Sect. 263A: Allocating Direct and Indirect...

Sect. 263A: Allocating Direct and Indirect Costs Mastering Established and Evolving Regs, Guidance and Rulings

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THURSDAY, JANUARY 10, 2013

Presenting a live 110-minute teleconference with interactive Q&A

Jan Skelton, Tax Principal, Deloitte Tax, New York

Ross Margelefsky, Manager, PricewaterhouseCoopers, New York

Kristine Mora, Senior Manager, Ernst & Young, Washington, D.C.

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Sect. 263A: Allocating Direct and Indirect Costs Seminar

Jan Skelton, Deloitte Tax

[email protected]

Jan. 10, 2013

Ross Margelefsky, PricewaterhouseCoopers

[email protected]

Kristine Mora, Ernst & Young

[email protected]

Today’s Program

Fundamental Sect. 263A Concepts

[Ross Margelefsky, Jan Skelton and Kristine Mora]

Relevant Sect. 263A Guidance

[Kristine Mora]

Ongoing Compliance Challenges Under Sect. 263A

[Jan Skelton]

Slide 8 – Slide 27



Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT

MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR

RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

7

FUNDAMENTAL SECT. 263A CONCEPTS

Ross Margelefsky, PricewaterhouseCoopers



General Principles Of §263A

I. Provides uniform rules for capitalization of costs to:

A. Real and tangible personal property produced, and

B. Real and personal property acquired for resale

II. Applies to both inventory and self-constructed assets (i.e.,

assets produced for sale or use within the taxpayer’s business)

III. Generally requires taxpayers to capitalize costs over and

above those that are being capitalized for book purposes

9

General Applicability

I. Terms broadly defined:

A. “Produce” is defined to include property produced under

contract for the taxpayer.

B. Tangible property is defined to include certain creative

property (books, films, sound recordings).

II. Exceptions are provided in

1.263A-1(b), including:

A. Small resellers – Average gross receipts of <$10M for past

three years

B. Producer – Indirect material costs less than <$200K

10

Costs Required To Be Capitalized

I. All direct costs must be capitalized.

A. Producers: Direct material costs, direct labor costs

B. Resellers: Acquisition costs (

1.471-3)

II. Indirect costs must be capitalized when they directly benefit,

or are incurred by reason of, the performance of production or

(capitalizable) resale activities.

11

Overview Of Calculation

I. Step 1: Identify costs capitalized for financial accounting

II. Step 2: Identify “additional” costs required to be capitalized

for tax purposes (whether positive or negative)

III. Step 3: Allocate additional indirect costs to production

activities

IV. Step 4: Allocate mixed service costs to production activities

V. Step 5: If inventory, allocate additional Sect. 263A costs

between ending inventory and cost of goods sold, and if self-

constructed assets, capitalize into basis and depreciate

capitalized costs

12

Typical Book/Tax UNICAP Cost Differences

I. Practical capacity (FAS 151)

II. Standard cost variances

III. Distribution costs/pick-and-pack labor

IV. Packaging material costs treated as handling costs (see TAM

201030025)

V. Sales-based royalties (see Robinson Knife & proposed

regulations) vs. licensing costs and manufacturing-based

royalties (see Plastic Engineering)

VI. G&A (mixed-service) costs

VII.Schedule M-3 adjustments (e.g., depreciation, pension, stock

options/FAS 123, bonuses)

13

Capitalizable Indirect Costs

I. Treas. Reg.

1.263A-1(e)(3)(ii):

A. Indirect labor

B. Officer’s compensation

C. Pension and other related

costs

D. Employee benefit expenses

F. Purchasing costs

G. Handling costs

H. Storage costs

I. Cost recovery

J. Depletion

K. Rent

L. Taxes

M. Insurance

N. Utilities

O. Repairs and maintenance

P. Engineering and design

Q. Spoilage

R. Tools and equipment

S. Quality and control

T. Bidding (successful)

U. Licensing and franchise

V. Interest (

263A(f)

W. Capitalizable service costs

14

Indirect Costs Not Capitalized

I. Treas. Reg.

1.263A-1(e)(3)(iii):

A. Selling and distribution

B. Research and experimental

C.

179

D.

165 losses

E. Cost recovery allowances on temporarily idle equipment and facilities

F. Taxes assessed on the basis of income

G. Strike expenses

H. Warranty and product liability costs

I. On-site storage costs

J. Unsuccessful bidding expenses

K. Deductible service costs

15

Slide Intentionally Left Blank

Service Costs

I. 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. Selling

and distribution

A. Capitalizable service costs

B. Deductible service costs

C. Mixed service costs

1.

1.263A-1(g)(4)(ii): 90-10 de minimis rule

2. CCA 200946035: Research and experimental

expenditures

17

Cost Allocation Methodologies (§1.263A-1(g))

I. Specific identification, such as

A. Job costing systems

II. Standard costs or burden rates

III. Facts and circumstances, such as:

A. Time spent on production vs. non-production activities for

labor-type costs

B. Square footage allocations for occupancy-type costs

IV. Safe harbors

A. 1/3-2/3 rule for purchasing costs

18

Mixed Service Cost Allocation Methods (§1.263A-1(g)(4))

I. Direct reallocation

II. Step allocation

III. Simplified service cost methods (SSCM)

IV. Other reasonable methods such as:

A. Headcount

B. Labor hours

V. Filing requirement for Schedule M-3 filers

A. Question 9 on Schedule B – Form 1120: At any time during the tax year,

did the corporation treat for tax purposes indirect costs, as defined in

regulations sections 1.263A-1(e)(3)(ii)(F), (G) and (H) as mixed-service

costs, as defined in regulations Sect. 1.263A-1(e)(4)(ii)(C)?

1. Subparagraphs F, G and H relate to purchasing, storage and handling

costs.

19

Simplified Service Cost Methods

SSCM with production cost allocation ratio =

(

263A production costs*/total costs**) x MSC

SSCM with labor-based allocation ratio =

(

263A labor costs*/total labor costs*) x MSC

* Excluding MSC

** Excluding MSC, income taxes and interest

20

Additional §263A Cost Allocation Methods (§1.263A-1(f))

I. Burden rate

A. Pre-determined rates/allowances used to approximate cost

B. Significant variances must be capitalized to ending inventory.

II. Standard cost

A. Standard/budgeted costs to purchase or produce items used

to approximate cost

B. Variances between standard and actual must be capitalized

to ending inventory.

C. Standards usually updated at least annually via “revaluation

reserve”

21

Additional §263A Cost Allocation Methods (§1.263A-1(f)), Cont.

III. Simplified production/resale methods

A. Treats all resale/production costs as applicable to all

items purchased or produced

B. Generally less favorable method, especially if significant

1. Raw materials

2. In-transit inventory

22

Simplified Production Method (SPM)

Step 1: Compute absorption ratio

Absorption ratio = Additional

263A costs incurred during the year

Total

471 costs incurred during the year

Step 2: Allocate additional

263A costs to ending inventory

Absorption ratio x ending Inventory (or LIFO increment)

23

Simplified Resale Method (SRM)

Step 1: Compute absorption ratios

Purchasing costs ratio = Purchasing costs incurred during the year

Purchases

Storage and handling costs ratio = S&H costs incurred during the year

Beginning inventory + purchases

Step 2: Compute combined absorption ratio

Purchasing costs ratio + S&H costs ratio = Combined absorption ratio

Step 3: Allocate additional

263A costs to ending inventory

Combined absorption ratio x ending inventory (or LIFO Increment)

24

Simplified Resale Method (SRM), Cont.

I. More favorable than SPM, because denominator of S&H ratio

diluted by beginning inventory

II. Available to resellers and resellers with de minimis production

activities

A. Might not be available to some “resellers” because of

broad interpretation of “produce”

25

Historic Absorption Ratio (HAR)

I. Used in lieu of calculating actual absorption ratio each taxable year

in qualifying period (generally five years); see Reg.

1.263A-2(b)(4)

II. Test period is three taxable years immediately prior to election

(election without consent of commissioner using cut-off basis).

III. At end of qualifying period (recomputation year), taxpayer calculates

actual absorption ratio.

IV. If absorption ratio is within 0.5% (plus or minus) of previous HAR,

then qualifying period is extended.

V. If not within 0.5% (plus or minus), establish new HAR based on new

three-year test period

VI. Must file Form 3115 to revoke election, which normally will not be

granted during qualifying period; see Reg.

1.263A-2(b)(4)(iii)

26

RELEVANT SECT. 263A GUIDANCE


© 2012 Ernst & Young LLP

Relevant Sect. 263A Guidance: Sales-Based Royalties Proposed Regulations

► What are sales-based royalties?

► Royalties that are incurred only upon the sale of property produced

or property acquired for resale.

► IRS appears to take the position that “minimum royalties” are not

included in this definition.

► Summary of issue

► Many taxpayers historically treated sales-based royalties as

allocable directly to cost of goods sold, and did not capitalize the

cost to goods still on hand at the end of the year.

► The IRS often challenged this treatment on exam, asserting that

some royalties are capitalizable under Sect. 263A even if they are

sales-based.

► Robinson Knife Manuf. Co. v. Commissioner, 600 F.3d 121 (2d

Cir. 2010), rev’g T.C. Memo 2009-9


Relevant Sect. 263A Guidance: Sales-Based Royalties Proposed Regulations (Cont.)

► Current law – Simplified production method

► Royalty expenses incurred by reason of, or to benefit production or resale

activities, are production costs within the meaning of Sect. 263A.

► Royalty costs, including sales-based royalty costs, 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, are indirect costs

that are properly allocable to the property produced or acquired for

resale to the extent the costs directly benefit or are incurred by reason

of production or resale activities.

► As discussed previously, under the simplified UNICAP methods,

capitalizable costs are spread across all items of inventory, regardless of

whether they are benefited by those costs.

► Any amounts capitalized as additional Sect. 263A costs, such as sales-

based royalties, would become partially capitalized to ending inventory

under those simplified methods, even though the sales-based royalties

are not incurred until the goods are sold.



► Current law – Facts-and-circumstances or burden rate methods

► Royalty expenses incurred by reason of, or to benefit production or

resale activities, are production costs within the meaning of Sect.

1.263A-1(e)(3)(i).

► Costs are generally allocated only to inventory items that have

incurred those costs.

► Costs such as sales-based royalties are generally capitalized only

to goods that have been sold and not to ending inventory.



► Example – Simplified production method ► Additional Sect. 263A costs excluding sales-based royalties: $1,000

► Sales-based royalties: $100

► Sect. 471 costs incurred during the year: $10,000

► Ending inventory: $500

Current law

Additional Section 263A costs $1,100 ($1,000 + $100) = 11%

Section 471 costs $10,000

Ending inventory $500

Additional Section 263A costs $55

Proposed regulations

Additional Section 263A costs $1,000 = 10%

Section 471 costs $10,000

Ending inventory $500

Additional Section 263A costs $50



► Guidance was issued in the form of proposed regulations in

December 2010 which generally require capitalization of the sales-

based royalties to inventory, but allocate those costs to inventory that

has already been sold.

► The proposed regulations achieve a similar result to that in Robinson

Knife, but instead of determining that sales-based royalty costs are

not capitalizable, they provide that the costs are capitalizable to goods

that have been sold.

► The proposed regulations also address sales-based vendor

allowances and provide that a sales-based vendor allowance is an

adjustment to the cost of the merchandise sold or deemed sold under

the taxpayer's cost flow assumption.



► If finalized, the regulations suggest that taxpayers incurring sales-

based royalty costs will be able to recover such costs via cost of

goods sold in the year products are sold, rather capitalize a portion of

such costs to ending inventory.

► The regulations would be effective for tax years ending on or after

publication as final regulations in the Federal Register.

► Some taxpayers have filed non-automatic accounting method

changes or are working with IRS exam teams to adopt the

methodology in the proposed regulations.


Relevant Sect. 263A Guidance: Negative 263A Costs Proposed Regulations

► What are negative Sect. 263A costs?

► Negative amounts generally occur when a taxpayer capitalizes a cost as a

Sect. 471 cost that is greater than the amount required to be capitalized

for tax purposes.

► Examples include costs that are not capitalizable for tax purposes, such

as qualified 174 costs, pick-and-pack costs, etc.; as well as book/tax

differences related to inventoriable costs such as depreciation.

► Summary of issue

► Many taxpayers historically treated negative Sect. 263A costs as a

reduction to the pool of total additional 263A costs.

► The IRS often challenged this treatment on exam in 2007 and prior years.

► In April 2007, the IRS issued Notice 2007-29, which provided that,

pending the issuance of additional guidance, it would not challenge the

inclusion of negative amounts in calculating additional costs under Sect.

263A.


Relevant Sect. 263A Guidance: Negative 263A Costs Proposed Regulations (Cont.)

► Guidance was issued in the form of proposed regulations in

September 2012 which generally prohibit the inclusion of negative

costs in additional 263A costs under the simplified methods, subject

to the following exceptions:

► Small taxpayers (average annual gross receipts of $10 million or

less)

► Taxpayers using the simplified resale method

► Taxpayers using a new modified simplified production method

► All other taxpayers must remove the negative costs from Sect. 471

costs, using a method that approximates the manner in which the

taxpayer originally capitalized the costs.

► The proposed regulations would generally prohibit treating cash or

trade discounts under Sect. 1.471-3(b) as negative amounts under

any simplified method.


► New proposed modified simplified production method

► Two absorption ratios, rather than one as in the original SPM:

► Pre-production costs

► Production costs

► Reduces the distortions that result from the original SPM by

allocating production costs, including negative 263A costs, to

goods that have incurred those costs and not to raw materials.

► Pre-production cost absorption ratio applied to raw material and

raw material content of WIP and finished goods.

► Many of the benefits of burden rate methods, but with less work.

► Some additional work could be required if SPM is currently

used.

► Could reduce work if non-simplified method is currently used.



► The proposed regulations also adopt a new definition of Sect. 471

costs.

► All costs, other than interest, that a taxpayer capitalizes to its

inventory in its financial statements.

► However, Sect. 471 costs must include direct costs, regardless of

the financial statement treatment.

► This definition is consistent with what most taxpayers are currently

doing in practice.

► However some taxpayers, particularly retailers, currently reverse

out “book UNICAP” and treat all indirect costs as additional 263A

costs.



► The regulations would be effective for tax years ending on or after

publication as final regulations in the Federal Register.

► If finalized as written, many taxpayers would have to file accounting

method changes to adopt the new methods.


ONGOING COMPLIANCE CHALLENGES UNDER SECT. 263A


Property Produced Under A Contract

Sect. 1.263A-2(a)(1)(ii)(B)(1) provides that, in general, property

produced for the taxpayer under a contract with another party is treated

as property produced by the taxpayer, to the extent the taxpayer makes

payments or otherwise incurs costs with respect to the property.

Sect. 1.263A-3(a)(2)(iii) permits resellers with de minimis production

activities to be treated as resellers. Production activities are de minimis

if the gross receipts from the produced property are less than 10% of

total gross receipts, and the labor costs associated with the property are

less than 10% of total labor costs.

In Suzy’s Zoo v. Commissioner, 114 T.C. 1 (2000), aff’d 88 AFTR2d par.

2001-5560 (Nov. 21, 2001), a designer of greeting cards printed by a third

party was treated as the producer of greeting cards. The court rejected

the argument that the de minimis rule applied.

Deloitte Development LLC. All rights reserved. 42

Property Produced Under A Contract: Producer Or Reseller?

Application of property produced under a contract rule – producer

or reseller?

• Private label goods sold by a department store

― Likely to meet de minimis rule

• Products sold by specialty retailer

― Less than 10% of sales and labor?

Implication of treatment as a producer rather than a reseller

• Unable to use simplified resale method

• Unable to use $10M small reseller exception

• Possble capitalization of more costs


Property Produced Under A Contract: Self-Constructed Assets

Property produced under a contract includes property constructed

by another for the taxpayer for the taxpayer’s self-use – e.g.,

self-constructed assets.

Indirect costs must be capitalized to self-constructed assets under

Sect. 263A. These self-constructed assets could include office

buildings, stores, customer service centers, etc.

Note that when a taxpayer produces self-constructed assets

(regardless of whether under a contract) and also produces or

sells inventory, if the simplified service cost method (SSCM) is

used to determine mixed service costs allocable to inventory,

then mixed service costs must be allocated first to self-

constructed assets under another method of accounting prior to

the application of the SSCM.


Interplay With Sect. 199

A taxpayer seeking to claim a Sect. 199 deduction must treat

itself as a producer under Sect. 263A.

Under Sect. 263A, in the case of property produced under a

contract, both the taxpayer having property produced for it under

a contract and the contractor performing the work on the

property may subject to Sect. 263A, if the contractor is regarded

as the “tax-owner” of the property under Sect. 263A. However,

under Sect. 199, only one party can be treated as the producer of

the property. Thus, a taxpayer may be treated as a producer

required to capitalize costs under Sect. 263A but not as a

producer entitled to a Sect. 199 benefit.


Producer, Service Provider Or Reseller?

In Suzy’s Zoo, the Court of Appeals held that the greeting card designer

was the only owner of the greeting cards throughout the entire

production process. Thus, the designer was required to capitalize costs

under Sect. 263A. The implication is that the printer is not a tax owner

of the property but rather a service provider not required to capitalize

costs under Sect. 263A. The IRS disagrees with this principle.

In a technical advice memorandum, the IRS National Office did agree

that an auto mechanic repairing customer owner vehicles was not a

producer. The IRS seems to believe that to the extent parts are provided

in the repair process, the mechanic is a reseller. However, under

Osteopathic Medical Oncology & Hematology, P.C. v. Commissioner, 113

T.C. 376 (1999), items that are an “integral, indispensable, inseparable”

part of rendering services should not be regarded as inventory held for

sale.


Restaurants

• Restaurants have historically viewed themselves as members of the hospitality

services industry – e.g., as service providers.

• Over the last 15 years, the IRS Exam function has proposed audit adjustments

to treat restaurants as producers under Sect. 263A. Audit defense techniques

that should be considered include:

― Under the “three-I” test articulated in Osteopathic Medical, food

used in food preparation services should not be treated as inventory

and therefore should not be subject to Sect. 263A.

― Issues with property provided incident to services rule in Sect.

1.263A-1(b)(11)

― If an adjustment is proposed:

― Ensure “direct labor” is not treated as an allocable indirect

cost

― Pursue option of using a burden rate method rather than the

SPM


Dual Function Storage Facilities

Resellers are generally required to capitalize storage costs. However,

costs incurred in an “on-site” storage facility are not required to be

capitalized. On-site generally means on the site of a retail sales facility.

A storage facility that serves both an on-site and off-site storage facility

is a dual-function storage facility. Costs allocable to the off-site function

must be capitalized.

Facts that could cause a facility to be a dual function storage facility:

• Leases

• Bulk purchases

• Shipments to other stores

• Internet orders


Miscellaneous Issues

• Expansive definition of handing activities

• Application of 1/3-2/3 rule on a person-by-person basis

• Schedule M adjustments


Method Change Issues

• Change in method of accounting

• Automatic method change vs. advance consent change

• Three-year revaluation method

• Prevelence of requiring concurrent unicap changes when other

changes are made


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