[Code of Federal Regulations]
[Title 26, Volume 3]
[Revised as of April 1, 2002]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.263A-1]
[Page 433-451]
TITLE 26--INTERNAL REVENUE
CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY
(CONTINUED)
COMPUTATION OF TAXABLE INCOME (Continued)--Table of Contents
Sec. 1.263A-1 Uniform capitalization of costs.
(a) Introduction--(1) In general. The regulations under
Secs. 1.263A-1 through 1.263A-6 provide guidance to taxpayers that are
required to capitalize certain costs under section 263A. These
regulations generally apply to all costs required to be capitalized
under section 263A except for interest that must be capitalized under
section 263A(f) and the regulations thereunder. Statutory or regulatory
exceptions may provide that section 263A does not apply to certain
activities or costs; however, those activities or costs may nevertheless
be subject to capitalization requirements under other provisions of the
Internal Revenue Code and regulations.
(2) Effective dates. (i) In general, this section and Secs. 1.263A-2
and 1.263A-3 apply to costs incurred in taxable years beginning after
December 31, 1993. In the case of property that is inventory in the
hands of the taxpayer, however, these sections are effective for taxable
years beginning after December 31, 1993. Changes in methods of
accounting necessary as a result of the rules in
[[Page 434]]
this section and Secs. 1.263A-2 and 1.263A-3 must be made under terms
and conditions prescribed by the Commissioner. Under these terms and
conditions, the principles of Sec. 1.263A-7 must be applied in revaluing
inventory property.
(ii) For taxable years beginning before January 1, 1994, taxpayers
must take reasonable positions on their federal income tax returns when
applying section 263A. For purposes of this paragraph (a)(2)(iii), a
reasonable position is a position consistent with the temporary
regulations, revenue rulings, revenue procedures, notices, and
announcements concerning section 263A applicable in taxable years
beginning before January 1, 1994. See Sec. 601.601(d)(2)(ii)(b) of this
chapter.
(3) General scope--(i) Property to which section 263A applies.
Taxpayers subject to section 263A must capitalize all direct costs and
certain indirect costs properly allocable to--
(A) Real property and tangible personal property produced by the
taxpayer; and
(B) Real property and personal property described in section
1221(1), which is acquired by the taxpayer for resale.
(ii) Property produced. Taxpayers that produce real property and
tangible personal property (producers) must capitalize all the direct
costs of producing the property and the property's properly allocable
share of indirect costs (described in paragraphs (e)(2)(i) and (3) of
this section), regardless of whether the property is sold or used in the
taxpayer's trade or business. See Sec. 1.263A-2 for rules relating to
producers.
(iii) Property acquired for resale. Retailers, wholesalers, and
other taxpayers that acquire property described in section 1221(1) for
resale (resellers) must capitalize the direct costs of acquiring the
property and the property's properly allocable share of indirect costs
(described in paragraphs (e)(2)(ii) and (3) of this section). See
Sec. 1.263A-3 for rules relating to resellers. See also section
263A(b)(2)(B), which excepts from section 263A personal property
acquired for resale by a small reseller.
(iv) Inventories valued at market. Section 263A does not apply to
inventories valued at market under either the market method or the lower
of cost or market method if the market valuation used by the taxpayer
generally equals the property's fair market value. For purposes of this
paragraph (a)(3)(iv), the term fair market value means the price at
which the taxpayer sells its inventory to its customers (e.g., as in the
market value definition provided in Sec. 1.471-4(b)) less, if
applicable, the direct cost of disposing of the inventory. However,
section 263A does apply in determining the market value of any inventory
for which market is determined with reference to replacement cost or
reproduction cost. See Secs. 1.471-4 and 1.471-5.
(v) Property produced in a farming business. Section 263A generally
requires taxpayers engaged in a farming business to capitalize certain
costs. See sections 263A(d) and 263A(e) and Sec. 1.263A-4 for rules
relating to taxpayers engaged in a farming business.
(vi) Creative property. Section 263A generally requires taxpayers
engaged in the production and resale of creative property to capitalize
certain costs.
(vii) Property produced or property acquired for resale by foreign
persons. Section 263A generally applies to foreign persons.
(b) Exceptions--(1) Small resellers. See section 263A(b)(2)(B) for
the $10,000,000 gross receipts exception for small resellers of personal
property. See Sec. 1.263A-3(b) for rules relating to this exception. See
also the exception for small resellers with de minimis production
activities in Sec. 1.263A-3(a)(2)(ii) and the exception for small
resellers that have property produced under contract in Sec. 1.263A-
3(a)(3).
(2) Long-term contracts. Except 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.
(3) Costs incurred in certain farming businesses. See section
263A(d) for an exception for costs paid or incurred in certain farming
businesses. See Sec. 1.263A-4 for specific rules relating to taxpayers
engaged in the trade or business of farming.
(4) Costs incurred in raising, harvesting, or growing timber. See
section 263A(c)(5)
[[Page 435]]
for an exception for costs paid or incurred in raising, harvesting, or
growing timber and certain ornamental trees. See Sec. 1.263A-4, however,
for rules relating to taxpayers producing certain trees to which section
263A applies.
(5) Qualified creative expenses. See section 263A(h) for an
exception for qualified creative expenses paid or incurred by certain
free-lance authors, photographers, and artists.
(6) Certain not-for-profit activities. See section 263A(c)(1) for an
exception for property produced by a taxpayer for use by the taxpayer
other than in a trade or business or an activity conducted for profit.
This exception does not apply, however, to property produced by an
exempt organization in connection with its unrelated trade or business
activities.
(7) Intangible drilling and development costs. See section
263A(c)(3) for an exception for intangible drilling and development
costs. Additionally, section 263A does not apply to any amount allowable
as a deduction under section 59(e) with respect to qualified
expenditures under sections 263(c), 616(a), or 617(a).
(8) Natural gas acquired for resale. Under this paragraph (b)(8),
section 263A does not apply to any costs incurred by a taxpayer relating
to natural gas acquired for resale to the extent such costs would
otherwise be allocable to cushion gas.
(i) Cushion gas. Cushion gas is the portion of gas stored in an
underground storage facility or reservoir that is required to maintain
the level of pressure necessary for operation of the facility. However,
section 263A applies to costs incurred by a taxpayer relating to natural
gas acquired for resale to the extent such costs are properly allocable
to emergency gas.
(ii) Emergency gas. Emergency gas is natural gas stored in an
underground storage facility or reservoir for use during periods of
unusually heavy customer demand.
(9) Research and experimental expenditures. See section 263A(c)(2)
for an exception for any research and experimental expenditure allowable
as a deduction under section 174 or the regulations thereunder.
Additionally, section 263A does not apply to any amount allowable as a
deduction under section 59(e) with respect to qualified expenditures
under section 174.
(10) Certain property that is substantially constructed. Section
263A does not apply to any property produced by a taxpayer for use in
its trade or business if substantial construction occurred before March
1, 1986.
(i) For purposes of this section, substantial construction is deemed
to have occurred if the lesser of--
(A) 10 percent of the total estimated costs of construction; or
(B) The greater of $10 million or 2 percent of the total estimated
costs of construction, was incurred before March 1, 1986.
(ii) For purposes of the provision in paragraph (b)(10)(i) of this
section, the total estimated costs of construction shall be determined
by reference to a reasonable estimate, on or before March 1, 1986, of
such amount. Assume, for example, that on March 1, 1986, the estimated
costs of constructing a facility were $150 million. Assume that before
March 1, 1986, $12 million of construction costs had been incurred.
Based on the above facts, substantial construction would be deemed to
have occurred before March 1, 1986, because $12 million (the costs of
construction incurred before such date) is greater than $10 million (the
lesser of $15 million; or the greater of $10 million or $3 million). For
purposes of this provision, construction costs are defined as those
costs incurred after construction has commenced at the site of the
property being constructed (unless the property will not be located on
land and, therefore, the initial construction of the property must begin
at a location other than the intended site). For example, in the case of
a building, construction commences when work begins on the building,
such as the excavation of the site, the pouring of pads for the
building, or the driving of foundation pilings into the ground.
Preliminary activities such as project engineering and architectural
design do not constitute the commencement of construction, nor are such
costs considered construction costs, for purposes of this paragraph
(b)(10).
(11) Certain property provided incident to services--(i) In general.
Under this
[[Page 436]]
paragraph (b)(11), section 263A does not apply to property that is
provided to a client (or customer) incident to the provision of services
by the taxpayer if the property provided to the client is--
(A) De minimis in amount; and
(B) Not inventory in the hands of the service provider.
(ii) Definition of services. For purposes of this paragraph (b)(11),
services is defined with reference to its ordinary and accepted meaning
under federal income tax principles. In determining whether a taxpayer
is a bona-fide service provider under this paragraph (b)(11), the nature
of the taxpayer's trade or business and the facts and circumstances
surrounding the taxpayer's trade or business activities must be
considered. Examples of taxpayers qualifying as service providers under
this paragraph include taxpayers performing services in the fields of
health, law, engineering, architecture, accounting, actuarial science,
performing arts, or consulting.
(iii) De minimis property provided incident to services. In
determining whether property provided to a client by a service provider
is de minimis in amount, all facts and circumstances, such as the nature
of the taxpayer's trade or business and the volume of its service
activities in the trade or business, must be considered. A significant
factor in making this determination is the relationship between the
acquisition or direct materials costs of the property that is provided
to clients and the price that the taxpayer charges its clients for its
services and the property. For purposes of this paragraph (b)(11), if
the acquisition or direct materials cost of the property provided to a
client incident to the services is less than or equal to five percent of
the price charged to the client for the services and property, the
property is de minimis. If the acquisition or direct materials cost of
the property exceeds five percent of the price charged for the services
and property, the property may be de minimis if additional facts and
circumstances so indicate.
(12) De minimis rule for certain producers with total indirect costs
of $200,000 or less. See Sec. 1.263A-2(b)(3)(iv) for a de minimis rule
that treats producers with total indirect costs of $200,000 or less as
having no additional section 263A costs (as defined in paragraph (d)(3)
of this section) for purposes of the simplified production method.
(13) Exception for the origination of loans. For purposes of section
263A(b)(2)(A), the origination of loans is not considered the
acquisition of intangible property for resale. (But section
263A(b)(2)(A) does include the acquisition by a taxpayer of pre-existing
loans from other persons for resale.)
(c) General operation of section 263A--(1) Allocations. Under
section 263A, taxpayers must capitalize their direct costs and a
properly allocable share of their indirect costs to property produced or
property acquired for resale. In order to determine these capitalizable
costs, taxpayers must allocate or apportion costs to various activities,
including production or resale activities. After section 263A costs are
allocated to the appropriate production or resale activities, these
costs are generally allocated to the items of property produced or
property acquired for resale during the taxable year and capitalized to
the items that remain on hand at the end of the taxable year. See
however, the simplified production method and the simplified resale
method in Secs. 1.263A-2(b) and 1.263A-3(d).
(2) Otherwise deductible. (i) Any cost which (but for section 263A
and the regulations thereunder) may not be taken into account in
computing taxable income for any taxable year is not treated as a cost
properly allocable to property produced or acquired for resale under
section 263A and the regulations thereunder. Thus, for example, if a
business meal deduction is limited by section 274(n) to 80 percent of
the cost of the meal, the amount properly allocable to property produced
or acquired for resale under section 263A is also limited to 80 percent
of the cost of the meal.
(ii) The amount of any cost required to be capitalized under section
263A may not be included in inventory or charged to capital accounts or
basis any earlier than the taxable year during which the amount is
incurred within the meaning of Sec. 1.446-1(c)(1)(ii).
(3) Capitalize. Capitalize means, in the case of property that is
inventory in the hands of a taxpayer, to include in inventory costs and,
in the case of
[[Page 437]]
other property, to charge to a capital account or basis.
(4) Recovery of capitalized costs. Costs that are capitalized under
section 263A are recovered through depreciation, amortization, cost of
goods sold, or by an adjustment to basis at the time the property is
used, sold, placed in service, or otherwise disposed of by the taxpayer.
Cost recovery is determined by the applicable Internal Revenue Code and
regulation provisions relating to the use, sale, or disposition of
property.
(d) Definitions--(1) Self-constructed assets. Self-constructed
assets are assets produced by a taxpayer for use by the taxpayer in its
trade or business. Self-constructed assets are subject to section 263A.
(2) Section 471 costs--(i) In general. Except as otherwise provided
in paragraphs (d)(2)(ii) and (iii) of this section, for purposes of the
regulations under section 263A, a taxpayer's section 471 costs are the
costs, other than interest, capitalized under its method of accounting
immediately prior to the effective date of section 263A. Thus, although
section 471 applies only to inventories, section 471 costs include any
non-inventory costs, other than interest, capitalized or included in
acquisition or production costs under the taxpayer's method of
accounting immediately prior to the effective date of section 263A.
(ii) New taxpayers. In the case of a new taxpayer, section 471 costs
are those acquisition or production costs, other than interest, that
would have been required to be capitalized by the taxpayer if the
taxpayer had been in existence immediately prior to the effective date
of section 263A.
(iii) Method changes. If a taxpayer included a cost described in
Sec. 1.471-11(c)(2)(iii) in its inventoriable costs immediately prior to
the effective date of section 263A, that cost is included in the
taxpayer's section 471 costs under paragraph (d)(2)(i) of this section.
Except as provided in the following sentence, a change in the financial
reporting practices of a taxpayer for costs described in Sec. 1.471-
11(c)(2)(iii) subsequent to the effective date of section 263A does not
affect the classification of these costs as section 471 costs. A
taxpayer may change its established methods of accounting used in
determining section 471 costs only with the consent of the Commissioner
as required under section 446(e) and the regulations thereunder.
(3) Additional section 263A costs. Additional section 263A costs are
defined as the costs, other than interest, that were not capitalized
under the taxpayer's method of accounting immediately prior to the
effective date of section 263A (adjusted as appropriate for any changes
in methods of accounting for section 471 costs under paragraph
(d)(2)(iii) of this section), but that are required to be capitalized
under section 263A. For new taxpayers, additional section 263A costs are
defined as the costs, other than interest, that the taxpayer must
capitalize under section 263A, but which the taxpayer would not have
been required to capitalize if the taxpayer had been in existence prior
to the effective date of section 263A.
(4) Section 263A costs. Section 263A costs are defined as the costs
that a taxpayer must capitalize under section 263A. Thus, section 263A
costs are the sum of a taxpayer's section 471 costs, its additional
section 263A costs, and interest capitalizable under section 263A(f).
(e) Types of costs subject to capitalization--(1) In general.
Taxpayers subject to section 263A must capitalize all direct costs and
certain indirect costs properly allocable to property produced or
property acquired for resale. This paragraph (e) describes the types of
costs subject to section 263A.
(2) Direct costs--(i) Producers. Producers must capitalize direct
material costs and direct labor costs.
(A) Direct material costs include the costs of those materials that
become an integral part of specific property produced and those
materials that are consumed in the ordinary course of production and
that can be identified or associated with particular units or groups of
units of property produced.
(B) Direct labor costs include the costs of labor that can be
identified or associated with particular units or groups of units of
specific property produced. For this purpose, labor encompasses full-
time and part-time employees, as
[[Page 438]]
well as contract employees and independent contractors. Direct labor
costs include all elements of compensation other than employee benefit
costs described in paragraph (e)(3)(ii)(D) of this section. Elements of
direct labor costs include basic compensation, overtime pay, vacation
pay, holiday pay, sick leave pay (other than payments pursuant to a wage
continuation plan under section 105(d) as it existed prior to its repeal
in 1983), shift differential, payroll taxes, and payments to a
supplemental unemployment benefit plan.
(ii) Resellers. Resellers must capitalize the acquisition costs of
property acquired for resale. In the case of inventory, the acquisition
cost is the cost described in Sec. 1.471-3(b).
(3) Indirect costs--(i) In general. Indirect costs are defined as
all costs other than direct material costs and direct labor costs (in
the case of property produced) or acquisition costs (in the case of
property acquired for resale). Taxpayers subject to section 263A must
capitalize all indirect costs properly allocable to property produced or
property acquired for resale. Indirect costs are properly allocable to
property produced or property acquired for resale when the costs
directly benefit or are incurred by reason of the performance of
production or resale activities. Indirect costs may be allocable to both
production and resale activities, as well as to other activities that
are not subject to section 263A. Taxpayers subject to section 263A must
make a reasonable allocation of indirect costs between production,
resale, and other activities.
(ii) Examples of indirect costs required to be capitalized. The
following are examples of indirect costs that must be capitalized to the
extent they are properly allocable to property produced or property
acquired for resale:
(A) Indirect labor costs. Indirect labor costs include all labor
costs (including the elements of labor costs set forth in paragraph
(e)(2)(i) of this section) that cannot be directly identified or
associated with particular units or groups of units of specific property
produced or property acquired for resale (e.g., factory labor that is
not direct labor). As in the case of direct labor, indirect labor
encompasses full-time and part-time employees, as well as contract
employees and independent contractors.
(B) Officers' compensation. Officers' compensation includes
compensation paid to officers of the taxpayer.
(C) Pension and other related costs. Pension and other related costs
include contributions paid to or made under any stock bonus, pension,
profit-sharing or annuity plan, or other plan deferring the receipt of
compensation, whether or not the plan qualifies under section 401(a).
Contributions to employee plans representing past services must be
capitalized in the same manner (and in the same proportion to property
currently being acquired or produced) as amounts contributed for current
service.
(D) Employee benefit expenses. Employee benefit expenses include all
other employee benefit expenses (not described in paragraph
(e)(3)(ii)(C) of this section) to the extent such expenses are otherwise
allowable as deductions under chapter 1 of the Internal Revenue Code.
These other employee benefit expenses include: worker's compensation;
amounts otherwise deductible or allowable in reducing earnings and
profits under section 404A; payments pursuant to a wage continuation
plan under section 105(d) as it existed prior to its repeal in 1983;
amounts includible in the gross income of employees under a method or
arrangement of employer contributions or compensation that has the
effect of a stock bonus, pension, profit-sharing or annuity plan, or
other plan deferring receipt of compensation or providing deferred
benefits; premiums on life and health insurance; and miscellaneous
benefits provided for employees such as safety, medical treatment,
recreational and eating facilities, membership dues, etc. Employee
benefit expenses do not, however, include direct labor costs described
in paragraph (e)(2)(i) of this section.
(E) Indirect material costs. Indirect material costs include the
cost of materials that are not an integral part of specific property
produced and the cost of materials that are consumed in the ordinary
course of performing production or resale activities that cannot be
identified or associated with particular units or groups of units of
property.
[[Page 439]]
Thus, for example, a cost described in Sec. 1.162-3, relating to the
cost of a material or supply, is an indirect material cost.
(F) Purchasing costs. Purchasing costs include costs attributable to
purchasing activities. See Sec. 1.263A-3(c)(3) for a further discussion
of purchasing costs.
(G) Handling costs. Handling costs include costs attributable to
processing, assembling, repackaging and transporting goods, and other
similar activities. See Sec. 1.263A-3(c)(4) for a further discussion of
handling costs.
(H) Storage costs. Storage costs include the costs of carrying,
storing, or warehousing property. See Sec. 1.263A-3(c)(5) for a further
discussion of storage costs.
(I) Cost recovery. Cost recovery includes depreciation,
amortization, and cost recovery allowances on equipment and facilities
(including depreciation or amortization of self-constructed assets or
other previously produced or acquired property to which section 263A or
section 263 applies).
(J) Depletion. Depletion includes allowances for depletion, whether
or not in excess of cost. Depletion is, however, only properly allocable
to property that has been sold (i.e., for purposes of determining gain
or loss on the sale of the property).
(K) Rent. Rent includes the cost of renting or leasing equipment,
facilities, or land.
(L) Taxes. Taxes include those taxes (other than taxes described in
paragraph (e)(3)(iii)(F) of this section) that are otherwise allowable
as a deduction to the extent such taxes are attributable to labor,
materials, supplies, equipment, land, or facilities used in production
or resale activities.
(M) Insurance. Insurance includes the cost of insurance on plant or
facility, machinery, equipment, materials, property produced, or
property acquired for resale.
(N) Utilities. Utilities include the cost of electricity, gas, and
water.
(O) Repairs and maintenance. Repairs and maintenance include the
cost of repairing and maintaining equipment or facilities.
(P) Engineering and design costs. Engineering and design costs
include pre-production costs, such as costs attributable to research,
experimental, engineering, and design activities (to the extent that
such amounts are not research and experimental expenditures as described
in section 174 and the regulations thereunder).
(Q) Spoilage. Spoilage includes the costs of rework labor, scrap,
and spoilage.
(R) Tools and equipment. Tools and equipment include the costs of
tools and equipment which are not otherwise capitalized.
(S) Quality control. Quality control includes the costs of quality
control and inspection.
(T) Bidding costs. Bidding costs are costs incurred in the
solicitation of contracts (including contracts pertaining to property
acquired for resale) ultimately awarded to the taxpayer. The taxpayer
must defer all bidding costs paid or incurred in the solicitation of a
particular contract until the contract is awarded. If the contract is
awarded to the taxpayer, the bidding costs become part of the indirect
costs allocated to the subject matter of the contract. If the contract
is not awarded to the taxpayer, bidding costs are deductible in the
taxable year that the contract is awarded to another party, or in the
taxable year that the taxpayer is notified in writing that no contract
will be awarded and that the contract (or a similar or related contract)
will not be rebid, or in the taxable year that the taxpayer abandons its
bid or proposal, whichever occurs first. Abandoning a bid does not
include modifying, supplementing, or changing the original bid or
proposal. If the taxpayer is awarded only part of the bid (for example,
the taxpayer submitted one bid to build each of two different types of
products, and the taxpayer was awarded a contract to build only one of
the two types of products), the taxpayer shall deduct the portion of the
bidding costs related to the portion of the bid not awarded to the
taxpayer. In the case of a bid or proposal for a multi-unit contract,
all bidding costs must be included in the costs allocated to the subject
matter of the contract awarded to the taxpayer to produce or acquire for
resale any of such units. For example, where the
[[Page 440]]
taxpayer submits one bid to produce three similar turbines and the
taxpayer is awarded a contract to produce only two of the three
turbines, all bidding costs must be included in the cost of the two
turbines. For purposes of this paragraph (e)(3)(ii)(T), a contract
means--
(1) In the case of a specific unit of property, any agreement under
which the taxpayer would produce or sell property to another party if
the agreement is entered into before the taxpayer produces or acquires
the specific unit of property to be delivered to the party under the
agreement; and
(2) In the case of fungible property, any agreement to the extent
that, at the time the agreement is entered into, the taxpayer has on
hand an insufficient quantity of completed fungible items of such
property that may be used to satisfy the agreement (plus any other
production or sales agreements of the taxpayer).
(U) Licensing and franchise costs. Licensing and franchise costs
include fees incurred in securing the contractual right to use a
trademark, corporate plan, manufacturing procedure, special recipe, or
other similar right associated with property produced or property
acquired for resale. These costs include the otherwise deductible
portion (e.g., amortization) of the initial fees incurred to obtain the
license or franchise and any minimum annual payments and royalties that
are incurred by a licensee or a franchisee.
(V) Interest. Interest includes interest on debt incurred or
continued during the production period to finance the production of real
property or tangible personal property to which section 263A(f) applies.
(W) Capitalizable service costs. Service costs that are required to
be capitalized include capitalizable service costs and capitalizable
mixed service costs as defined in paragraph (e)(4) of this section.
(iii) Indirect costs not capitalized. The following indirect costs
are not required to be capitalized under section 263A:
(A) Selling and distribution costs. These costs are marketing,
selling, advertising, and distribution costs.
(B) Research and experimental expenditures. Research and
experimental expenditures are expenditures described in section 174 and
the regulations thereunder.
(C) Section 179 costs. Section 179 costs are expenses for certain
depreciable assets deductible at the election of the taxpayer under
section 179 and the regulations thereunder.
(D) Section 165 losses. Section 165 losses are losses under section
165 and the regulations thereunder.
(E) Cost recovery allowances on temporarily idle equipment and
facilities--(1) In general. Cost recovery allowances on temporarily idle
equipment and facilities include only depreciation, amortization, and
cost recovery allowances on equipment and facilities that have been
placed in service but are temporarily idle. Equipment and facilities are
temporarily idle when a taxpayer takes them out of service for a finite
period. However, equipment and facilities are not considered temporarily
idle--
(i) During worker breaks, non-working hours, or on regularly
scheduled non-working days (such as holidays or weekends);
(ii) During normal interruptions in the operation of the equipment
or facilities;
(iii) When equipment is enroute to or located at a job site; or
(iv) When under normal operating conditions, the equipment is used
or operated only during certain shifts.
(2) Examples. The provisions of this paragraph (e)(3)(iii)(E) are
illustrated by the following examples:
Example 1. Equipment operated only during certain shifts. Taxpayer A
manufactures widgets. Although A's manufacturing facility operates 24
hours each day in three shifts, A only operates its stamping machine
during one shift each day. Because A only operates its stamping machine
during certain shifts, A's stamping machine is not considered
temporarily idle during the two shifts that it is not operated.
Example 2. Facility shut down for retooling. Taxpayer B owns and
operates a manufacturing facility. B closes its manufacturing facility
for two weeks to retool its assembly line. B's manufacturing facility is
considered temporarily idle during this two-week period.
[[Page 441]]
(F) Taxes assessed on the basis of income. Taxes assessed on the
basis of income include only state, local, and foreign income taxes, and
franchise taxes that are assessed on the taxpayer based on income.
(G) Strike expenses. Strike expenses include only costs associated
with hiring employees to replace striking personnel (but not wages of
replacement personnel), costs of security, and legal fees associated
with settling strikes.
(H) Warranty and product liability costs. Warranty costs and product
liability costs are costs incurred in fulfilling product warranty
obligations for products that have been sold and costs incurred for
product liability insurance.
(I) On-site storage costs. On-site storage costs are storage and
warehousing costs incurred by a taxpayer at an on-site storage facility,
as defined in Sec. 1.263A-3(c)(5)(ii)(A), with respect to property
produced or property acquired for resale.
(J) Unsuccessful bidding expenses. Unsuccessful bidding costs are
bidding expenses incurred in the solicitation of contracts not awarded
to the taxpayer.
(K) Deductible service costs. Service costs that are not required to
be capitalized include deductible service costs and deductible mixed
service costs as defined in paragraph (e)(4) of this section.
(4) Service costs--(i) Introduction. This paragraph (e)(4) provides
definitions and categories of service costs. Paragraph (g)(4) of this
section provides specific rules for determining the amount of service
costs allocable to property produced or property acquired for resale. In
addition, paragraph (h) of this section provides a simplified method for
determining the amount of service costs that must be capitalized.
(A) Definition of service costs. Service costs are defined as a type
of indirect costs (e.g., general and administrative costs) that can be
identified specifically with a service department or function or that
directly benefit or are incurred by reason of a service department or
function.
(B) Definition of service departments. Service departments are
defined as administrative, service, or support departments that incur
service costs. The facts and circumstances of the taxpayer's activities
and business organization control whether a department is a service
department. For example, service departments include personnel,
accounting, data processing, security, legal, and other similar
departments.
(ii) Various service cost categories--(A) Capitalizable service
costs. Capitalizable service costs are defined as service costs that
directly benefit or are incurred by reason of the performance of the
production or resale activities of the taxpayer. Therefore, these
service costs are required to be capitalized under section 263A.
Examples of service departments or functions that incur capitalizable
service costs are provided in paragraph (e)(4)(iii) of this section.
(B) Deductible service costs. Deductible service costs are defined
as service costs that do not directly benefit or are not incurred by
reason of the performance of the production or resale activities of the
taxpayer, and therefore, are not required to be capitalized under
section 263A. Deductible service costs generally include costs incurred
by reason of the taxpayer's overall management or policy guidance
functions. In addition, deductible service costs include costs incurred
by reason of the marketing, selling, advertising, and distribution
activities of the taxpayer. Examples of service departments or functions
that incur deductible service costs are provided in paragraph (e)(4)(iv)
of this section.
(C) Mixed service costs. Mixed service costs are defined as service
costs that are partially allocable to production or resale activities
(capitalizable mixed service costs) and partially allocable to non-
production or non-resale activities (deductible mixed service costs).
For example, a personnel department may incur costs to recruit factory
workers, the costs of which are allocable to production activities, and
it may incur costs to develop wage, salary, and benefit policies, the
costs of which are allocable to non-production activities.
(iii) Examples of capitalizable service costs. Costs incurred in the
following departments or functions are generally allocated among
production or resale activities:
(A) The administration and coordination of production or resale
activities
[[Page 442]]
(wherever performed in the business organization of the taxpayer).
(B) Personnel operations, including the cost of recruiting, hiring,
relocating, assigning, and maintaining personnel records or employees.
(C) Purchasing operations, including purchasing materials and
equipment, scheduling and coordinating delivery of materials and
equipment to or from factories or job sites, and expediting and follow-
up.
(D) Materials handling and warehousing and storage operations.
(E) Accounting and data services operations, including, for example,
cost accounting, accounts payable, disbursements, and payroll functions
(but excluding accounts receivable and customer billing functions).
(F) Data processing.
(G) Security services.
(H) Legal services.
(iv) Examples of deductible service costs. Costs incurred in the
following departments or functions are not generally allocated to
production or resale activities:
(A) Departments or functions responsible for overall management of
the taxpayer or for setting overall policy for all of the taxpayer's
activities or trades or businesses, such as the board of directors
(including their immediate staff), and the chief executive, financial,
accounting, and legal officers (including their immediate staff) of the
taxpayer, provided that no substantial part of the cost of such
departments or functions benefits a particular production or resale
activity.
(B) Strategic business planning.
(C) General financial accounting.
(D) General financial planning (including general budgeting) and
financial management (including bank relations and cash management).
(E) Personnel policy (such as establishing and managing personnel
policy in general; developing wage, salary, and benefit policies;
developing employee training programs unrelated to particular production
or resale activities; negotiating with labor unions; and maintaining
relations with retired workers).
(F) Quality control policy.
(G) Safety engineering policy.
(H) Insurance or risk management policy (but not including bid or
performance bonds or insurance related to activities associated with
property produced or property acquired for resale).
(I) Environmental management policy (except to the extent that the
costs of any system or procedure benefits a particular production or
resale activity).
(J) General economic analysis and forecasting.
(K) Internal audit.
(L) Shareholder, public, and industrial relations.
(M) Tax services.
(N) Marketing, selling, or advertising.
(f) Cost allocation methods--(1) Introduction. This paragraph (f)
sets forth various detailed or specific (facts-and-circumstances) cost
allocation methods that taxpayers may use to allocate direct and
indirect costs to property produced and property acquired for resale.
Paragraph (g) of this section provides general rules for applying these
allocation methods to various categories of costs (i.e., direct
materials, direct labor, and indirect costs, including service costs).
In addition, in lieu of a facts-and-circumstances allocation method,
taxpayers may use the simplified methods provided in Secs. 1.263A-2(b)
and 1.263A-3(d) to allocate direct and indirect costs to eligible
property produced or eligible property acquired for resale; see those
sections for definitions of eligible property. Paragraph (h) of this
section provides a simplified method for determining the amount of mixed
service costs required to be capitalized to eligible property. The
methodology set forth in paragraph (h) of this section for mixed service
costs may be used in conjunction with either a facts-and-circumstances
or a simplified method of allocating costs to eligible property produced
or eligible property acquired for resale.
(2) Specific identification method. A specific identification method
traces costs to a cost objective, such as a function, department,
activity, or product, on the basis of a cause and effect or other
reasonable relationship between the costs and the cost objective.
[[Page 443]]
(3) Burden rate and standard cost meth- ods--(i) Burden rate method-
-(A) In gen- eral. A burden rate method allocates an appropriate amount
of indirect costs to property produced or property acquired for resale
during a taxable year using predetermined rates that approximate the
actual amount of indirect costs incurred by the taxpayer during the
taxable year. Burden rates (such as ratios based on direct costs, hours,
or similar items) may be developed by the taxpayer in accordance with
acceptable accounting principles and applied in a reasonable manner. A
taxpayer may allocate different indirect costs on the basis of different
burden rates. Thus, for example, the taxpayer may use one burden rate
for allocating the cost of rent and another burden rate for allocating
the cost of utilities. Any periodic adjustment to a burden rate that
merely reflects current operating conditions, such as increases in
automation or changes in operation or prices, is not a change in method
of accounting under section 446(e). A change, however, in the concept or
base upon which such rates are developed, such as a change from basing
the rates on direct labor hours to basing them on direct machine hours,
is a change in method of accounting to which section 446(e) applies.
(B) Development of burden rates. The following factors, among
others, may be used in developing burden rates:
(1) The selection of an appropriate level of activity and a period
of time upon which to base the calculation of rates reflecting operating
conditions for purposes of the unit costs being determined.
(2) The selection of an appropriate statistical base, such as direct
labor hours, direct labor dollars, machine hours, or a combination
thereof, upon which to apply the overhead rate.
(3) The appropriate budgeting, classification, and analysis of
expenses (for example, the analysis of fixed versus variable costs).
(C) Operation of the burden rate method. The purpose of the burden
rate method is to allocate an appropriate amount of indirect costs to
production or resale activities through the use of predetermined rates
intended to approximate the actual amount of indirect costs incurred.
Accordingly, the proper use of the burden rate method under this section
requires that any net negative or net positive difference between the
total predetermined amount of costs allocated to property and the total
amount of indirect costs actually incurred and required to be allocated
to such property (i.e., the under or over-applied burden) must be
treated as an adjustment to the taxpayer's ending inventory or capital
account (as the case may be) in the taxable year in which such
difference arises. However, if such adjustment is not significant in
amount in relation to the taxpayer's total indirect costs incurred with
respect to production or resale activities for the year, such adjustment
need not be allocated to the property produced or property acquired for
resale unless such allocation is made in the taxpayer's financial
reports. The taxpayer must treat both positive and negative adjustments
consistently.
(ii) Standard cost method--(A) In general. A standard cost method
allocates an appropriate amount of direct and indirect costs to property
produced by the taxpayer through the use of preestablished standard
allowances, without reference to costs actually incurred during the
taxable year. A taxpayer may use a standard cost method to allocate
costs, provided variances are treated in accordance with the procedures
prescribed in paragraph (f)(3)(ii)(B) of this section. Any periodic
adjustment to standard costs that merely reflects current operating
conditions, such as increases in automation or changes in operation or
prices, is not a change in method of accounting under section 446(e). A
change, however, in the concept or base upon which standard costs are
developed is a change in method of accounting to which section 446(e)
applies.
(B) Treatment of variances. For purposes of this section, net
positive overhead variance means the excess of total standard indirect
costs over total actual indirect costs and net negative overhead
variance means the excess of total actual indirect costs over total
standard indirect costs. The proper use of a standard cost method
requires that a taxpayer must reallocate to property
[[Page 444]]
a pro rata portion of any net negative or net positive overhead
variances and any net negative or net positive direct cost variances.
The taxpayer must apportion such variances to or among the property to
which the costs are allocable. However, if such variances are not
significant in amount relative to the taxpayer's total indirect costs
incurred with respect to production and resale activities for the year,
such variances need not be allocated to property produced or property
acquired for resale unless such allocation is made in the taxpayer's
financial reports. A taxpayer must treat both positive and negative
variances consistently.
(4) Reasonable allocation methods. A taxpayer may use the methods
described in paragraph (f) (2) or (3) of this section if they are
reasonable allocation methods within the meaning of this paragraph
(f)(4). In addition, a taxpayer may use any other reasonable method to
properly allocate direct and indirect costs among units of property
produced or property acquired for resale during the taxable year. An
allocation method is reasonable if, with respect to the taxpayer's
production or resale activities taken as a whole--
(i) The total costs actually capitalized during the taxable year do
not differ significantly from the aggregate costs that would be properly
capitalized using another permissible method described in this section
or in Secs. 1.263A-2 and 1.263A-3, with appropriate consideration given
to the volume and value of the taxpayer's production or resale
activities, the availability of costing information, the time and cost
of using various allocation methods, and the accuracy of the allocation
method chosen as compared with other allocation methods;
(ii) The allocation method is applied consistently by the taxpayer;
and
(iii) The allocation method is not used to circumvent the
requirements of the simplified methods in this section or in
Sec. 1.263A-2, Sec. 1.263A-3, or the principles of section 263A.
(g) Allocating categories of costs--(1) Direct materials. Direct
material costs (as defined in paragraph (e)(2) of this section) incurred
during the taxable year must be allocated to the property produced or
property acquired for resale by the taxpayer using the taxpayer's d of
accounting for materials (e.g., specific identification; first-in,
first-out (FIFO); or last-in, first-out (LIFO)), or any other reasonable
allocation method (as defined under the principles of paragraph (f)(4)
of this section).
(2) Direct labor. Direct labor costs (as defined in paragraph (e)(2)
of this section) incurred during the taxable year are generally
allocated to property produced or property acquired for resale using a
specific identification method, standard cost method, or any other
reasonable allocation method (as defined under the principles of
paragraph (f)(4) of this section). All elements of compensation, other
than basic compensation, may be grouped together and then allocated in
proportion to the charge for basic compensation. Further, a taxpayer is
not treated as using an erroneous method of accounting if direct labor
costs are treated as indirect costs under the taxpayer's allocation
method, provided such costs are capitalized to the extent required by
paragraph (g)(3) of this section.
(3) Indirect costs. Indirect costs (as defined in paragraph (e)(3)
of this section) are generally allocated to intermediate cost objectives
such as departments or activities prior to the allocation of such costs
to property produced or property acquired for resale. Indirect costs are
allocated using either a specific identification method, a standard cost
method, a burden rate method, or any other reasonable allocation method
(as defined under the principles of paragraph (f)(4) of this section).
(4) Service costs--(i) In general. Service costs are a type of
indirect costs that may be allocated using the same allocation methods
available for allocating other indirect costs described in paragraph
(g)(3) of this section. Generally, taxpayers that use a specific
identification method or another reasonable allocation method must
allocate service costs to particular departments or activities based on
a factor or relationship that reasonably relates the service costs to
the benefits received from the service departments or activities. For
[[Page 445]]
example, a reasonable factor for allocating legal services to particular
departments or activities is the number of hours of legal services
attributable to each department or activity. See paragraph (g)(4)(iv) of
this section for other illustrations. Using reasonable factors or
relationships, a taxpayer must allocate mixed service costs under a
direct reallocation method described in paragraph (g)(4)(iii)(A) of this
section, a step-allocation method described in paragraph (g)(4)(iii)(B)
of this section, or any other reasonable allocation method (as defined
under the principles of paragraph (f)(4) of this section).
(ii) De minimis rule. For purposes of administrative convenience, if
90 percent or more of a mixed service department's costs are deductible
service costs, a taxpayer may elect not to allocate any portion of the
service department's costs to property produced or property acquired for
resale. For example, if 90 percent of the costs of an electing
taxpayer's industrial relations department benefit the taxpayer's
overall policy-making activities, the taxpayer is not required to
allocate any portion of these costs to a production activity. Under this
election, however, if 90 percent or more of a mixed service department's
costs are capitalizable service costs, a taxpayer must allocate 100
percent of the department's costs to the production or resale activity
benefitted. For example, if 90 percent of the costs of an electing
taxpayer's accounting department benefit the taxpayer's manufacturing
activity, the taxpayer must allocate 100 percent of the costs of the
accounting department to the manufacturing activity. An election under
this paragraph (g)(4)(ii) applies to all of a taxpayer's mixed service
departments and constitutes the adoption of a (or a change in) method of
accounting under section 446 of the Internal Revenue Code.
(iii) Methods for allocating mixed service costs--(A) Direct
reallocation method. Under the direct reallocation method, the total
costs (direct and indirect) of all mixed service departments are
allocated only to departments or cost centers engaged in production or
resale activities and then from those departments to particular
activities. This direct reallocation method ignores benefits provided by
one mixed service department to other mixed service departments, and
also excludes other mixed service departments from the base used to make
the allocation.
(B) Step-allocation method. (1) Under a step-allocation method, a
sequence of allocations is made by the taxpayer. First, the total costs
of the mixed service departments that benefit the greatest number of
other departments are allocated to--
(i) Other mixed service departments;
(ii) Departments that incur only deductible service costs; and
(iii) Departments that exclusively engage in production or resale
activities.
(2) A taxpayer continues allocating mixed service costs in the
manner described in paragraph (g)(4)(iii)(B)(1) of this section (i.e.,
from the service departments benefitting the greatest number of
departments to the service departments benefitting the least number of
departments) until all mixed service costs are allocated to the types of
departments listed in this paragraph (g)(4)(iii). Thus, a step-
allocation method recognizes the benefits provided by one mixed service
department to another mixed service department and also includes mixed
service departments that have not yet been allocated in the base used to
make the allocation.
(C) Examples. The provisions of this paragraph (g)(4)(iii) are
illustrated by the following examples:
Example 1. Direct reallocation method. (i) Taxpayer E has the
following five departments: the Assembling Department, the Painting
Department, and the Finishing Department (production departments), and
the Personnel Department and the Data Processing Department (mixed
service departments). E allocates the Personnel Department's costs on
the basis of total payroll costs and the Data Processing Department's
costs on the basis of data processing hours.
(ii) Under a direct reallocation method, E allocates the Personnel
Department's costs directly to its Assembling, Painting, and Finishing
Department, and not to its Data Processing department.
[[Page 446]]
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Total Amount of
Department dept. payroll Allocation ratio Amount
costs costs allocated
----------------------------------------------------------------------------------------------------------------
Personnel............................................ $500,000 $50,000 ................. <$500,000<$250,000<$500,000<$275,000