n-07-29.pdf

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Part III - Administrative, Procedural, and Miscellaneous

Request for Comments and Interim Guidance Regarding Allocation of Costs under the
Simplified Methods of Accounting under § 263A

Notice 2007-29

The Internal Revenue Service and Treasury Department are studying the
appropriateness of the use of negative amounts in computing additional costs for
purposes of the simplified methods of accounting under § 263A of the Internal Revenue
Code. This notice invites public comment on changes to the simplified production
method under § 1.263A-2(b) and the simplified resale method under § 1.263A-3(d) of
the Income Tax Regulations. This notice also provides interim guidance pending the
publication of future guidance.

BACKGROUND

Section 471 provides the general rules for inventories and authorizes the
Secretary to determine when the use of inventories are necessary to clearly reflect
income and to determine the valuation methods that are acceptable for tax purposes.
The regulations under § 471 provide the general rules for the valuation of inventories.

Section 263A was enacted under the Tax Reform Act of 1986, and prescribes
uniform capitalization rules for property produced or held for resale. Under § 263A,
producers of real or tangible personal property and resellers of real or personal property
must capitalize the direct costs and a proper share of the indirect costs of the property.
Section 263A requires capitalization of indirect costs but generally does not set forth

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methods for allocating indirect costs. Instead, in accordance with the legislative history,
the regulations under § 263A generally provide that taxpayers must allocate indirect
costs to property using detailed or specific cost allocation methods, including a specific
identification method, the standard cost method, and methods using burden rates.
Alternatively, taxpayers may use the simplified production method or simplified resale
method (simplified methods), as applicable.

The legislative history to § 263A indicates that Congress desired the Service to
adopt a flexible approach in the § 263A regulations by providing simplified methods and
assumptions when the costs and burdens of compliance may outweigh the benefits.
Accordingly, the simplified methods are intended to alleviate the administrative burden
of complying with the capitalization rules of § 263A.

In general, the simplified methods determine aggregate amounts of additional
§ 263A costs allocable to ending inventory. Additional § 263A costs generally are those
costs, other than interest, that were not capitalized under the taxpayer's method of
accounting immediately prior to the effective date of § 263A, but that are required to be
capitalized under § 263A. Under the simplified methods, additional § 263A costs
allocable to ending inventory are determined by multiplying § 471 costs (generally, the
costs other than interest the taxpayer capitalized under its method of accounting
immediately prior to the effective date of § 263A) remaining on hand at year end by an
absorption ratio consisting of a numerator of additional § 263A costs incurred during the
taxable year over a denominator of § 471 costs incurred during the taxable year.

At the time the § 263A regulations were issued, some commentators expressed
concern that the simplified methods, in particular the simplified production method,

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would result in allocation of an excessive amount of § 263A costs to raw materials
inventories. They suggested that this result occurs because the simplified production
method does not take into account the fact that fewer indirect costs are incurred with
respect to raw materials that are normally held only a short period of time, compared to
other items of inventory held longer. The final regulations did not adopt these
recommendations because the simplified production method formula properly reflects
the costs of raw materials that are purchased on the last day of the year, and
incorporating the suggestions would have reduced the simplicity that the simplified
production method was intended to provide.

More recently, controversy has arisen regarding the inclusion of negative
amounts in additional § 263A costs and whether aggregate additional § 263A costs may
be a negative number. A negative amount may occur, for example, when a taxpayer
includes book costs greater than those required for tax purposes in the § 471 cost of
inventory. For example, if a taxpayer included book depreciation in § 471 costs in
accordance with § 1.471-11(c)(2)(iii)(b) and the book depreciation is greater than tax
depreciation for the year, the taxpayer may have capitalized too much depreciation for
purposes of § 263A and must reduce total § 263A costs by the excess. A negative
amount may result if the taxpayer does not adjust its § 471 costs to remove this excess
depreciation amount but instead makes a negative adjustment to its additional § 263A
costs. Some taxpayers have reasoned that allowing negative amounts is consistent
with the purpose of the simplified methods to alleviate the administrative burden of
complying with the capitalization rules of § 263A and may reduce overcapitalization that
sometimes results.

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The Service and Treasury Department are aware of this viewpoint but are
concerned that including negative amounts in additional § 263A costs may result in
significant distortions in some situations. Including negative amounts in additional
§ 263A costs may undercapitalize amounts because the simplified production method
formula may remove more of the cost from ending inventory than was actually
remaining in ending inventory. Generally, this distortion is caused by the use of a
different formula for removing the cost from ending inventory than the formula by which
the cost was originally capitalized under § 471. The inclusion of raw materials in the
simplified production method formula also may cause distortions. For example,
including a negative amount for book depreciation greater than tax depreciation (excess
depreciation) in the simplified production method formula may reduce ending inventory
by more than the amount of excess depreciation actually remaining in ending inventory.
In some circumstances this distortion may be a reversal of the overcapitalization of
excess tax depreciation over book depreciation in prior years, and thus, may not be a
cause for concern. However, the inclusion can cause significant, lasting distortion in
situations in which the taxpayer has a tax basis much lower than book basis in
depreciable property.

The Service and Treasury Department are considering amending the regulations
under § 263A to prohibit the use of some or all negative amounts in computing
additional § 263A costs under the existing simplified methods and to provide a new
alternative simplified method of cost allocation under § 263A. The Service and
Treasury Department will consider a new method that would allow negative amounts in
computing additional § 263A costs, avoid requiring changes to existing systems for

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determining § 471 costs, but reduce distortions. One option under consideration would
treat costs related to raw materials differently from those related to work-in-process or
finished goods. Another option would create distinctions based upon the type of cost,
with certain permanent items such as basis differences being allocated using a separate
formula. Additionally, the Service and Treasury Department are considering whether
special rules should be provided for smaller taxpayers to compute additional § 263A
costs.

# INTERIM GUIDANCE

Pending the issuance of additional published guidance, the Service will not
challenge the inclusion of negative amounts in computing additional costs under § 263A
or the permissibility of aggregate negative additional § 263A costs. These issues will
not be raised in any taxable year ending on or before publication of the guidance, and, if
already raised as an issue in examination or before Appeals or the Tax Court in a
taxable year ending on or before March 12, 2007, the issue will not be pursued by the
Service. In addition, pending further published guidance, the Service will not deny
consent for changes in method of accounting solely on the basis that the proposed
method involves the inclusion of negative amounts in computing additional costs under
§ 263A or the permissibility of aggregate negative additional § 263A costs. However,
the Service will not grant a taxpayer permission to treat a cost as a negative additional
§ 263A cost unless the taxpayer already treats that cost as a § 471 cost. In other
words, the Service will not approve a change in method of accounting to change the
costs capitalized under § 471 to begin capitalizing a cost under § 471 and to remove the
same cost from ending inventory by treating it as a negative additional § 263A cost. In

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addition, any taxpayers granted consent to make these changes will be required to
conform their methods of accounting to any future published guidance.
REQUEST FOR COMMENTS

The Service and Treasury Department specifically request public comments on
the following issues:

1\. If only some negative amounts are appropriate in computing additional § 263A costs
under the existing simplified methods, which costs should be allowed and under what
circumstances? For example, should variances that were treated as top-side
adjustments (aggregate adjustments to total ending inventory that are not allocated to
each item or unit in ending inventory) before enactment of § 263A be treated differently
from variances that first arose after enactment of § 263A? If negative amounts may be
included in the numerator of the existing methods for some costs, should aggregate
negative additional § 263A costs be prohibited or restricted? Should items that
generate a permanent difference, such as basis differences, be allowed under the
existing simplified methods, or should they be allocated using a different method?
2\. If the use of negative amounts is restricted for certain costs or in certain situations as
described in (1) above, what specific modifications should be made to the existing
simplified methods to effect this result and how should the negative costs be allocated?
Should a new, alternative simplified method be created to allocate the negative costs or
all additional § 263A costs?

3\. How might a new, alternative simplified method of allocating costs under § 263A be
designed that could be used for all additional § 263A costs, positive or negative, in lieu
of the existing simplified methods, that would treat costs related to raw materials

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(including raw material content of work-in-process and finished goods) differently from
those related to work-in-process or finished goods (excluding raw material content) and
achieve maximum simplicity while reducing distortions? In particular, comments are
requested on (a) how costs, including variances and book-tax differences, should be
allocated between raw materials, work-in-process and finished goods, (b) whether only
purchasing costs should be allocated to raw materials, (c) whether purchasing, storage,
and handling costs of raw materials should be allocated to raw materials, (d) whether §
471 costs should be adjusted for purchased raw materials in transit and beginning
inventory, and (e) whether separate absorption ratios should be calculated for raw
materials, work-in-process and finished goods, and, if so, how those ratios should be
calculated.

4\. Should the simplified methods be modified for small taxpayers and if so, how? In
particular, how should any changes described above be applied to small taxpayers?
What criteria should be used for determining whether a taxpayer is a small taxpayer?

Comments should be submitted in writing on or before July 2, 2007, and should
include a reference to Notice 2007-29. Send submissions to: CC:PA:LDP:PR (Notice
2007-29), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered Monday through Friday
between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (Notice 2007-29), Courier's
Desk, Internal Revenue Service, 1111 Constitution Avenue N.W., Washington, DC.
Alternatively, comments may be submitted electronically directly to the Service via the
following e-mail address: Notice.comments@irscounsel.treas.gov. Please include

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"Notice 2007-29" in the subject line of any electronic communication. All materials
submitted will be available for public inspection and copying.

# DRAFTING INFORMATION

The principal author of this notice is W. Thomas McElroy, Jr. of the Office of the
Associate Chief Counsel (Income Tax and Accounting). For further information
concerning this notice, contact Mr. McElroy at (202) 622-4970 (not a toll-free number).