On November 19, 2018, the Internal Revenue Service (IRS) and the Treasury Department (Treasury) issued final regulations (T.D. 9843) that address taxpayers’ use of negative amounts in calculating additional costs for purposes of section 263A. Maintaining the general restriction on the inclusion of negative adjustments and providing a new consistency requirement for taxpayers that are allowed to include negative adjustments, the final regulations incorporate, with some minor amendments, the proposed regulations (REG-126770-06) that were published in September 2012. The final regulations are relevant for taxpayers that are either resellers or producers of property that are required to capitalize costs.1
Background:
Generally referred to as the Uniform Capitalization (UNICAP) Rules, section 263A requires taxpayers to capitalize both direct and indirect costs that are allocable to (1) real or tangible personal property produced by the taxpayer, and (2) real and personal property acquired for resale by the taxpayer. Under section 263A, for federal tax purposes, taxpayers must capitalize costs that differ both in type and in amount from the costs that may be capitalized for financial reporting purposes. To comply with section 263A, a taxpayer must identify any additional costs outside of those that were capitalized solely for financial reporting purposes and allocate them between the costs of goods sold and ending inventory.
When applying the rules under section 263A, taxpayers are frequently faced with the issue of how to treat negative additional section 263A costs. The starting point for inventory calculations begins with the taxpayer’s book costs, which are generally referred to as “section 471 costs.” A complication arises when costs that are capitalized for financial reporting purposes are not required (or permitted) to be capitalized for federal income tax purposes. For example, when book depreciation is capitalized for financial accounting purposes (e.g., included in a taxpayer’s section 471 costs), and the depreciation allowed for book purposes is greater than the amount allowed for tax purposes, if these excess costs are not removed, the taxpayer would capitalize more depreciation for tax purposes than is required under section 263A, and inventory values are overstated. Since the enactment of section 263A, it has not been uncommon for taxpayers to eliminate such excess costs through a negative adjustment to the taxpayer’s additional section 263A costs so that the proper amount of costs are ultimately capitalized for tax purposes. Specifically, taxpayers use the section 263A allocation methods to remove such excess costs from ending inventory.
This practice arose for a number of reasons. First, prior to the enactment of section 263A, it was common for taxpayers to make similar adjustments to inventory calculations. Taxpayers routinely made similar simplifying adjustments to inventoriable costs under Treas. Reg. §§ 1.471-11, 1.471-3, and 1.451-3. Because most companies cannot remove such costs from their financial accounting systems, to accurately capture inventory costs for tax purposes, taxpayers made simplifying adjustments as part of tax calculations. Importantly, such adjustments were generally accepted by the IRS so that inventory costs could be properly reflected. Second, the IRS has a long-standing policy of refusing to allow taxpayers to change their methods of accounting to remove such costs from section 471 costs. Thus, by not allowing taxpayers to make these adjustments, inventory values would be overstated for tax purposes absent conforming negative adjustments. In fact, this issue was anticipated in the legislative history of section 263A, which included a discussion of the differences between book and tax depreciation. The legislative history to section 263A reveals that Congress was aware of the significant change required of retailers becoming subject to section 263A and the legislative history offers a flexible approach, including the use of simplifying methods in an effort to ensure compliance.2
Several years subsequent to the enactment of section 263A, controversy arose over whether negative amounts could be included as a result of discrepancies between book and tax depreciation. Explaining its concern over the inclusion of negative amounts, the IRS stated that because section 471 costs are usually allocated to inventory through a different method than the one used to allocate additional section 263A costs, the costs being removed under section 263A allocation methods could differ significantly from the costs allocated to inventory using that book-inventory method.3 For example, such costs might be allocated for book purposes on a per unit basis while being removed in aggregate as negative additional section 263A costs relying on a simplifying convention. Because costs were initially allocated to inventory using one approach and then removed from inventory using a very different approach, there was concern that the removal overstated the effect of the adjustment. The IRS and Treasury acknowledged that the allowance of negative amounts was consistent with policy goals of reducing overcapitalization and administrative burdens for inventory taxpayers. Nonetheless, concern was expressed that allowing negative adjustments could result in significant distortions.
Unable to reach a satisfying resolution or to identify a method of balancing the two policy goals of eliminating distortions and easing taxpayer burdens, the IRS released interim guidance addressing negative additional section 263A costs. Notice 2007-29 indicated that pending the release of additional guidance under section 263A, the IRS would not challenge taxpayers that used their section 263A allocation methods to allocate negative costs, nor would they challenge the permissibility of aggregate negative additional section 263A costs.4
The 2012 proposed regulations (REG-126770), which effectively supersede Notice 2007-09, barred the use of negative additional section 263A costs for large taxpayers unless the taxpayer fell into one of three exceptions. Reasoning that the general inclusion of negative additional section 263A costs under the simplified methods could be distortive, the proposed regulations included three exceptions under which taxpayers using specific accounting methods provided in the regulations could include negative amounts to remove section 471 costs without causing gross distortions.
These exceptions applied to:
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Taxpayers using the Simplified Resale Method (SRM);
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Producers using the Simplified Production Method (SPM) with average annual gross receipts of $10 million or less for the three previous tax years; and
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Taxpayers using the Modified Simplified Production Method (MSPM).
These exceptions were included in order to simplify allocation methods for taxpayers that resell or produce property and to further ensure compliance. Under the SRM and SPM, taxpayers would be able to allocate additional 263A costs to property on hand at year’s end (using a ratio of additional costs to their total section 471 costs). Under the MSPM, taxpayers could use a production method designed to allow them to more accurately allocate additional 263A costs among goods inventories, raw materials, and works in progress. These three exceptions were included to ease the administrative burden on taxpayers acting in compliance with section 263A.
Final Regulations
The final regulations implement, with some minor changes, the proposed regulations released in 2012. Under the final regulations, unless a taxpayer falls into one of three exceptions, the taxpayer is still generally prohibited from including negative adjustments in additional section 263A costs, due to an overriding concern that the allowance of a negative adjustment would result in “significant distortions” between the amount of section 471 costs allocated to ending inventory and the amount of additional section 263A costs.5
In accordance with the IRS goal of limiting potential distortions, the final regulations also provide a new consistency requirement for taxpayers that are allowed to include negative adjustments. The new requirement provides that a taxpayer that is allowed to include negative adjustments must use this method of accounting for all section 471 costs that are permitted to be removed using negative adjustments.
Further, the final regulations implement some modifications to the MSPM introduced in the proposed regulations, including eliminating the requirement for taxpayers to separately track direct material costs that are then incorporated into inventories. According to the regulations, these modifications will reduce “compliance costs, burden, and administrative complexity” for taxpayers.6
In addition to these final regulations, the IRS has issued Revenue Procedure 2018-56 (2018-50 IRB) which amends and modifies Revenue Procedure 2018-31 and provides procedures for taxpayers to obtain automatic consent of the Commissioner to make accounting method changes in compliance with the final regulations for the first, second or third tax year ending on or after November 20, 2018.
Tax Cuts and Jobs Act
Under the Tax Cuts and Jobs Act (TCJA), the final regulations stand to have a large impact on smaller taxpayers. Though the aim of the final regulations and section 263A in general is to eliminate distortions, it is worth noting that both the SPM and the SRM are averaging conventions and, thus, are both susceptible to distortions.
Both the SPM and the SRM allow taxpayers to allocate additional section 263A costs to inventory by applying an absorption ratio to existing section 471 costs at the end of a taxable year.7 Under the SPM (Treas. Reg. § 1.263A-2(b)), taxpayers are required to compute additional section 263A costs based on an absorption ratio of costs incurred during the taxable year to total section 471 costs incurred by the taxpayer in the same year. These costs are allocated to remaining produced property that is still on hand for the taxpayer at the end of the year. Under the SRM (Treas. Reg. § 1.263A-3(d)), taxpayers may compute a “combined absorption ratio” and multiply that by applicable section 471 costs incurred during the taxable year that still remain in the taxpayer’s ending inventory (or otherwise remain on hand at the end of the taxable year) in order to calculate additional section 263A costs.
As a result of its structuring, the SPM is still susceptible to distortions for taxpayers. For instance, the inclusion of negative amounts can result in a large distortion in the amount of additional section 263A costs that are allocated to ending inventory. Further, discrepancies in the methods of capitalizing costs under section 471 and the removal of costs from ending inventory under the SPM can also result in significant distortions.
Since the purpose of these final regulations is aimed at eliminating distortions, the exact impact on the majority of small taxpayers that use the SPM remains unclear.
Eversheds Sutherland Perspective
The preamble to the final regulations indicates that these regulations are intended to further simplify accounting methods and eliminate significant distortions. The final regulations provide that certain public comments have not been adopted and that certain changes have been implemented with the specific intention of “limit[ing] potential distortions” in simplified methods.8 In order to achieve these goals, the IRS and Treasury are focusing on attempting to make simplified accounting methods even more precise, a decision that is at odds with the larger tax policies. The simplified allocation methods were provided to taxpayers because a policy decision was made to foster compliance at the expense of precision.
Despite this intent to allow simplify calculation methods for taxpayers, the final regulations actually reduce the simplicity of the SPM, diminishing the distinguishing characteristic of this accounting method. The SPM is essentially an averaging convention; it is designed to reduce compliance costs for taxpayers while also minimizing the administrative complexity for IRA agents examining section 263A calculations. Many taxpayers rely on the SPM because it is more cost-effective and easier to implement and maintain than other, more precise and thus taxpayer-favorable, allocation methods. It is a reliable method for taxpayers that lack the resources and information to prepare calculations using more complex allocation methods. By changing the SPM, the final regulations hinder the very purpose the SPM was meant to serve.
Lastly, there are alternative methods of addressing and limiting distortions without diminishing an existing allocation method. The IRS could implement changes that allow taxpayers to change their methods of capturing section 471 costs. These changes would address a common accounting problem that results in distortions without diminishing the effectiveness of the much-relied upon SPM.
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1 T.D. 9843.
2 Joint Committee of Taxation, General Explanation of the Tax Reform Act of 1986, H.R. 3838.
3 TAM 200607021.
4 Notice 2007-29.
5 T.D. 9843.
6 T.D. 9843.
7 REG-126770-06.
8 T.D. 9843.
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