Firm Opposes Proposed Treatment of Allocable Contract Costs

Baker & McKenzie LLP respectfully submits 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 amended (the "Code")¹ published in the Federal Register on August 27, 2015 (the "Proposed Regulations"). We commend the Internal Revenue Service (the "IRS") and the U.S. Department of the Treasury ("Treasury") drafters for their efforts in this important area. Although there are several provisions in the Proposed Regulations about which we have concerns, our comments in this letter are limited to the statement and the related rule in the Proposed Regulations 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. The specific provisions in the Proposed Regulations that we address in this letter are the inclusion of a new eighth sentence in Section 1.199-4(b)(1) and a new Section 1.199-4(b)(2)(iii) (collectively, the "Proposed Rules"). The Proposed Rules are contrary to the prevailing legal principles underlying Section 199 and the conventional understanding of the law and facts relevant to the subject matter of the Proposed Rules. This letter also addresses the effective date of the Proposed Regulations in the context of the Proposed Rules.

Section 460 Allocable Contract Costs Analogous to Costs of Goods Sold.

Section 1.199-4(b)(1) of the Proposed Regulations provides that "[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)." The preamble to the Proposed Regulations asserts that "[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. The preamble does not include any citation to pertinent authority, does not explain the basis for this conclusory assertion, does not describe how the characterization of costs accounted for under the PCM as CGS follows from Section 460 or the Treasury Regulations thereunder, and does not explain the reasons for the change in treatment of costs under Section 460 relative to the existing Treasury Regulations under Section 199.

Contrary to the unsupported assertion in the preamble, allocable contract costs demonstrably are not analogous to CGS. Although the term "costs of goods sold" is not defined in the Code, solely for purposes of Section 199,² Section 1.199-4(b)(1) provides that "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 shown in the pertinent regulatory text, CGS is an inventory-related concept. As discussed below, the concept of inventory is antithetical to Section 460. Thus, the concept of CGS is also contrary to Section 460.

The Treasury Regulations establish that (i) CGS is an amount that is subtracted from gross receipts to arrive at gross income, and (ii) in determining CGS the impact of beginning and ending inventories must be considered. Specifically, Section 1.61-3(a) stipulates that "[i]n a manufacturing . . . business 'gross income' means the total sales, less the costs of goods sold." Further, Section 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."

These concepts do not have any application to contracts accounted for under Section 460. Specifically, CGS are subtracted from gross receipts to determine gross income. In contrast, under Section 460, allocable contract costs are deducted in calculating net income rather than in determining gross income. Section 1.460-4(b)(l) explains that under the PCM, "the taxpayer includes a portion of the total contract price in gross income as the taxpayer incurs allocable contract costs." Thus, the proportion of allocable contract costs incurred is used to determine the amount of gross income recognized under the PCM and allocable contract costs are not netted against gross receipts to determine gross income. This difference undermines any analogy between allocable contract costs under the PCM and the concept of CGS.

Moreover, in determining CGS, the change in inventory over time must be taken into account. This indicates that some portion of CGS is capitalized into ending inventory. The same does not apply with respect to costs under contracts accounted for under the PCM. Under the PCM, no amounts are capitalized into inventory. Rather, under the PCM, all costs are deducted as incurred.

Other provisions of the Code and Treasury Regulations illustrate the principle that inventory is not pertinent under the PCM. First, Section 471 requires the use of inventories when necessary in order clearly to determine the taxpayer's income. Section 1.471-10, which relates to the applicability of long-term contract methods, refers to Section 1.460-2 for guidance relating to certain manufacturing contracts. Section 1.460-2(a), in turn, provides that a taxpayer must use the 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." Section 1.460-2(b)(2)(iii) includes a safe harbor for "inventoried item[s]," which provides that "[a] unique item ceases to be unique no later than when the taxpayer normally includes similar items in its finished goods inventory." As a result, an item ceases to be unique (and thus is not subject to the Section 460 rules) when it is included in finished goods inventory. Second, Section 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, it is clear that the concept of inventory, which is an essential element in the determination of CGS, has no application to long-term contracts accounted for under the PCM or the costs incurred with respect to such contracts.

In conclusion, allocable contract costs differ from CGS in at least two important respects. First, allocable contract costs are not subtracted from gross receipts in determining gross income, as is the case with CGS. Second, under the PCM, allocable contract costs are not capitalized into inventory, as is the case with CGS. Accordingly, the Proposed Rules would create an inexplicable inconsistency with the long-standing treatment of costs allocable to contracts accounted for under Section 460. The Proposed Rules also are inconsistent with the Section 199 Regulations, which distinguish between CGS (which are allocated under Section 1.199-4(b)) and other costs and deductions (which are allocated under Sections 1.199-4(c) and (d)). Because costs related to contracts accounted for under the PCM are not CGS, they are appropriately allocated under Sections 1.199-4(c) and (d).

The Proposed Rules have no rational basis or foundation in the law or the prevailing principles relating to either CGS or allocable costs under the PCM. We therefore recommend that any final regulations under Section 199 not incorporate the Proposed Rules. Costs under contracts accounted for under the PCM should continue to be treated as other costs and deductions (and not as CGS) for purposes of allocating costs under Section 1.199-4. The removal of the Proposed Rules will not otherwise affect the operation of other parts of the Proposed Regulations.

Effective Date of Proposed Regulations When Published as Final.

The text of the Proposed Regulations provides that "the eighth sentence in § 1.199-4(b)(1) and paragraph (b)(2)(iii) . . . apply to taxable years beginning on or after the date the final regulations are published in the Federal Register." 80 Fed. Reg. 51990. Thus, the Proposed Regulations explicitly provide that the Proposed Rules, if adopted, would apply only prospectively. However, the discussion in the preamble to the Proposed Regulations relating to "Allocating Cost of Goods Sold" refers to the addition of Section 1.199-4(b)(2)(iii)(A) of the Proposed Regulations as a "clarification." 80 Fed. Reg. 51984. This creates unintended confusion with respect to the applicability and the effective date of the Proposed Rules, and arguably suggests that the rule may have retroactive application. That statement is inconsistent with the unambiguous effective date text in the Proposed Regulations and should not be included in the preamble to any final regulations. Instead, the preamble to any final regulations should make clear that any such new principles will apply on a prospective basis only.

² Treas. Reg. § 1.199-4(a).