taxpayers regarding forthcoming regulations interpreting the uniform capitalization rules under section 263A of the Internal Revenue 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 were published in the Federal Register on March 30, 1987, and August 7, 1987 (T.D. 8131, 1987-1 C.B. 98; T.D. 8148, 1987-2 C.B. 70). The Internal Revenue Service received numerous comments and suggestions with respect to the proposed regulations, and a public hearing on the regulations was held on December 7, 1987.

This notice alerts taxpayers to some of the more significant, forthcoming changes in the regulations that are being made in response to comments and suggestions received by the Internal Revenue Service. Except as expressly provided to the contrary, the definitions provided in section 1.263A-1T et. seq., of the Income Tax Regulations apply to the various terms used in the notice.

II. PROPERTY PRODUCED BY THE TAXPAYER.

(A) SIMPLIFIED PRODUCTION METHOD -- AVAILABILITY OF METHOD.

Section 1.263A-1(T)(b)(5) of the present regulations provides an elective simplified production method with respect to the production of property under section 263A. Under section 1.263A-1(T)(b)(5)(i) of the present regulations, the simplified production method is available only with respect to the production of real or personal property that is:

(i) stock in trade of the taxpayer or other property that is properly includable in the inventory of the taxpayer; or

(ii) property held by the taxpayer primarily for sale to customers in the ordinary course of the taxpayer's trade or business.

Under the present regulations, the simplified production method is not available with respect to property acquired for resale (except in cases where the trade or business consists of both production and resale activities), property constructed by a taxpayer for use in its trade or business, property produced under a long-term contract, or any other property produced by a taxpayer that is not described in section 1221(1) of the Internal Revenue Code. As explained in the preamble accompanying the March 30, 1987 regulations (see 52 FR at page 10056), the reason for this restriction is that the simplified production method is not appropriate for use in accounting for casual or occasional production of property, i.e., property which is not produced on a repetitive and routine basis, and which does not have a high "turnover" rate.

Commentators have suggested that the categories of property eligible for the simplified production method be expanded, from those eligible for such method under the present regulations, to other types of property that share the characteristics that are appropriate for application of the method. In response to these suggestions, forthcoming regulations will provide that the simplified production method is also available with respect to:

(i) property constructed by a taxpayer for use in its trade or business if the taxpayer is also producing, in the ordinary course of its business, inventory property (or any other property with respect to which the use of the simplified production method is permitted under the present regulations), and the property constructed by the taxpayer for use in its trade or business is substantially identical in nature to, and is produced in the same manner as, the inventory property (or such other property) produced by the taxpayer; or

(ii) property constructed by a taxpayer for use in its trade or business if, in the ordinary course of its production activities, the taxpayer produces such property on a routine and repetitive basis (i.e., the taxpayer produces numerous items of such property within a taxable year).

As provided in the present regulations, the election to use the simplified production method shall be made separately with respect to each trade or business of the taxpayer; moreover, the simplified production method must be used for all operations of the trade or business of the taxpayer. Thus, for example, a taxpayer is not permitted to use the simplified production method for part of its inventory property in a trade or business, and another method for the remaining amount of its inventory property in the same trade or business.

Notwithstanding the preceding paragraph, to avoid placing administrative burdens on taxpayers who have relied on the present regulations, taxpayers may use the simplified production method for all property for which the simplified production method is available under the present regulations, while at the same time choosing not to use the simplified production method for the additional categories of property for which the method is available under this notice. Thus, for example, a taxpayer may use the simplified production method for inventory property, while using another method for property constructed by the taxpayer for use in its trade or business, although the simplified production method would be available with respect to the latter type of property under this notice.

Taxpayers wishing to use the simplified production method with respect to the additional categories of property for which the method is available under this notice may do so under section VI of this notice, which provides expedited procedures for changing methods of accounting.

(B) SIMPLIFIED SERVICE COST METHOD.

(1) MODIFICATION OF FORMULA.

Section 1.263A-1T(b)(6) of the present regulations provides an elective simplified service cost method with respect to the production of property under section 263A. Under the simplified service cost method, taxpayers may determine the mixed service costs subject to capitalization with respect to certain property being produced, by multiplying the total mixed service costs incurred in the taxpayer's trade or business during the taxable year by the ratio of --

(i) the total production costs incurred in the taxpayer's trade or business under section 263A (excluding mixed service costs and interest) for the taxable year, to -

(ii) the total of all costs incurred in the operation of the taxpayer's trade or business (excluding mixed service costs and interest) for the taxable year.

Commentators have suggested that this formula results in the capitalization of an inappropriately high percentage of the taxpayer's mixed service costs under section 263A, primarily because of the inclusion of raw materials costs in both the numerator and denominator of the fraction. Commentators have suggested that a labor-based formula, similar to the formula used in the simplified resale method, be used to allocate mixed service costs under the simplified service cost method.

In response to these comments, forthcoming regulations will permit taxpayers to elect, under the simplified service cost method, to determine the mixed service costs subject to capitalization with respect to property being produced, by multiplying the total mixed service costs incurred in the taxpayer's trade or business during the taxable year by the ratio of --

(i) the sum of the labor costs allocable to the taxpayer's production activities under section 263A in the taxpayer's trade or business (excluding labor costs included in mixed service costs) for the taxable year, to --

(ii) the total of all labor costs incurred in the operation of the taxpayer's trade or business (excluding labor costs included in mixed service costs) for the taxable year.

Moreover, as provided in the existing regulations, to the extent that mixed service costs and labor costs are incurred in more than one trade or business, the taxpayer shall determine the amounts allocable to the particular trade or business in issue by using any reasonable method consistent with the principles of section 263A.

Taxpayers may elect to use the simplified service cost method containing the labor-based formula described in this section (the "labor-based simplified service cost method") separately for each trade or business of the taxpayer under section VI of this notice, which provides expedited procedures for changing methods of accounting. The property for which the labor-based simplified service cost method may be used consists of the same categories of property for which the simplified service cost method may be used, as provided in section II(B)(2) of this notice.

Alternatively, taxpayers not electing to use the labor-based simplified service cost method may continue to use the simplified service cost method as provided in the present regulations, subject to all of the requirements provided therein.

(2) AVAILABILITY OF METHOD FOR OTHER TYPES OF PROPERTY.

Under section 1.263A-1T(b)(6)(ii) of the present regulations, the simplified service cost method is only available with respect to the production of real or personal property that is:

(i) stock in trade of the taxpayer or other property that is properly includable in the inventory of the taxpayer; or

(ii) property held by a taxpayer primarily for sale to customers in the ordinary course of the taxpayer's trade or business.

Forthcoming regulations will provide that the simplified service cost method may also be used with respect to the additional categories of property eligible for the simplified production method under section II(A) of this notice.

As provided in the present regulations, the election to use the simplified service cost method shall be made separately with respect to each trade or business of the taxpayer; moreover, if elected, the simplified service cost method must be used for all operations of the trade or business of the taxpayer. Thus, for example, a taxpayer is not permitted to use the simplified service cost method for part of its inventory property in a trade or business, and another method for the remaining amount of its inventory property in such trade or business.

Notwithstanding the preceding paragraph, to avoid placing administrative burdens on taxpayers who have relied on the present regulations, taxpayers may use the simplified service cost method with respect to all property for which the simplified service cost method is available under the present regulations, while at the same time choosing not to use the simplified service cost method for the additional categories of property for which the method is available under this notice. Thus, for example, a taxpayer may use the simplified service cost method for inventory property, while using another method for property constructed by the taxpayer for use in its trade or business, although the simplified service cost method would be available with respect to the latter type of property under this notice.

Taxpayers wishing to use the simplified service cost method with respect to the additional categories of property for which the method is available under this notice may do so under section VI of this notice, which provides expedited procedures for changing methods of accounting.

(C) MANUFACTURERS AND ON-SITE STORAGE.

Section 1.263A-1T(d)(3)(ii)(A) of the present regulations permits taxpayers engaged in resale activities to expense the costs of on-site storage under section 263A. Commentators have inquired whether this provision would apply to taxpayers producing property under section 263A, in addition to taxpayers acquiring property for resale.

Forthcoming regulations will clarify that taxpayers producing property may expense a portion of the costs attributable to a storage facility, if, and to the extent that, such facility operates as an on-site storage facility as defined under the present regulations, i.e., the facility is physically attached to, and an integral part of, a retail sales facility and the taxpayer sells merchandise stored at the facility to retail customers physically present at the facility. If a facility described in the preceding sentence is used for other purposes as well, then the rules for dual function facilities would apply to such facility.

III. PROPERTY ACQUIRED FOR RESALE.

(A) SIMPLIFIED RESALE METHOD.

(1) SEPARATE METHOD FOR MIXED SERVICE COSTS.

Section 1.263A-1T(d)(3) of the regulations provides a simplified method of accounting (the "simplified resale method") for the costs of property acquired for resale. Under the simplified resale method, costs pertaining to off-site storage, purchasing, handling, and fixed service costs ("additional section 263A resale costs") are allocated to the taxpayer's inventory based on an allocation ratio provided in section 1.263A-1T(d)(4) of the regulations.

Two separate calculations involving mixed service costs are provided under the present regulations. The first calculation, provided in section 1.263A-1T(d)(4)(iii) of the present regulations, provides for the use of a fraction based on a certain ratio of the taxpayer's labor costs to determine the amount of mixed service costs that will be considered as additional section 263A costs. Once the amount of mixed service costs that will be treated as additional section 263A costs has been determined, the second calculation is made that includes such additional section 263A costs in the allocation ratio to determine how many of the costs shall be capitalized in ending inventory.

The Internal Revenue Service has received comments suggesting that these two different calculations involving mixed service costs be separated to constitute two different simplified methods that may be independently elected by taxpayers, as opposed to the present regulations which require taxpayers electing the simplified resale method to use both calculations as part of the same method.

In response to these comments, forthcoming regulations will permit taxpayers to make a separate election to use a simplified method (the "simplified resale service cost method") in determining the amount of mixed service costs included as additional section 263A resale costs. The simplified resale service cost method will consist of the same formula as is presently available under section 1.263A- 1T(d)(4)(iii) of the regulations, whereunder the amounts of mixed service costs included as additional section 263A resale costs are determined through the use of a fraction based on a certain ratio of the taxpayer's labor costs.

Additionally, forthcoming regulations will permit taxpayers to separately elect the use of the simplified resale method (as revised by this section III(A)(1)), which provides for the allocation of all of the taxpayer's additional section 263A resale costs to the taxpayer's ending inventory based on the allocation ratio provided in section 1.263A-1T(d)(4)(ii) of the present regulations.

The election of either separate method shall be made independently of the other method; taxpayers may elect only one of the methods, both of the methods, or none of the methods, at their option. Moreover, taxpayers that have elected the use of the simplified resale method under the present regulations may, if they choose, continue the use of such method.

Taxpayers that elect to use the simplified resale service cost method, and/or the simplified resale method (as modified by this notice) may do so under section VI of this notice, which provides expedited procedures for changing methods of accounting. Any election must be made separately for each trade or business of the taxpayer.

(2) ALTERNATIVE SIMPLIFIED RESALE METHOD.

Section 1.263A-1T(d)(4)(ii) of the regulations provides that the allocation ratio for apportioning additional section 263A resale costs (including handling and storage costs) is to be based on purchases made by the taxpayer during the taxable year. Moreover, the allocation ratio is then multiplied by the amounts in the taxpayer's ending inventory that are treated as purchased during the current year under the taxpayer's method of accounting.

As explained in the preamble accompanying the March 30, 1987 regulations (see 52 FR at pages 10054-55), the allocation ratio provided in the regulations differs from the allocation ratio described in the legislative history of the 1986 Act with respect to storage and handling costs (2 H.R. Rep. No. 99-841, 99th Cong., 2d Sess. II 305-08 (1986)) (the "Conference Report"). As the preamble indicated, the regulations did not include beginning inventory balances in the denominator of the allocation ratio, on the grounds that including such balances would be inconsistent with the determination that beginning inventory balances do not accumulate accretions of annual storage and handling costs.

The Internal Revenue Service has received comments criticizing the provision of the regulations that requires taxpayers to exclude beginning inventory balances from the allocation ratio for storage and handling costs.

Forthcoming regulations will provide that taxpayers may elect to use an "alternative simplified resale method" whereunder a taxpayer would: (i) calculate a separate allocation ratio for handling and storage costs (and related mixed service costs) that includes both beginning inventory balances and purchases in the denominator of the allocation ratio; and, multiply such allocation ratio by (ii) all amounts included in the taxpayer's ending inventory, including purchases made during the year as well as amounts also present in beginning inventory for the year under the taxpayer's method of accounting.

In addition, under the alternative simplified resale method, the taxpayer would: (i) calculate a separate allocation ratio for purchasing costs (and related mixed service costs) that includes only purchases in the denominator of the allocation ratio; and multiply such allocation ratio by (ii) all amounts included in the taxpayer's ending inventory that are viewed as purchases made during the taxable year under the taxpayer's method of accounting.

Taxpayers electing to use the alternative simplified resale method would separately determine the amount of mixed service costs related to their off-site storage ("storage"), purchasing and handling activities by multiplying the total amount of mixed service costs incurred by the taxpayer in the trade or business for the taxable year by a separate ratio for each particular activity that consists of:

(i) the labor costs allocable to each particular activity (i.e., storage, purchasing, and handling) excluding labor costs that are included in mixed service costs, to

(ii) the total of all labor costs incurred in the taxpayer's trade or business, excluding labor costs that are included in mixed service costs.

EXAMPLE (1). Assume the same facts as in Example (1) of section 1.263A-1T(d)(4)(iv) of the regulations, i.e., that Taxpayer A, using the first-in, first-out (FIFO) method of accounting for inventories, incurred $400,000 of storage costs, $500,000 of purchasing costs, $300,000 in handling costs, and $200,000 of mixed service costs during the taxable year. A's beginning inventory balance (excluding additional section 263A resale costs) was $2 million. A made $8 million in gross purchases during the taxable year, and A's ending inventory balance (excluding additional section 263A resale costs) was $3 million. The amounts in ending inventory which are viewed as consisting of purchases made during the taxable year, under the FIFO method, are $3 million. In addition, assume that A's mixed service costs of $200,000 that were treated as additional section 263A resale costs, initially consisted of $400,000 of total mixed service costs incurred in A's trade or business. The total mixed service costs of $400,000 were then included in the labor based formula, described in section 1.263A-1T(d)(4)(iii) of the regulations, in determining that $200,000 of such mixed service costs would be treated as additional section 263A resale costs or purposes of the allocation ratio in section 1.263A- 1T(d)(4)(ii) of the regulations.

Assume also that labor costs incurred in each particular activity (excluding labor costs included in mixed service costs) are as follows: (i) storage -- $100,000, (ii) purchasing $200,000, and (iii) handling -- $200,000. Total labor costs incurred in A's trade or business (excluding labor costs included in mixed service costs) are $1,000,000. Thus, with respect to the total mixed service costs in the trade or business of $400,000, the following amounts of such costs would be allocated to storage, purchasing and handling activities as additional section 263A resale costs: (i) storage -- $40,000 of mixed service costs ($100,000/$1,000,000 multiplied by $400,000); (ii) purchasing -- $80,000 of mixed service costs ($200,000/$1,000,000 multiplied by $400,000); and (iii) handling -- $80,000 of mixed service costs ($200,000/$1,000,000 multiplied by $400,000).

With respect to purchasing costs, the allocation ratio of additional section 263A resale costs (i.e., purchasing costs and allocable mixed service costs) to purchases made during the taxable year is 7.25 percent (i.e., $580,000 ($500,000 + $80,000) divided by $8,000,000). The additional section 263A resale purchasing costs required to be capitalized in ending inventory are equal to $217,500, i.e., the product of the allocation ratio (7.25 percent) multiplied by the amount of purchases for the year which are viewed as being held in ending inventory ($3,000,000).

With respect to storage and handling costs, the calculations under the alternative simplified method differ from Example (1) of the present regulations due to the inclusion of beginning inventory balances. For storage and handling costs (combined), the allocation ratio of additional section 263A resale costs to beginning inventory and purchases made during the taxable year is 8.2 percent (i.e., $820,000 divided by $10,000,000 ($2,000,000 beginning inventory plus purchases of $8,000,000)). The additional section 263A resale storage and handling costs required to be capitalized in ending inventory are equal to $246,000, i.e., the product of the allocation ratio (8.2 percent) multiplied by the total amount of ending inventory equal to $3,000,000, including (where applicable) both beginning inventory amounts and purchases for the taxable year.

Thus the total amount of additional section 263A resale costs capitalized for the taxable year under the alternative simplified resale method is equal to $463,500 ($217,500 purchasing and $246,000 storage and handling).

EXAMPLE (2). Assume the same facts as are provided in Example (2) of section 1.263A-1T(d)(4)(iv) of the regulations, i.e., that Taxpayer B uses the last-in, first out method (LIFO) of accounting for inventories, and that the same facts exist as in Example (1). The amounts in ending inventory which are viewed as consisting of purchases made during the taxable year under the LIFO method are $1 million.

With respect to purchasing costs, the allocation ratio of additional section 263A resale costs to purchases made during the taxable year is 7.25 percent (i.e., $580,000 divided by $8,000,000). The additional section 263A resale purchasing costs required to be capitalized in ending inventory are equal to $72,500, i.e., the product of the allocation ratio (7.25 percent) multiplied by the amount of purchases for the year which are viewed as being held in ending inventory ($1,000,000).

With respect to storage and handling costs, the calculations differ from Example (2) of the present regulations due to the inclusion of beginning inventory balances. For storage and handling costs (combined), the allocation ratio of additional section 263A resale costs to beginning inventory and purchases made during the taxable year is the same as in Example (1), i.e., 8.2 percent (i.e., $820,000 divided by $10,000,000 ($2,000,000 beginning inventory plus purchases of $8,000,000)). The additional section 263A resale storage and handling costs required to be capitalized in ending inventory are equal to $246,000, i.e., the product of the allocation ratio (8.2 percent) multiplied by the total amount of ending inventory of $3,000,000, including (where applicable) inventory which is viewed as being contained in the taxpayer's beginning inventory for the taxable year and purchases for the taxable year.

With respect to the LIFO increment of $1,000,000 for the taxable year, $82,000 of the additional section 263A resale storage and handling costs are required to be capitalized (8.2 percent multiplied by $1,000,000). The remaining $164,000 (8.2 percent multiplied by $2,000,000) of additional section 263A resale storage and handling costs are required to be capitalized with respect to the beginning LIFO inventory of $2,000,000; such amounts would be allocated to each layer of costs comprising the beginning LIFO inventory in the proportion that such layer bears to the entire beginning inventory balance. Moreover, additional section 263A resale storage and handling costs required to be capitalized for future years would also be capitalized with respect to this beginning LIFO inventory. Thus, absent a decrement in the taxpayer's LIFO balances, the total cumulative amounts of storage and handling costs capitalized with respect to existing LIFO layers would increase each year under the alternative simplified resale method.

The total amount of section 263A resale costs capitalized -- for the taxable year under the alternative simplified resale method is equal to $318,500 ($72,500 purchasing plus $246,000 storage and handling).

Taxpayers may elect to use the alternative simplified resale method separately for each trade or business of the taxpayer under the provisions of section VI of this notice, which provides procedures for expedited changes in methods of accounting.

Alternatively, taxpayers not electing to use the alternative simplified resale method may continue to use the simplified resale method as provided in the present regulations, subject to all of the requirements provided therein.

(B) PROPERTY PRODUCED UNDER CONTRACT FOR SUBSEQUENT RESALE.

Section 1.263A-1T(b)(5)(i) of the regulations provides that the taxpayer may not use the simplified resale method for any trade or business that consists of the production of property. With respect to businesses that involve both the production of property and the acquisition of property for resale, only the simplified methods available to producers of property (e.g., the simplified production method) may be used by the taxpayer. Section 1.263A-1T(a)(5)(ii) of the regulations provides that property produced for the taxpayer under a contract with the taxpayer is treated as property produced by the taxpayer to the extent that the taxpayer makes payments or otherwise incurs costs with respect to such property.

The Internal Revenue Service has received comments noting that any taxpayer that acquires property for resale which is produced for the taxpayer under contract may, under the present regulations, be prohibited from using the simplified resale method because the taxpayer will be viewed as producing the property under section 1.263A-1T(a)(5)(ii) of the regulations. Such a result would effectively prevent many taxpayers acquiring property for resale from using the simplified resale method because of arrangements such taxpayers make with other parties to produce property under "private label" for the taxpayer to resell. In addition, treating such property as produced by the taxpayer could effect the determination of whether the taxpayer is eligible for the $10 million gross receipts exception of section 263A(b)(2)(B) of the Code.

Forthcoming regulations will clarify that a taxpayer acquiring property for resale will not be ineligible to use the simplified resale method solely by reason of the fact that property is produced for the taxpayer under contract. Such a taxpayer is, however, required to capitalize, under the simplified resale method, all costs it incurs with respect to the property being produced under contract as if the property were produced by the taxpayer. Moreover, a taxpayer will not be viewed, for purposes of the $10 million gross receipts exception in section 263A(b)(2)(B) of the Code, as producing property solely by reason of the fact that the property acquired for resale is being produced under contract for the taxpayer.

(C) DE MINIMIS PRODUCTION ACTIVITIES.

As previously mentioned, section 1.263A-1T(b)(5)(i) of the regulations provides that the taxpayer may not use the simplified resale method for any trade or business that involves the production of property.

Commentators have noted that many taxpayers acquiring property for resale also engage in limited amounts of production activities in the same trade or business. Thus, the present regulations could prevent such taxpayers from using the simplified resale method. Such a result would arguably frustrate the intention of Congress in enacting section 263A(h)(2) of the Code, which specifically authorizes the availability of simplified methods for taxpayers acquiring property for resale.

In response to these comments, forthcoming regulations will clarify that taxpayers will not be precluded from using the simplified resale method with respect to a trade or business in which the taxpayer acquires property for resale solely by reason of a de minimis amount of production activities occurring in the same trade or business. Such a taxpayer is, however, required to capitalize, under the simplified resale method, all costs it incurs with respect to the property as if the property were produced by the taxpayer. The determination of whether the amount of production activities is de minimis shall be made with appropriate consideration being given to the volume of the resale activities in the particular trade or business in issue.

EXAMPLE (1). Taxpayer C is engaged in the retail grocery business and operates numerous grocery stores throughout the United States. C's grocery stores typically contain a section of the store where taxpayers can purchase breads, pastries, sandwiches, salads and other prepared foods that have been produced by C itself (e.g., C's employees have baked the breads or made the salads). Assume that, after giving appropriate consideration to the volume of resale activities in C's business, it is determined that the production activities occurring in C's stores are de minimis in relation to the volume of resale activities occurring in such business. Thus, C will not be precluded from using the simplified resale method to account for its grocery business.

EXAMPLE (2). Taxpayer D is engaged in the retail trade business and operates numerous department stores throughout the United States. D buys appliances and other items in parts from manufacturers, and assembles such appliances in order to hold them for sale to customers. Moreover, D frequently installs appliances and other items in the homes of customers who purchase such products from D. Assume that, after giving appropriate consideration to the volume of resale activities in D's business, it is determined that the production activities occurring in D's business are de minimis in comparison to the volume of resale activities occurring in such business. Thus, D will not be precluded from using the simplified resale method to account for its business.

(D) SERVICES VERSUS PROPERTY ACQUIRED FOR RESALE.

Taxpayers have inquired as to whether the requirement under section 263A to capitalize costs with respect to property acquired for resale applies with respect to taxpayers providing both services and property to customers in a trade or business where the property provided to customers is de minimis in amount.

Forthcoming regulations will provide that a taxpayer will not be required to capitalize costs with respect to property acquired for resale under section 263A if only a de minimis amount of property is provided to customers in the ordinary course of the taxpayer's trade or business. Moreover, the determination of whether the amount of property provided to customers is de miminis in amount shall be made with appropriate consideration being given to the volume of service activities in the particular trade or business in issue.

Notwithstanding the foregoing, for purposes of this section III(D), property provided to customers will not be viewed as de minimis in amount if the taxpayer was required, under prior law, to account for such property as inventory under section 471 or the regulations thereunder (including administrative interpretations thereof). Similarly, nothing in this section shall be construed as allowing a taxpayer to change it method of accounting for materials or supplies without obtaining the consent of the Commissioner, if the taxpayer's method of accounting for such supplies was to include the charges for the supplies in expense only when they were actually consumed, as opposed to when they were purchased. See, e.g., section 1.162-3 of the regulations.

With respect to trades or businesses where the amount of property provided to customers is not de minimis in amount, the provisions of section 263A with respect to property acquired for resale shall apply to such property, notwithstanding the fact that the predominant nature of the business may be the provision of services. Moreover, the requirements of the preceding sentence shall apply without regard to the taxpayer's treatment under prior law of the property acquired, e.g., without regard to whether the taxpayer expensed the costs of such property under prior law (including section 1.162-3 of the regulations).

EXAMPLE (1). Taxpayer G is engaged in providing architectural services. In the course of its business activities, G provides various types of property to its clients, including graphs, charts, blueprints, prototypes and models of various structures and designs. Assume that, although G is providing property to customers, the property provided is de minimis in amount in comparison to the volume of service activities being provided to customers. Thus, section 263A does not apply to the property acquired by G for resale.

EXAMPLE (2). Taxpayer H is engaged in providing automobile repair and maintenance services. In the course of its business activities, H provides various automobile parts to customers including carburetors, spark plugs, hoses, belts, mufflers and other parts. Assume that, although H may be predominantly engaged in the provision of services, the property provided to customers by H is not de minimis in amount. (In addition, the property provided to customers would not be de minimis in amount because such property was required to be accounted for as inventory under section 471 of prior law.) Therefore, the rules of section 263A with respect to property acquired for resale apply to the automobile parts and supplies acquired by H.

EXAMPLE (3). Taxpayer M is engaged in providing optical care, eyewear, and and supplies to customers. In the course of its business activities, M examines and fits customers for corrective lenses and provides such lenses and related supplies to customers. M maintains a supply of certain types of lenses, eyeglass frames, other optical wear and supplies. All orders for lenses not maintained in M's inventory are provided to M by a supplier. M does not cut or grind lenses for eyeglasses. Assume that, although M engages in the provision of services, the property provided to customers by M is not de minimis in amount. (In addition, the property provided to customers would not be de minimis in amount because such property was required to be accounted for as inventory under section 471 of prior law.) Therefore, the rules of section 263A with respect to property acquired for resale apply to the property acquired by M.

(E) CAPITALIZATION OF HANDLING COSTS.

Under section 263A, costs attributable to handling processing, assembly, repackaging and other similar activities ("handling costs") are generally required to be capitalized with respect to both property produced by the taxpayer and property acquired by the taxpayer for resale. As section 1.263A-1T(d)(3)(ii)(C) of the regulations provides, handling costs include all costs incurred in transporting goods (including loading and unloading costs) to or between storage facilities or sale outlets of the taxpayer, as well as costs of processing, assembling, and repackaging goods.

Forthcoming regulations will clarify that, with respect to property acquired for resale, labor costs incurred at a retail facility to unload a truck, unpack and handle the goods that were contained in the truck, and mark and tag such goods are not required to be capitalized for purposes of section 263A, if, and to the extent that, such goods will be sold in "on-site" sales (as defined in section 1.263A-1T(d)(3)(ii)(A) of the regulations) to customers at such retail facility. In addition, as the present regulations provide, storage costs incurred with respect to goods contained within the on-site facility would be expensed and not subject to capitalization. Moreover, with respect to retail facilities, labor costs of sales clerks and other similar personnel incurred in displaying goods and in handling goods in the course of waiting on customers for the purpose of making on-site sales are not required to be capitalized.

The costs of activities such as processing (i.e., changing or altering the nature or form of a product), assembly, packaging and similar activities incurred at a retail facility that are not de minimis in amount are required to be capitalized by the taxpayer. Similarly, costs that were required, under the law (including administrative interpretations thereof) prior to the effective date of the 1986 Act, to be accounted for as the costs of manufacturing inventory property or the costs of producing any other type of property, are required to be capitalized by the taxpayer regardless of the type of facility where they are incurred. Thus, for example, the costs of activities such as assembling merchandise (e.g., furniture, appliances, or other similar items), printing or monogramming property, customizing or altering property, or other similar activities in connection with the sale of such property, are required to be capitalized by the taxpayer regardless of the type of facility where they are incurred. (See, e.g., Rev. Rul. 81-272, 1981-2 C.B. 116.)

(F) DISTRIBUTION COSTS.

Under section 1.263A-1T(d)(3)(ii)(C)(3) of the regulations, distribution costs are defined as the cost of delivering goods directly to an unrelated customer. Commentators have inquired as to the treatment of costs incurred in transporting goods to a person related to the taxpayer, including the costs of transporting goods to a related person that has purchased such goods from the taxpayer. Forthcoming regulations will clarify that the costs of transporting goods by a taxpayer to a related person are to be capitalized by the taxpayer as a cost of the goods being transported. Thus, for example, when the taxpayer sells goods to a related person, the costs of transporting such goods will be included in determining the basis of the goods that are sold, and hence the resulting gain or loss from such sale, for all purposes of the Code and the regulations thereunder. (See, e.g., sections 267, 707, and 1502.) Moreover, for purposes of this provision, parties shall be related if they are described in section 267(b) or 707(b).

(G) $10 MILLION GROSS RECEIPTS EXCEPTION FOR CERTAIN TAXPAYERS.

Section 263A(b)(2)(B) provides an exception from the general rules of section 263A with respect to personal property acquired in a taxable year for resale by a taxpayer whose average annual gross receipts for the three preceding taxable years do not exceed $10 million. For purposes of determining the gross receipts of the taxpayer, all persons treated as a single employer under section 52(a) or (b), or section 414(m) or (o), shall be treated as one person. Persons treated as a single employer under section 52(a) include members of controlled groups within the meaning of section 1563(a), regardless of whether such persons would be treated as "component members" of such group under section 1563(b). (See section 1.52-1(c) of the regulations.) Thus, for example, the gross receipts of a franchised corporation that is treated as an excluded member for purposes of section 1563(b) would be included for purposes of the aggregation rules of the gross receipts test under section 263A(b)(2)(B), if such corporation and the taxpayer were members of the same controlled group under section 1563(a).

With respect to persons ("members") that are treated as a single employer (the "group") for a taxable year, the gross receipts of the group shall be determined by aggregating the gross receipts of all members of the group, excluding gross receipts attributable to transactions occuring between such members. Moreover, in determining the gross receipts of any member of the group for a taxable year of less than 12 months, the gross receipts shall be annualized by (i) multiplying the gross receipts for the short period by 12, and (ii) dividing the result by the number of months in the short period.

In addition, in determining the gross receipts of the group for the three taxable years preceding the taxable year in issue (the "three taxable years test"), the gross receipts of all persons (or their predecessors) who are members of the group as of the first day of the taxable year in issue shall be included in such determination, regardless of whether such persons were members of the group for any of the three preceding taxable years. Similarly, the gross receipts of persons that were members of the group for any or all of the three preceding taxable years, but who (including their successors) are not members of the group as of the first day of the taxable year in issue, shall not be included for purposes of the three taxable years test.

EXAMPLE (1) Assume that a parent corporation (P) has continually owned 100 percent of the stock of another corporation (S1) since 1983, and that P and S1 are calendar year taxpayers. S1 acquires property for resale. In addition, P acquired 100 percent of the stock of another calendar year corporation (S2) as of the beginning of business on January 1, 1987.

In determining whether S1's resale activities are subject to the provisions of section 263A for the taxable year beginning January 1, 1987, the gross receipts of P S1 and S2 for 1984 1985 and 1986 shall be aggregated, excluding the gross receipts attributable to transactions occurring between the three corporations. The gross receipts of S2 are taken into account because it was a member of the group on January 1, 1987.

EXAMPLE (2) Assume that a parent corporation (P) has continually owned 100 percent of the stock of two other corporations, (S1) and (S2), since 1983, and that the three corporations are calendar year taxpayers. S1 acquires property for resale. On December 31, 1986, P sells all of its stock in S2. In determining whether S1's resale activities are subject to the provisions of section 263A for the taxable year beginning January 1, 1987, only the gross receipts of P and S1 for 1984, 1985, and 1986 shall be aggregated, excluding the gross receipts attributable to transactions occurring between the two corporations. The gross receipts of S2 are not taken into account because it was not a member of the group on January 1, 1987.

IV. RULES OF GENERAL APPLICATION.

(A) DEFERRED INTERCOMPANY TRANSACTIONS.

Section 1.263A-1T(e)(1)(ii) of the present regulations requires taxpayers changing their method of accounting with respect to inventory property to revalue the outstanding balances of deferred gain or loss as of the beginning of the year of change if such gain or loss relates to the sale or exchange of inventory property in a deferred intercompany transaction. Under the regulations, the deferred gain or loss is revalued to the amount that would have resulted had the cost of goods sold for the inventory property been determined under the capitalization rules of section 263A.

Commentators have noted that the present regulations appear to require the revaluation of the amount of deferred gain or loss in situations where the inventory property sold in the deferred intercompany transaction is being held by the buying member of the affiliated group for use in its trade or business, as distinguished from being held by such member as inventory. Forthcoming regulations will clarify that taxpayers shall revalue the amount of deferred gain or loss only in situations where the inventory property sold in the deferred intercompany transaction was held as inventory by the buying member as of the date the taxpayer is required to change its method of accounting for inventory under section 263A. Taxpayers shall not revalue the amount of deferred gain or loss in situations where the buying member is not holding the purchased property as inventory.

(B) LIFO TAXPAYERS -- NEW BASE YEAR.

Section 1.263A-1T(e)(6)(iv) of the present regulations allows taxpayers using the dollar-value LIFO method of accounting for inventories to revalue all existing LIFO layers of a trade or business based on the "3-year average method," as defined in the regulations. (The present regulations limit the availability of the 3-year average method to dollar-value LIFO taxpayers; no change in this rule is anticipated.) Pursuant to the legislative history of the 1986 Act, under section 1.263A-1T(e)(6)(iv)(A) of the regulations, taxpayers using the 3-year average method are required to establish the year prior to the year of change in method of accounting under section 263A as a new base year.

Commentators have inquired as to whether the requirement to establish a new base year under the 3-year average method would apply where a taxpayer was using the simplified production method or the simplified resale method to account for production or resale costs under section 263A. Forthcoming regulations will clarify that taxpayers using the simplified production method or the simplified resale method (including the alternative simplified resale method) are not required to establish a new base year under the 3-year average method. However, to prevent the imposition of administrative burdens on taxpayers who may have interpreted the present regulations to require such a new base year, taxpayers described in the preceding sentence may, if they chose, establish a new base year under the 3- year average method. Moreover, for purposes of section 263A, forthcoming regulations will provide that dollar-value LIFO taxpayers not using the 3-year average method are permitted to establish a new base year, but are not required to do so.

Taxpayers that wish to establish a new base year, other than taxpayers described in the preceding paragraph, are required to obtain the Commissioner's consent to such a change in method of accounting. Taxpayers that established a new base year under section 263A in the belief that such a new base year was required, may change their method of accounting to the previous base year if they are not required to establish a new base year under the provisions of this notice. Such a change in method of accounting may be made under section VI of this notice, which provides expedited procedures for changes in methods of accounting.

Similarly, taxpayers that did not establish a new base year under section 263A in the belief that such a new base year was not permitted, may change their method of accounting to the new base year if they are permitted to do so under the provisions of this notice. Such a change in method of accounting may be made under section VI of this notice, which provides expedited procedures for changes in methods of accounting.

(C) INTANGIBLE AND TANGIBLE PROPERTIES.

Section 263A(b)(1) provides that the uniform capitalization rules apply to the production of real or tangible personal property, while section 263A(b)(2) provides that the uniform capitalization rules apply to real or personal property acquired for resale.

Thus, pursuant to the statute and accompanying legislative history, section 1.263A-1T(d)(1) requires the capitalization of the costs of tangible or intangible property acquired for resale. For example, section 1.263A-1T(d)(1) requires the capitalization of the costs incurred with respect to the purchase of securities by a dealer in such properties, including, for example, the costs incurred in the research department of such taxpayer.

Commentators have inquired as to whether a taxpayer that originates loans (i.e., loans money to other persons in return for promissory notes or other documents evidencing a promise to repay) would be treated as acquiring intangible property for resale under section 263A.

In response to these inquiries, forthcoming regulations shall provide that the origination of a loan shall be treated under section 263A as the production of intangible property, as opposed to the acquisition of intangible property for resale. Thus, the capitalization rules of section 263A shall not apply to such activity, because section 263A only applies to the production of tangible personal property. Section 263A, however, applies to taxpayers purchasing pre-existing loans from other parties for resale. Such taxpayers are treated as acquiring intangible property for resale, and hence are subject to the uniform capitalization rules. The provisions of this paragraph apply only for purposes of section 263A and no inference relating to the treatment of such property for other purposes of the Code is intended (see e.g., Rev. Rul. 72-523, 1972-2 C.B. 242).

(D) SERVICE DEPARTMENTS -- ACCOUNTS RECEIVABLE.

Section 1.263A-1T(b)(4)(vi)(E) of the present regulations provides that accounting and data service operations, including accounts receivable functions, are ordinarily required to be capitalized with respect to production or resale activities. (This provision in the regulations under section 263A follows the rules applicable to "extended-period" long-term contracts under section 1.451-3 of the regulations, which, as the legislative history to the 1986 Act provides, were to serve as the basic model for the uniform capitalization rules).

Commentators have noted that accounts receivable and customer billing functions would appear to be associated with selling activities as opposed to production or resale activities. Thus, it would appear inappropriate to require the capitalization of these types of costs under section 263A.

In response to these comments, the term "accounts receivable" shall be deleted from section 1.263A-1T(b)(4)(vi)(E) of the regulations and the term "billing"" will be revised to exclude customer billing functions. Taxpayers using the simplified service cost method or the simplified resale method (or, if appropriate, other simplified methods provided in this notice) should note, however, that accounts receivable and billing activities are included in the total costs of various departments or functions performing mixed service activities under section 1.263A-1T(b)(6)(iii)(E) or 1.263A-1T(d)(4)(iii)(C) of the regulations.

(E) CAPITALIZATION OF PERIOD COSTS.

Section 1.263A-1T(b) enumerates various types of costs that are required to be capitalized by taxpayers, as well as types of costs that are not required to be capitalized under section 263A ("period costs"). Commentators have inquired as to whether taxpayers, in order to avoid administrative complexities and for other reasons, may capitalize period costs under section 263A, notwithstanding the fact that such costs are not required to be capitalized.

Forthcoming regulations will provide that taxpayers may choose to capitalize period costs under section 263A unless such practice results in a material distortion of the taxpayer's income. In addition, a period cost that is capitalized with respect to inventory property shall be included in computing beginning inventory, ending inventory, and cost of goods sold. Moreover, any taxpayer that capitalizes particular period costs under this section must consistently capitalize such costs and shall treat such practice as a method of accounting under the Code.

Taxpayers that wish to capitalize particular period costs as provided in this notice may do so under the section VI of this notice, which provides expedited procedures for changing methods of accounting.

(F) PENSION COSTS -- Past and Current Components.

Under the 1986 Act, section 263A generally requires the capitalization of amounts representing contributions to various pension plans, and other similar arrangements. (See section 1.263A- 1T(b)(2)(iii)(P) of the regulations). An exception to this general rule is provided under the 1986 Act whereunder taxpayers are not required to capitalize certain contributions to a pension or annuity plan to the extent such contributions represent past service costs. (See section 1.263A-1T(b)(2)(v)(H) of the regulations).

Section 10204 of the Omnibus Budget Reconciliation Act of 1987 (Pub. L. 100-203) (the "1987 Act") repeals this exception for past service costs under section 263A and requires the capitalization of such past service costs under section 263A as follows: (i) with respect to property that is not inventory, for costs incurred after December 31, 1987, in taxable years ending after such date; and (ii) with respect to inventory property, for taxable years beginning after December 31, 1987. Generally, this provision of the 1987 Act repealing the exception for past service costs is effective exactly one year after the provisions of 263A enacted in the 1986 Act are effective.

Commentators have suggested that taxpayers, in order to avoid administrative burdens, be permitted, at their option, to capitalize past service costs under the effective date provisions of the 1986 Act, notwithstanding the fact that the provision requiring capitalization of past service costs is not effective until the following taxable year. In response to these comments, forthcoming regulations will allow taxpayers to adopt such a practice.

Taxpayers who wish to change their methods of accounting as described in this section IV(F) for past service costs under the provisions of the 1986 Act, may do so on a Federal income tax return adopting the use of such method for their first taxable year for which section 263A becomes effective under the 1986 Act, including an amended income tax return filed on or before May 19, 1989.

Regardless of the effective date upon which taxpayers capitalize past service costs, taxpayers shall capitalize past service costs in the same manner (and in the same proportion to property being acquired or produced), as they capitalize present service costs.

(G) WARRANTY COSTS AND PRODUCT LIABILITY INSURANCE.

Commentators have inquired whether warranty costs, i.e., costs incurred by a taxpayer in fulfilling product warranty obligations with respect to products that have been sold, are required to be capitalized. Similar questions have been raised regarding premiums paid for product liability insurance, i.e., insurance that protects the taxpayer against liability from defects and similar problems with respect to products that have been sold.

Section 1.263A-1T(b)(2)(iii)(O) provides that insurance, such as insurance on plant, machinery or equipment, or insurance on the subject matter of the activity, is required to be capitalized. Section 1.263A-1T(b)(2)(v)(A) of the regulations provides, however, that marketing, selling, advertising and distribution expenses are not required to be capitalized with respect to production or resale activities. It is the view of the Internal Revenue Service that, generally, warranty costs and costs of obtaining product liability insurance are in the nature of marketing and selling costs described in section 1.263A-1T(b)(2)(v)(A) of the regulations, and therefore are not required to be capitalized under section 263A.

(H) DEPLETION.

Consistent with the legislative history of section 263A, section 1.263A-1T(b)(2)(iii)(K) of the regulations requires the capitalization of depletion (whether or not in excess of cost). Commentators have noted that the requirement to capitalize depletion would appear to be relevant only in determining the basis of property that is sold (e.g., cost of goods sold) since under the Code depletion is only available with respect to depletable properties when they are sold, as opposed to when they are produced by the taxpayer. Thus, capitalization of depletion would not appear to apply to properties that have been produce by the taxpayer and that are still on hand, i.e., properties that have not been sold.

Forthcoming regulations will clarify that the requirement to capitalize depletion applies in determining the basis of property that is sold, and hence the resulting gain or loss from such sale, for all purposes of the Code and the regulations thereunder. Moreover, such regulations will provide that the producing taxpayer does not capitalize depletion with respect to properties until such properties are sold.

(I) PREPUBLICATION EXPENDITURES.

Section 1.263A-1T(a)(5)(iii) of the regulations requires the prepublication expenditures of books publishers (and publishers of similar properties) to be capitalized under section 263A. Under the regulations, prepublication expenditures include payments made to authors of literary works.

Commentators have inquired as to whether this requirement to capitalize payments made to authors would apply to commissions or royalties that were paid to authors where such commissions were based on contemporaneous sales of the books. Commentators have noted that it would be inappropriate for a publisher to capitalize commissions where such commissions related only to books that had been sold by the publishers, and not to any books (or copyrights pertaining to such books) that were still on hand.

In response to these comments, forthcoming regulations will not require the capitalization of payments made to authors where such payments are commissions for sales of books that have already taken place. If, in contrast, payments are made to authors as pre-paid commissions for future sales of books, such payments shall be capitalized and deducted by the publisher as such future sales occur. Moreover, payments made to authors of literary works that pertain to the use, by the publisher, of the author's rights in the literary works, and that are not based on particular sales of the books, shall be capitalized and amortized as prepublication expenditures under section 167 of the Code. In determining whether payments made to authors are described in the preceding sentence, the substance of the transaction, and not its form, shall control.

(J) DUAL FUNCTION FACILITIES.

Section 1.263A-1T(d)(3)(ii)(A)(2) of the present regulations provides guidance with respect to taxpayers operating "dual function facilities", i.e., facilities that serve as both on-site and off-site storage facilities. The regulations provide that a percentage of a dual function facility shall be treated as an on-site storage facility equal to the ratio of --

(i) gross on-site sales of the facility, i.e., gross sales of the facility made to retail customers visiting the premises in person and purchasing merchandise stored therein, to

(ii) total gross sales of the facility.

Commentators have inquired as to treatment of facilities with respect to items that are stored in such facilities and shipped, but not sold, to other facilities of the taxpayer (or any other person) or with respect to items for the taxpayer's own use that are stored by the taxpayer at a storage facility. Forthcoming regulations will clarify that the value of such shipped items shall be included in the denominator of the ratio, previously described, for purposes of determining (i) whether a facility is a dual function facility, and (ii) the percentage of a dual function facility that shall be treated as an on-site facility. For this purpose, the value of shipped but unsold items shall be the "arm's length" price for such items as such term is defined in section 1.263A-1T(b)(2)(vi)(C) of the regulations. Similarly, forthcoming regulations will clarify that the portion of the facility used to store items (such as equipment or supplies) for the taxpayer's own use shall be treated as an off-site facility for purposes of making these determinations as well.

(K) MATERIALS AND SUPPLIES.

Section 1.162-3 of the regulations allows taxpayers to deduct, under certain circumstances and conditions, the total costs of materials and supplies (collectively, "supplies") in the taxable year in which such supplies are purchased. Under the law prior to the 1986 Act, manufacturers of inventory were required to "capitalize" (as that term is defined in section 1.263A-1T(a)(5)(i) of the regulations) the costs of supplies as costs of producing inventory. See sections 1.471-11(b)(2)(i) and 11(c)(2)(i)(f) of the regulations. Thus, taxpayers electing to expense the costs of supplies when purchased under section 1.162-3 of the regulations were then required, under section 1.471-11, to capitalize that deduction as a cost of producing inventory, to the extent such supplies were used or consumed in the production of such inventory.

The same principles apply under section 263A, i.e., to the extent that supplies are used or consumed with respect to the production of property or the acquisition of property for resale, the deduction under section 1.162-3 of the regulations with respect to such supplies shall be capitalized as a cost of such property under section 263A.

(L) ALLOCATION METHODS AND DE MINIMIS RULE.

Section 1.263A-1T(b)(3)(iii)(A)(2) of the present regulations provides a de minimis rule with respect to allocation methods used under section 263A. Under those regulations, an allocation method that is not described in the regulations under section 263A may be used by the taxpayer if, with respect to the taxpayer's production or resale activities taken as a whole:

(i) the total amounts of such costs which the taxpayer capitalizes during the taxable year do not differ significantly (with appropriate consideration being given to the volume of the taxpayer's production or resale activities) from the total amounts which would be capitalized under the requirements of section 263A; and

(ii) the allocation method is applied consistently by the taxpayer and does not result in a significantly disproportionate allocation of costs to production or resale activities in such a manner as to circumvent the principles of this section.

Under the present regulations, this de minimis rule is also available with respect to the various simplified methods allowed under section 263A.

Commentators have inquired as to whether this de minimis rule only applies to the allocation methods used to capitalize indirect costs, or whether, instead, the rule also applies to direct costs and interest required to be capitalized under section 263A. Forthcoming regulations will clarify that the de minimis rule described in this section applies to any cost required to be capitalized under section 263A. (As provided in the present regulations under section 263A, the use of a particular allocation method for any taxable year is a method of accounting and the consent of the Commissioner is required with respect to any change in such method.)

(M) STORAGE COSTS.

Section 263A requires the capitalization of storage costs and other related costs with respect to the production of property and the acquisition of property for resale. Commentators have noted that the simplified production method, permitted under section 1.263A- 1T(b)(5) of the present regulations, and the simplified resale method, permitted under section 1.263A-1T(d)(3) of the present regulations, apply additional section 263A costs (including storage and other costs) only to items in ending inventory that are viewed as purchased or produced during the year under the taxpayer's method of accounting.

This convention, allowed under these simplified methods for reasons of administrative convenience and simplicity, is not available for taxpayers who do not elect the use of these simplified methods and who are thus required to capitalize their costs under section 263A based on the facts and circumstances of the particular taxpayer's operation, with the same degree of specificity as required of manufacturers capitalizing costs under prior law. See the legislative history to the 1986 Act which provides that "the Committee intends that storage costs incurred by a manufacturer following completion (or substantial completion) of the manufacturing process with regard to a product will likewise be subject to capitalization under these rules. Thus, the bill overrules any case law holding to the contrary (without inference as to the validity of such cases under present law)." Senate Report at 142.

Thus, with respect to a taxpayer not electing the simplified production method or the simplified resale method, storage costs are subject to capitalization as other costs incurred in the taxpayer's operations, i.e., based on the facts and circumstances of the particular taxpayer's operations.

Thus, in the case of property that is under production by the taxpayer, storage costs are subject to capitalization during each year in which the property is under production in the same manner and with the same degree of specificity as other inventoriable costs incurred with respect to such property. For this purpose, property shall be considered to be under production ("work in process") until the property is held for sale or ready to be placed in service. Thus, property constitutes work in process during the course of any production activity, including an activity that involves only the passage of time, such as an aging, curing, or maturation process. In the case of raw materials, storage costs are required to be capitalized for each year during which the raw materials are physically held by the taxpayer, based on a facts and circumstances determination (and not necessarily on the taxpayer's cost-flow assumption, e.g., LIFO).

With respect to property the production of which is complete (property that ceases to be work in process, as described in the previous paragraph, i.e., "finished goods"), storage costs are subject to capitalization for each year during which the finished goods are physically held by the taxpayer, based on a facts and circumstances determination (and not necessarily on the taxpayer's cost-flow assumption; e.g., LIFO). In addition, the carrying cost of such finished goods must reflect the storage costs required to be capitalized with respect to such property for periods in which the property was treated as work in process. Similarly, in the case of a taxpayer that acquires property for resale, storage costs are subject to capitalization for each year during which the property is physically held by the taxpayer based on a facts and circumstances determination (and not necessarily on the taxpayer's cost-flow assumption, e.g., LIFO).

(N) LOWER OF COST OR MARKET.

Under section 1.471-2(c) of the regulations, certain taxpayers may elect to use the lower of cost or market method (the "LCM method" or "LCM") of valuing inventories. Other taxpayers are allowed to value inventories on the basis of market. The legislative history to the 1986 Act provides that "the uniform capitalization rules are not intended to modify present law rules relating to valuation of inventories on a basis other than cost. Thus, the rules will not affect the valuation of inventories at market by a taxpayer using the lower of cost or market method, or by a dealer in securities or commodities using the market method. However, the rules will apply to inventories valued at cost by a taxpayer using the lower of cost or market method." Conference Report at II-305.

Under section 1.471-4 of the regulations, relating to the LCM method, the term "market" generally means the current bid price for the particular inventory in question, in the volume in which such inventory is usually purchased by the taxpayer. In particular, with respect to inventory produced by the taxpayer, the term "bid price" pertains to the bid price for the basic elements of cost (materials, labor and burden) in the produced inventory. Thus, market is generally defined to mean the costs of replacing or reproducing inventory property, with such cost including, where appropriate, indirect costs (i.e., "burden") incurred in the process of replacing or reproducing the inventory.

Under the 1986 Act, costs attributable to the purchasing, handling, and storage of inventory are required to be treated as inventory costs with respect to both produced inventory and inventory acquired for resale. The requirement to capitalize such costs reflects a Congressional determination that such costs integrally relate to the acquisition or production of inventory property, and therefore the failure to capitalize such costs "produces a mismatching of expenses and the related income and an unwarranted deferral of taxes." Senate Report at 140.

Based on the foregoing, forthcoming regulations will retain the basic provisions of the present regulations relating to the definition of market. Thus, with respect to produced inventories, the market price will consist of the current bid price with respect to the basic elements of cost of such inventories (materials, labor, and burden, i.e, all direct and indirect costs pertaining to such inventories as described in section 1.263A-1T(b)(2) of the regulations, including, but not limited to the cost of purchasing, handling, and storage activities conducted by the taxpayer). These same rules applicable to produced inventories shall also apply with respect to inventories acquired for resale. Thus, with respect to inventories acquired for resale, the market price will consist of current bid price with respect to the basic elements of cost of such inventories (materials, labor, and burden, i.e., all direct and indirect costs pertaining to such inventories as described in section 1.263A-1T(b)(2) of the regulations, including but not limited to the cost of purchasing, handling, and storage activities conducted by the taxpayer).

V. PROPERTY PRODUCED IN A FARMING BUSINESS.

(A) FARMERS AND CONSTRUCTIVE OWNERSHIP RULES.

The uniform capitalization rules apply to the production of certain plants or animals in the trade or business of farming. Under section 263A(d)(3) of the Code, certain taxpayers may elect not to have the capitalization rules apply to the production of their plants or animals; electing taxpayers are required to recapture certain costs upon a disposition of the farm property, and to use the alternative depreciation system with respect to all property used predominantly in any farming business of the taxpayer or a related person.

For purposes of the requirement to use the alternative depreciation system, section 263A(e)(2)(B)(i) defines a related person to include members of the taxpayer's family, with the term "family" specified in section 263A(e)(2)(C) to consist of the taxpayer's spouse and any of the taxpayer's children who have not attained age 18 before the close of the taxable year. In addition, section 263A(e)(2)(B)(ii) defines a related party to include any corporation if 50 percent or more of the stock of such corporation is owned (directly or through the application of section 318) by the taxpayer or members of the taxpayer's family. A similar rule with respect to partnerships is provided in section 263A(e)(2)(B)(iv) of the Code and section 1.263A-1T(c)(6)(vi)(C)(4) of the present regulations.

Commentators have noted that a literal reading of the statute and regulations could suggest that, in determining whether a taxpayer owns 50 percent or more of a corporation or partnership, the constructive family ownership rules of section 318(a)(1) would apply. Such a result would be anomalous because the constructive family ownership rules of section 318(a)(1) are broader than the definition of "family" in section 263A(e)(2)(C). For example, if such an interpretation were correct, a corporation owned by a taxpayer's adult son would be deemed related to the electing taxpayer and therefore would be required to use the alternative depreciation system with respect to farm property, although the taxpayer's adult son could own the property directly without having to use such depreciation system.

In response to these comments, forthcoming regulations will clarify that the definition of members of a family in section 263A(e)(2)(C) of the Code will supersede the definition of members of family in section 318(a)(1) of the Code for purposes of applying the rules of section 263A(e)(2)(B).

(B) SIMPLIFIED PRODUCTION METHOD AND UNIT LIVESTOCK METHOD.

Under section 1.263A-1T(b)(5) of the regulations, taxpayers are permitted to use the simplified production method of accounting for the costs of producing property. The simplified production method involves determining the amounts of costs that would have been capitalized under the taxpayer's prior method of accounting ("section 471 costs") and making various quantitative comparisons, as specified in the regulations, of those section 471 costs with the taxpayer's additional costs required to be capitalized under section 263A, excluding interest ("additional section 263A costs"). Moreover, section 1.263A-1T(b)(5)(iii) of the regulations defines "section 471 costs" as any costs includable in production costs under the taxpayer's prior method of accounting regardless of whether such prior method required the absorption of costs to inventories under section 1.471-11 of the regulations. Commentators have inquired as to the availability of the simplified production method for farmers using the unit-livestock method of accounting for the costs of raising livestock.

Based on the foregoing, forthcoming regulations will clarify that farmers using the unit-livestock method of accounting are permitted to elect the simplified production method under section 263A. In such a situation, the term "section 471 costs" are the costs taken into account by the taxpayer under the unit-livestock method using the taxpayer's historical unit price (as modified by Notice 88-24, 1988-14 I.R.B. 6, which generally repeals the rule allowing taxpayers to avoid any increase in unit cost with respect to purchases of animals made in the last six months of the taxable year). The term "additional section 263A costs" consists of all additional costs required to be capitalized under section 263A, including (i) increases in the amounts in various categories of costs already reflected in the taxpayer's unit-livestock standard prices (e.g., increases in the price of feeding an animal that have occurred since the unit-livestock prices were initially established); and (ii) additional categories of costs that are required to be capitalized under section 263A and that were not reflected in the initial unit- livestock standard prices (e.g., general and administrative costs and depreciation, including depreciation on the calf's mother).

Taxpayers presently using the unit-livestock method who wish the use (sic) the simplified production method with respect to the costs of raising livestock under section 263A may do so under section VI of this notice, which provides expedited procedures for changing methods of accounting.

VI. EXPEDITED CHANGES IN METHODS OF ACCOUNTING.

The purpose of this section is to provide expedited procedures for taxpayers who wish to change their method of accounting. This section is only applicable to a change in method of accounting if another provision of this notice dealing with such change in method expressly refers to this section in providing guidance to taxpayers. To the extent that a change in method of accounting is not described in the preceding sentence, this section does not apply to such change in method, and such change is subject to all provisions of the Code, the regulations thereunder, and applicable administrative provisions.

With respect to any taxpayer changing its method of accounting under this section, such change may be adopted:

(1) on a Federal income tax return adopting the use of such method (including any necessary revisions of adjustments under section 481(a)) for its first taxable year for which section 263A becomes effective, including an amended Federal income tax return filed on or before May 19, 1989; or

(2) on a Federal income tax return adopting the use of such method for its second taxable year for which section 263A becomes effective, including an amended Federal income tax return filed on or before May 19, 1989, if and only if the previous method used by the taxpayer in accounting for the particular items or costs in issue for the taxable year described in clause (1) above was a correct method of accounting under section 263A nd the regulations thereunder.

With respect to any taxpayer described in clause (2) of the preceding sentence, the change in method of accounting shall be made (i) by applying such method to all costs incurred in the taxable year for which the method is being adopted, and (ii) without restating beginning balances for such year and without any corresponding adjustment under section 481(a) for any year.

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, contact Paulette C. Galanko of the Legislation and Regulations Division at (202) 566- 3288 or Carol Conjura of the Corporation Tax Division at (202) 566- 3024 (not a toll-free call).