Allocation of Costs Under the Simplified Methods, 54482-54490 [2012-21743]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 77, Number 172 (Wednesday, September 5, 2012)]
[Proposed Rules]
[Pages 54482-54490]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-21743]



[[Page 54482]]

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-126770-06]
RIN 1545-BG07


Allocation of Costs Under the Simplified Methods

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations on allocating 
costs to certain property produced by the taxpayer or acquired by the 
taxpayer for resale. The proposed regulations affect taxpayers that are 
producers or resellers of property that are required to capitalize 
certain costs to the property and that allocate costs under the 
simplified production method or the simplified resale method. The 
proposed regulations provide rules for the treatment of negative 
additional costs.

DATES: Written (including electronic) comments and requests for a 
public hearing must be received by December 4, 2012.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-126770-06), room 
5205, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered between the 
hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-126770-06), Courier's 
Desk, Internal Revenue Service, 1111 Constitution Avenue NW., 
Washington, DC. Taxpayers also may submit comments electronically via 
the Federal eRulemaking Portal at www.regulations.gov (IRS REG-126770-
06).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Christopher Call, (202) 622-4970; concerning submissions of comments or 
to request a public hearing, Oluwafunmilayo Taylor, (202) 622-7180 (not 
toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    This document contains proposed amendments to the Income Tax 
Regulations, 26 CFR part 1, relating to the allocation of costs under 
the simplified methods of accounting under section 263A of the Internal 
Revenue Code (Code).
    Section 263A requires taxpayers to capitalize the direct costs and 
indirect costs that are properly allocable to: (1) Real or tangible 
personal property the taxpayer produces, and (2) real property and 
personal property described in section 1221(a)(1) that the taxpayer 
acquires for resale. Section 1.263A-1(e)(2)(i) of the Income Tax 
Regulations provides that direct costs for producers are direct 
material costs and direct labor costs. Section 1.263A-1(e)(2)(ii) 
provides that resellers must capitalize the acquisition cost of 
property acquired for resale. Section 1.263A-1(e)(3)(i) defines 
indirect costs 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). Indirect costs are properly 
allocable to property produced or acquired for resale when the costs 
directly benefit or are incurred by reason of the performance of 
production or resale activities.
    Section 263A generally requires taxpayers to allocate capitalizable 
section 263A costs to specific items in inventory. The legislative 
history of section 263A indicates that Congress intended that taxpayers 
would allocate additional section 263A costs (costs, other than 
interest, that were not capitalized under the taxpayer's method of 
accounting immediately prior to the effective date of section 263A, but 
that are required to be capitalized under section 263A) with the same 
degree of specificity that was required of inventoriable costs prior to 
the enactment of section 263A. Congress contemplated that taxpayers 
would continue to use the same methods of allocating costs to items in 
their inventory that were available under prior law. See S. Rep. No. 
313, 99th Cong. 2d Sess. 142 (1986). Consistent with these principles, 
the regulations under Sec.  1.263A-1(f)(2) and (f)(3) provide that 
taxpayers may elect to use a ``facts-and-circumstances'' allocation 
method, such as the specific identification method, burden rate, 
standard cost method, or any other method to allocate direct and 
indirect costs to units of property produced or acquired for resale, if 
the method is reasonable within the meaning of Sec.  1.263A-1(f)(4).
    Section 1.263A-1(f)(1) authorizes taxpayers to use the simplified 
methods provided in Sec.  1.263A-2(b) (the simplified production 
method) or Sec.  1.263A-3(d) (the simplified resale method) to allocate 
costs to eligible property produced or eligible property acquired for 
resale in lieu of a facts-and-circumstances allocation method. The 
simplified methods differ from facts-and-circumstances methods in that, 
as applied to inventories, they allocate a pool of capitalizable costs 
(additional section 263A costs) between ending inventory and cost of 
goods sold using a defined ratio and are an exception to the general 
rule that additional section 263A costs must be allocated to specific 
items of inventory. Thus, the simplified methods are intended to reduce 
the complexity and administrative burdens of having to develop detailed 
cost accounting systems for the additional costs required to be 
capitalized under section 263A.
    Under the simplified production method, a taxpayer must allocate 
additional section 263A costs to produced property on hand at the end 
of the taxable year based on the ratio of these costs incurred during 
the year to the taxpayer's total section 471 costs incurred during the 
year (the absorption ratio). The current regulations define additional 
section 263A costs 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, but that are required to be 
capitalized under section 263A. See Sec.  1.263A-1(d)(3). The current 
regulations define section 471 costs as costs, other than interest, 
capitalized under the taxpayer's method of accounting immediately prior 
to the effective date of section 263A. If a taxpayer was not in 
existence before the effective date of section 263A, section 471 costs 
are generally those costs that would have been required to be 
capitalized under Sec.  1.471-11. See Sec.  1.263A-1(d)(2). The 
absorption ratio is multiplied by the section 471 costs incurred during 
the taxable year that remain in ending inventory or are otherwise on 
hand at year end to determine the additional section 263A costs 
allocable to produced property on hand at the end of the taxable year.
    Under the simplified resale method, an eligible taxpayer computes a 
combined absorption ratio and multiplies it by the section 471 costs 
incurred during the taxable year that remain in its ending inventory or 
are otherwise on hand at year end to determine the additional section 
263A costs allocable to eligible property on hand at year end. Section 
1.263A-3(d)(3)(i)(C)(1) defines the combined absorption ratio as the 
sum of the storage and handling costs absorption ratio as defined by 
Sec.  1.263A-3(d)(3)(i)(D) and the purchasing costs absorption ratio as 
defined by Sec.  1.263A-3(d)(3)(i)(E).
    Notice 2007-29 (2007-1 CB 881) requests comments on the treatment 
of negative amounts under the simplified methods. A negative amount 
generally occurs when a taxpayer capitalizes a cost as a section 471 
cost in an amount that is greater than the amount required to be 
capitalized for tax purposes. For

[[Page 54483]]

example, if a taxpayer included book depreciation in section 471 costs 
in accordance with Sec.  1.471-11(c)(2)(iii)(b) and the book 
depreciation is greater than tax depreciation for the year, the 
taxpayer would have capitalized more depreciation than is required to 
be capitalized under section 263A for that year. A negative amount may 
result if the taxpayer does not remove this excess depreciation amount 
by adjusting section 471 costs but instead makes an adjustment to its 
additional section 263A costs. See Sec.  601.601(d)(2)(ii)(b).
    In some situations, including negative amounts in the numerator of 
the simplified production method formula may result in significant 
distortions of the amount of additional section 263A costs that is 
allocated to ending inventory. Distortions may also occur when the 
method used to capitalize a cost under section 471 is different than 
the method used under the simplified production method to remove the 
cost from ending inventory. The extent of the distortion, and whether 
it is favorable or unfavorable to the taxpayer, generally depends on 
when the cost is incurred in the production process and how the cost 
was allocated to raw materials, work-in-process, or finished goods 
inventories for purposes of section 471.
    Notice 2007-29 provides that, pending the issuance of additional 
published guidance, the IRS will not challenge the inclusion of 
negative amounts in computing additional costs under section 263A or 
the permissibility of aggregate negative additional section 263A costs. 
The notice solicits public comments regarding possible changes to the 
simplified methods involving negative additional section 263A costs. 
Comments were received and considered in developing these proposed 
regulations.

Explanation of Provisions

1. Prohibition on Negative Amounts

    To reduce the distortions that occur by including negative amounts 
under the simplified methods, the proposed regulations provide that, 
subject to certain exceptions described later in this preamble, 
taxpayers may not include negative amounts in additional section 263A 
costs. Specific comments are requested on transition rules for 
taxpayers currently using the simplified production method with the 
historic absorption ratio election (see section 1.263A-2(b)(4)), 
including comments on how the regulations should apply to taxpayers 
that are part way through the qualifying period as described in section 
1.263A-2(b)(4)(ii)(C).
    To reduce the administrative burden for smaller taxpayers using the 
simplified production method for which the costs and burdens of 
excluding negative amounts from additional section 263A costs may 
otherwise outweigh the benefits, the proposed regulations allow 
producers with average annual gross receipts of $10,000,000 or less to 
include negative amounts in additional section 263A costs under the 
simplified production method.
    Additionally, because negative additional section 263A costs cause 
less distortion under the simplified resale method than under the 
simplified production method, the proposed regulations allow taxpayers 
using the simplified resale method to remove section 471 costs that are 
not required to be capitalized for tax purposes from ending inventory 
by treating them as negative additional section 263A costs.
    The proposed regulations generally prohibit treating cash or trade 
discounts described in Sec.  1.471-3(b) as negative amounts under any 
of the simplified methods. Comments are requested on reasonable methods 
of allocating between ending inventory and cost of goods sold cash or 
trade discounts that taxpayers do not capitalize for book purposes (and 
therefore are not section 471 costs within the meaning of Sec.  1.263A-
1(d)(2)).

2. New Modified Simplified Production Method

    In response to Notice 2007-29, a commentator suggested an 
alternative to the simplified production method that would reduce 
overcapitalization and distortion, including distortions resulting from 
including negative amounts in additional section 263A costs. The 
commentator suggested that the simplified production method may 
allocate an excessive amount of section 263A costs to raw materials 
inventories because the formula does not take into account the fact 
that taxpayers incur fewer indirect costs for raw materials and because 
different inventoriable costs turn over at different rates. The 
commentator's alternative simplified method would allocate additional 
section 263A costs related to raw materials using a formula that is 
different from the formula used to allocate additional section 263A 
costs related to work-in-process and finished goods.
    As suggested by this comment, the proposed regulations allow 
producers to use a new modified simplified production method that 
reduces the distortions that exist under the traditional simplified 
methods by more precisely allocating additional section 263A costs, 
including negative amounts, among raw materials, work-in-process, and 
finished goods inventories. Under the modified simplified production 
method, producers determine the allocable portion of preproduction 
related additional section 263A costs (such as storage and handling for 
raw materials) using a preproduction cost absorption ratio. The 
preproduction cost absorption ratio is applied to raw material section 
471 costs incurred during the taxable year and remaining on hand at 
year end. For purposes of computing the allocable portion of 
preproduction related additional section 263A costs, raw material costs 
on hand at year end include unprocessed raw materials and raw materials 
that are integrated into work-in-progress and finished goods. Under the 
modified simplified production method, producers determine the 
allocable portion of all other additional section 263A costs using a 
production cost absorption ratio.
    In addition to reducing distortions that exist under the simplified 
production method by more precisely allocating additional section 263A 
costs to raw materials, the modified simplified production method 
provides producers with a method to remove section 471 costs that are 
not required to be capitalized for tax purposes from ending inventory 
by treating them as negative additional section 263A costs. Both 
resellers and producers, thereby, are allowed to use methods that more 
precisely allocate additional section 263A costs while alleviating 
administrative burden, consistent with the purpose of the simplified 
methods.
    As with other simplified methods, a taxpayer must maintain adequate 
records substantiating proper use of the modified simplified production 
method (see section 6001).
    Comments are requested on the modified simplified production 
method, including: (1) Whether distortions will occur if preproduction 
related additional section 263A costs are not directly traced from raw 
materials through work-in-process and finished goods inventories from 
year to year; (2) how mixed service costs should be allocated between 
raw materials, work-in-process, and finished goods inventories under 
the new formula; and (3) how the new formula should apply to a taxpayer 
using the last-in, first-out method of accounting.

[[Page 54484]]

3. Simplified Definition of Section 471 Costs and Elimination of 
Separate Provisions for New Taxpayers

    For most taxpayers, section 471 costs generally are the acquisition 
or production costs, other than interest, that the taxpayer capitalized 
under its method of accounting immediately before the effective date of 
section 263A. See Sec.  1.263A-1(d)(2)(i). If a taxpayer was not in 
existence at that time, section 471 costs generally are the acquisition 
or production costs, other than interest, that the taxpayer would have 
been required to capitalize if the taxpayer had been in existence 
immediately before the effective date of section 263A. See Sec.  
1.263A-1(d)(2)(ii).
    To provide greater simplicity and consistency among taxpayers, the 
proposed regulations adopt a single definition of section 471 costs 
that applies to taxpayers that were in existence before the effective 
date of section 263A and to newer taxpayers, whether using the 
simplified production method, the modified simplified production 
method, or the simplified resale method. The proposed regulations 
provide that, for purposes of the simplified methods, a taxpayer's 
section 471 costs, in general, are the costs, other than interest, that 
a taxpayer capitalizes to its inventory in its financial statements. 
However, a taxpayer must include all direct costs in its section 471 
costs regardless of the taxpayer's treatment of the costs in its 
financial statements. The proposed regulations require a taxpayer that 
is not permitted to remove section 471 costs as negative additional 
section 263A costs to reduce its section 471 costs. The proposed 
regulations provide that a taxpayer that reduces its section 471 costs 
must use a reasonable method that approximates the manner in which the 
taxpayer originally capitalized the costs.

Effective/Applicability Date

    The regulations are proposed to apply to taxable years ending on or 
after the date the regulations are published as final regulations in 
the Federal Register.

Effect on Other Documents

    Notice 2007-29 would be superseded as of the date these regulations 
are published as final regulations in the Federal Register.

Special Analyses

    This notice of proposed rulemaking is not a significant regulatory 
action as defined in Executive Order 12866, as supplemented by 
Executive Order 13563. Therefore, a regulatory assessment is not 
required. Section 553(b) of the Administrative Procedure Act (5 U.S.C. 
chapter 5) does not apply to these regulations. Because the regulations 
do not impose a collection of information on small entities, the 
Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. 
Pursuant to section 7805(f) of the Code, this notice of proposed 
rulemaking has been submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.

Comments and Requests for Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any comments that are submitted timely 
to the IRS as prescribed in this preamble under the ADDRESSES heading. 
The IRS and the Treasury Department request comments on all aspects of 
the proposed rules. All comments will be available at 
www.regulations.gov or upon request.
    A public hearing will be scheduled if requested in writing by any 
person who timely submits written comments. If a public hearing is 
scheduled, notice of the date, time, and place for the public hearing 
will be published in the Federal Register.

Drafting Information

    The principal author of these proposed regulations is W. Thomas 
McElroy, Jr. of the Office of Associate Chief Counsel (Income Tax and 
Accounting). However, other personnel from the IRS and the Treasury 
Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART I--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority:  26 U.S.C. 7805 * * *

    Section 1.263A-1 also issued under 26 U.S.C. 263A. * * *
    Section 1.263A-2 also issued under 26 U.S.C. 263A. * * *

    Par. 2. Section 1.263A-0 is amended as follows:
    1. Revising the entries in Sec.  1.263A-1 for paragraphs (d)(2) and 
(d)(3).
    2. Revising the entries in Sec.  1.263A-2 for paragraphs (c) and 
(d).
    3. Adding new entries to Sec.  1.263A-2 for paragraphs (e), (f) and 
(g).
    The revisions and addition read as follows:


Sec.  1.263A-0  Outline of regulations under section 263A.

* * * * *


Sec.  1.263A-1  Uniform capitalization of costs.

* * * * *
    (d) * * *
    (2) Section 471 costs.
    (i) In general.
    (ii) Removal of costs from inventory.
    (iii) Method changes.
    (3) Additional section 263A costs
    (i) In general.
    (ii) Negative amounts.
    (A) In general.
    (B) Exception for small taxpayers using the simplified production 
method.
    (C) Exception for modified simplified production method and 
simplified resale method.
* * * * *


Sec.  1.263A-2  Rules relating to property produced by the taxpayer.

* * * * *
    (c) Modified simplified production method.
    (1) In general.
    (2) Eligible property.
    (3) Modified simplified production method without historic 
absorption ratio election.
    (i) General allocation formula.
    (A) In general.
    (B) Allocable preproduction additional section 263A costs.
    (C) Allocable production additional section 263A costs.
    (D) Effect of allocation.
    (E) Treatment of mixed service costs.
    (ii) Definitions
    (A) Preproduction absorption ratio.
    (1) In general.
    (2) Preproduction additional section 263A costs.
    (3) Raw material costs.
    (B) Production absorption ratio.
    (1) In general.
    (2) Production additional section 263A costs.
    (3) Production section 471 costs.
    (iii) LIFO taxpayers electing the modified simplified production 
method.
    (A) In general.
    (B) LIFO increment.
    (1) In general.
    (2) Combined absorption ratio defined.
    (C) LIFO decrement.
    (iv) De minimis rule for producers with total indirect costs of 
$200,000 or less.
    (v) Examples.
    (4) Modified simplified production method with historic absorption 
ratio election.

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    (i) In general.
    (ii) General allocation formula.
    (A) In general.
    (B) Preproduction historic absorption ratio.
    (C) Production historic absorption ratio.
    (iii) LIFO taxpayers making the historic absorption ratio election.
    (A) In general.
    (B) Combined historic absorption ratio.
    (C) Total allocable additional section 263A costs incurred during 
the test period.
    (D) Total section 471 costs remaining on hand at year end during 
the test period.
    (iv) Extension of qualifying period.
    (v) Transition rule.
    (vi) Examples.
    (d) Additional simplified methods for producers.
    (e) Cross reference.
    (f) Change in method of accounting.
    (1) In general.
    (2) Scope limitations.
    (3) Audit protection.
    (4) Section 481(a) adjustment.
    (5) Time for requesting change.
    (g) Effective/applicability date.
    Par. 3. Section 1.263A-1 is amended by:
    1. Revising paragraphs (d)(2) and (d)(3).
    2. Adding a sentence to the end of paragraph (m).
    The addition and revisions read as follows:


Sec.  1.263A-1  Uniform capitalization of costs.

* * * * *
    (d) * * *
    (2) Section 471 costs--(i) In general. Except as otherwise provided 
in paragraph (d)(2)(ii) of this section, for purposes of section 263A, 
a taxpayer's section 471 costs are the costs, other than interest, that 
a taxpayer capitalizes to its inventory (or other eligible property) in 
its financial statements. Thus, although section 471 applies only to 
inventories, section 471 costs include any non-inventory costs, other 
than interest, that a taxpayer capitalizes or includes in acquisition 
or production costs in its financial statements. However, 
notwithstanding the last sentence of paragraph (g)(2) of this section, 
section 471 costs must include all direct costs of producing property 
and of acquiring property held for resale, whether or not a taxpayer 
capitalizes these costs to inventory or to other eligible property in 
its financial statements. See paragraph (e)(2) of this section for a 
description of direct production costs and direct costs of acquiring 
property held for resale.
    (ii) Removal of costs from inventory. A taxpayer must reduce its 
section 471 costs by those costs that the taxpayer capitalizes to its 
inventory (or other eligible property) in its financial statements that 
may not be capitalized under either Sec.  1.263A-1(c)(2) or Sec.  
1.263A-1(j)(2)(ii), and those period costs that the taxpayer 
capitalizes to its inventory (or other eligible property) in its 
financial statements that, under Sec.  1.263A-1(j)(2), the taxpayer 
chooses not to capitalize under section 263A (for example, section 179 
costs). A taxpayer described in paragraph (d)(3)(ii)(B) or 
(d)(3)(ii)(C) of this section that may remove these costs from 
inventory by including them as negative amounts in additional section 
263A costs instead may reduce its section 471 costs for these costs. A 
taxpayer that reduces its section 471 costs must use a reasonable 
method that approximates the manner in which the taxpayer originally 
capitalized the costs to its inventory (or other eligible property) in 
its financial statements.
    (iii) Method changes. A taxpayer may change its method of 
accounting for determining section 471 costs only with the consent of 
the Commissioner as required under section 446(e) and the corresponding 
regulations. If a taxpayer is using the simplified production method 
described in Sec.  1.263A-2(b), the modified simplified production 
method described in Sec.  1.263A-2(c), or the simplified resale method 
described in Sec.  1.263A-3(d), and changes its financial reporting 
practices regarding the costs capitalized to its inventory (or other 
eligible property) in a manner that would change its section 471 costs 
under the general provisions of paragraph (d)(2)(i) of this section, 
then the taxpayer must secure the Commissioner's consent prior to 
computing its taxable income under the new method of accounting for 
section 471 costs.
    (3) Additional section 263A costs--(i) In general. Additional 
section 263A costs are defined as the costs, other than interest, that 
are not included in a taxpayer's section 471 costs, but that are 
required to be capitalized under section 263A. Additional section 263A 
costs do not include the direct costs that are required to be included 
in a taxpayer's section 471 costs under paragraph (d)(2)(i) of this 
section.
    (ii) Negative amounts--(A) In general. Except as otherwise provided 
by regulations or other published guidance, see Sec.  601.601(d)(2), a 
taxpayer may not include negative amounts in additional section 263A 
costs.
    (B) Exception for small taxpayers using the simplified production 
method. Paragraph (d)(3)(ii)(A) of this section does not apply to a 
taxpayer using the simplified production method under Sec.  1.263A-2(b) 
if the taxpayer's (or its predecessors') average annual gross receipts 
for the three previous taxable years (test period) do not exceed 
$10,000,000. The rules of Sec.  1.263A-3(b) apply for purposes of 
determining the amount of a taxpayer's gross receipts and the test 
period.
    (C) Exception for modified simplified production method and 
simplified resale method. In general, a taxpayer using the modified 
simplified production method under Sec.  1.263A-2(c) or the simplified 
resale method under Sec.  1.263A-3(d) may (but is not required to) 
remove as negative amounts under section 263A indirect costs that are 
included in the taxpayer's section 471 costs but that are not required 
to be, or may not be, capitalized into inventory (or other eligible 
property) for federal income tax purposes. However, a taxpayer using 
the modified simplified production method or the simplified resale 
method may not use negative amounts to adjust additional section 263A 
costs for cash or trade discounts described in Sec.  1.471-3(b).
* * * * *
    (m) * * * Paragraphs (d)(2) and (d)(3) of this section apply for 
taxable years ending on or after the date these regulations are 
published as final regulations in the Federal Register.
    Par. 4. Section 1.263A-2 is amended by:
    1. Redesignating paragraphs (c), (d), (e), and (f) as paragraphs 
(d), (e), (f), and (g).
    2. Adding a new paragraph (c).
    3. Revising newly designated paragraph (g).
    The addition and revisions read as follows:


Sec.  1.263A-2  Rules relating to property produced by the taxpayer.

* * * * *
    (c) Modified simplified production method--(1) In general. This 
paragraph (c) provides a modified simplified method for determining the 
additional section 263A costs properly allocable to ending inventories 
of property produced and other eligible property on hand at the end of 
the taxable year.
    (2) Eligible property. For purposes of this paragraph (c), eligible 
property has the same meaning as in paragraph (b)(2) of this section.
    (3) Modified simplified production method without historic 
absorption ratio election--(i) General allocation formula--(A) In 
general. Except as otherwise provided in paragraph (c)(3)(iv) of this 
section, a taxpayer may

[[Page 54486]]

compute the total additional section 263A costs allocable to eligible 
property remaining on hand at the close of the taxable year under the 
modified simplified production method as follows:

Allocable preproduction additional section 263A costs + Allocable 
production additional section 263A costs.

    (B) Allocable preproduction additional section 263A costs. The 
amount of preproduction additional section 263A costs allocable to 
ending inventory or to other eligible property on hand at the end of 
the taxable year is computed as follows:

Preproduction absorption ratio x raw material section 471 costs 
incurred during the taxable year and remaining on hand at year end.

    (C) Allocable production additional section 263A costs. The amount 
of production additional section 263A costs allocable to ending 
inventory or to other eligible property on hand at the end of the 
taxable year is computed as follows:

Production absorption ratio x production section 471 costs incurred 
during the taxable year and remaining on hand at year end.

    (D) Effect of allocation. The allocable preproduction additional 
section 263A costs and the allocable production additional section 263A 
costs are totaled to compute the additional section 263A costs, which 
are added to the taxpayer's ending section 471 costs to determine the 
total section 263A costs that are capitalized. See, however, paragraph 
(c)(3)(iii) of this section for special rules for LIFO taxpayers. 
Except as otherwise provided in this section or in Sec.  1.263A-1 or 
Sec.  1.263A-3, additional section 263A costs that are allocated to 
inventories on hand at the close of the taxable year under the modified 
simplified production method are treated as inventory costs for all 
purposes of the Internal Revenue Code.
    (E) Treatment of mixed service costs. A taxpayer must apportion 
capitalizable mixed service costs (the aggregate portion of mixed 
service costs that are properly allocable to the taxpayer's production 
or resale activities as additional section 263A costs) between 
preproduction additional section 263A costs described in paragraph 
(c)(3)(ii)(A)(2) of this section and production additional section 263A 
costs described in paragraph (c)(3)(ii)(B)(2) of this section. Under 
the modified simplified production method, a taxpayer must allocate 
capitalizable mixed service costs to preproduction additional section 
263A costs in proportion to the raw material costs in total section 471 
costs. The taxpayer must include the capitalizable mixed service costs 
that are not allocated to preproduction additional section 263A costs 
in production additional section 263A costs.
    (ii) Definitions--(A) Preproduction absorption ratio--(1) In 
general. Under the modified simplified production method, the 
preproduction absorption ratio is determined as follows:
[GRAPHIC] [TIFF OMITTED] TP05SE12.013

    (2) Preproduction additional section 263A costs. Preproduction 
additional section 263A costs are the sum of the additional section 
263A costs (as defined in Sec.  1.263A-1(d)(3)) incurred during the 
current taxable year that are described in paragraph (a)(3)(ii) of this 
section to the extent the costs are not treated as section 471 costs 
and the allocable portion of capitalizable mixed service costs as 
described in paragraph (c)(3)(i)(E) of this section.
    (3) Raw material costs. Raw material costs are defined as the 
direct costs of acquiring raw materials that a taxpayer purchases 
during its current taxable year. Raw material section 471 costs 
incurred during the taxable year and remaining on hand at year end 
include the raw material costs in work-in-process and finished goods as 
well as unprocessed raw materials.
    (B) Production absorption ratio--(1) In general. Under the modified 
simplified production method, the production absorption ratio is 
determined as follows:
[GRAPHIC] [TIFF OMITTED] TP05SE12.014

    (2) Production additional section 263A costs. Production additional 
section 263A costs are the sum of all additional section 263A costs (as 
defined in Sec.  1.263A-1(d)(3)) incurred during the current taxable 
year that are not preproduction additional section 263A costs as 
described in this section and the allocable portion of capitalizable 
mixed service costs as described in paragraph (c)(3)(i)(E) of this 
section. For example, production additional section 263A costs include 
the additional section 263A costs that constitute post-production costs 
as defined in paragraph (a)(3)(iii) of this section.
    (3) Production section 471 costs. Production section 471 costs are 
defined as the total section 471 costs that a taxpayer incurs during 
its current taxable year less the taxpayer's raw material costs.
    (iii) LIFO taxpayers electing the modified simplified production 
method--(A) In general. Under the modified simplified production 
method, a taxpayer using a LIFO method must calculate a particular 
year's index (for example, under Sec.  1.472-8(e)) without regard to 
its additional section 263A costs. Similarly, a taxpayer that adjusts 
current-year costs by applicable indexes to determine whether there has 
been an inventory increment or decrement in the current year for a 
particular LIFO pool must disregard the additional section 263A costs 
in making that determination.
    (B) LIFO increment--(1) In general. If a taxpayer determines there 
has been an inventory increment, the taxpayer must state the amount of 
the increment in current-year dollars (stated in terms of section 471 
costs). The taxpayer then multiplies this amount by the combined 
absorption ratio, as defined in paragraph (c)(3)(iii)(B)(2) of this 
section. The resulting product is the additional section 263A costs 
that must be added to the taxpayer's increment for the year stated in 
terms of section 471 costs.
    (2) Combined absorption ratio defined. For purposes of this 
paragraph (c)(3)(iii), the numerator of the combined absorption ratio 
is the total additional section 263A costs allocable to eligible 
property remaining on hand at the close of the taxable year, as

[[Page 54487]]

described in paragraph (c)(3)(i)(A) of this section. The denominator of 
the combined absorption ratio is the total section 471 costs remaining 
on hand at year end, as described in paragraph (b)(3)(ii)(B) of this 
section.
    (C) LIFO decrement. If a taxpayer determines there has been an 
inventory decrement, the taxpayer must state the amount of the 
decrement in dollars for the particular year for which the LIFO 
decrement has occurred. The additional section 263A costs incurred in 
prior years that apply to the decrement are included in cost of goods 
sold. The taxpayer determines the additional section 263A costs that 
apply to the decrement by multiplying the additional section 263A costs 
allocated to the layer of the pool in which the decrement occurred by 
the ratio of the decrement (excluding additional section 263A costs) to 
the section 471 costs in the layer of that pool.
    (iv) De minimis rule for producers with total indirect costs of 
$200,000 or less. Paragraph (b)(3)(iv) of this section, which provides 
that the additional section 263A costs allocable to eligible property 
remaining on hand at the close of the taxable year are deemed to be 
zero for producers with total indirect costs of $200,000 or less, 
applies to the modified simplified production method.
    (v) Examples. The rules of this paragraph (c)(3) are illustrated by 
the following examples:

    Example 1. FIFO inventory method. (i) Taxpayer P uses the first-
in, first-out (FIFO) method of accounting for inventories and a 
calendar taxable year. P's beginning inventory for 2010 is 
$2,500,000, including $2,000,000 of section 471 costs and $500,000 
of additional section 263A costs.
    (ii) During 2010, P incurs $10,000,000 of section 471 costs, 
including $4,000,000 of raw material costs (as defined in paragraph 
(c)(3)(ii)(A)(3) of this section) and $6,000,000 of production 
section 471 costs (as defined in paragraph (c)(3)(ii)(B)(3) of this 
section). P also incurs $1,060,000 of additional section 263A costs, 
including $340,000 of preproduction additional section 263A costs 
(as defined in paragraph (c)(3)(ii)(A)(2) of this section) and 
$720,000 of production additional section 263A costs (as defined in 
paragraph (c)(3)(ii)(B)(2) of this section).
    (iii) At the end of 2010, P's section 471 costs incurred during 
the taxable year remaining in ending inventory are $3,500,000, 
including $2,000,000 of raw materials section 471 costs and 
$1,500,000 of production section 471 costs.
    (iv) P computes its preproduction absorption ratio for 2010 
under paragraph (c)(3)(ii)(A) of this section as follows:
[GRAPHIC] [TIFF OMITTED] TP05SE12.015

    (v) P computes its production absorption ratio for 2010 under 
paragraph (c)(3)(ii)(B)(1) of this section as follows:
[GRAPHIC] [TIFF OMITTED] TP05SE12.016

    (vi) Under paragraph (c)(3)(i)(B) of this section, P computes 
its allocable preproduction additional section 263A costs by 
multiplying the preproduction absorption ratio by raw materials 
section 471 costs incurred during the taxable year and remaining in 
ending inventory (8.5 percent * $2,000,000 = $170,000).
    (vii) Under paragraph (c)(3)(i)(C) of this section, P computes 
its allocable production additional section 263A costs by 
multiplying the production absorption ratio by production section 
471 costs incurred during the taxable year and remaining in ending 
inventory at year end (12 percent * $1,500,000 = $180,000).
    (viii) Under paragraph (c)(3)(i)(A) of this section, P computes 
its total additional section 263A costs allocable to ending 
inventory by adding its allocable preproduction additional section 
263A costs to its allocable production additional section 263A costs 
($170,000 + $180,000 = $350,000).
    (ix) P adds the $350,000 additional section 263A costs to the 
$3,500,000 of section 471 costs remaining in its ending inventory to 
calculate its total ending inventory of $3,850,000. P includes the 
balance of P's additional section 263A costs incurred during 2010, 
$710,000 ($1,060,000 less $350,000), in P's cost of goods sold.

     Example 2. LIFO inventory method.  (i) The facts are the same 
as in Example 1, except that P uses the LIFO inventory method rather 
than the FIFO method. P's 2010 LIFO increment is $1,500,000.
    (ii) Under paragraph (c)(3)(iii)(B)(1) of this section, P 
determines the additional section 263A costs allocable to its 2010 
LIFO increment by multiplying the increment by a combined absorption 
ratio. Under paragraph (c)(3)(iii)(B)(2) of this section, P computes 
the combined absorption ratio as follows:
[GRAPHIC] [TIFF OMITTED] TP05SE12.017

    (iii) P's additional section 263A costs allocable to its 2010 
increment are $150,000 (10 percent * $1,500,000). Under paragraph 
(c)(3)(iii)(B)(1) of this section, P adds the $150,000 additional 
section 263A costs to its $1,500,000 LIFO increment to determine a 
total 2010 LIFO increment of $1,650,000. P's ending inventory is 
$4,150,000 (its beginning inventory of $2,500,000 plus the 
$1,650,000 increment). P includes the remaining $910,000 ($1,060,000 
less $150,000) of additional section 263A costs incurred during 2010 
in P's cost of goods sold.
     Example 3. Mixed service costs.  (i) During 2010, Taxpayer R 
incurs $200,000 of capitalizable mixed service costs (within the 
meaning of paragraph (c)(3)(i)(E) of this section). R incurs 
$8,000,000 of section 471 costs, including $2,000,000 of raw 
material costs (as defined in paragraph (c)(3)(ii)(A)(3) of this 
section).
    (ii) Under paragraph (c)(3)(i)(E) of this section, R allocates 
its mixed service costs to preproduction additional section 263A 
costs

[[Page 54488]]

by computing the proportion of raw material costs in its section 471 
costs and multiplying its mixed service costs by this percentage. 
The proportion of raw material costs in R's section 471 costs is 25 
percent ($2,000,000/$8,000,000). R allocates $50,000 (25 percent * 
$200,000) of mixed service costs to preproduction additional section 
263A costs. R includes the remaining $150,000 ($200,000 less 
$50,000) of capitalizable mixed service costs as production 
additional section 263A costs.

    (4) Modified simplified production method with historic absorption 
ratio election--(i) In general. Except as otherwise provided in this 
paragraph (c)(4), paragraph (b)(4) of this section applies to the 
historic absorption ratio election under the modified simplified 
production method.
    (ii) General allocation formula--(A) In general. Except as provided 
in paragraph (c)(4)(iii) of this section (relating to LIFO taxpayers), 
a taxpayer making the historic absorption ratio election under the 
modified simplified production method uses a preproduction historic 
absorption ratio and a production historic absorption ratio in place of 
the actual preproduction absorption ratio and production absorption 
ratio under paragraph (c)(3)(ii) of this section. The preproduction and 
production historic absorption ratios are based on costs a taxpayer 
capitalizes during its test period.
    (B) Preproduction historic absorption ratio. The preproduction 
historic absorption ratio is computed as follows:
[GRAPHIC] [TIFF OMITTED] TP05SE12.018

    (C) Production historic absorption ratio. The production historic 
absorption ratio is computed as follows:
[GRAPHIC] [TIFF OMITTED] TP05SE12.019

    (iii) LIFO taxpayers making the historic absorption ratio 
election--(A) In general. Instead of the combined absorption ratio 
under paragraph (c)(3)(iii)(B)(2) of this section, a LIFO taxpayer 
making the historic absorption ratio election under the modified 
simplified production method calculates a combined historic absorption 
ratio based on costs a taxpayer capitalizes during its test period.
    (B) Combined historic absorption ratio. The combined historic 
absorption ratio is computed as follows:
[GRAPHIC] [TIFF OMITTED] TP05SE12.020

    (C) Total allocable additional section 263A costs incurred during 
the test period. Total allocable additional section 263A costs incurred 
during the test period are the sum of the total additional section 263A 
costs allocable to eligible property on hand at year end as described 
in paragraph (c)(3)(i)(A) of this section, for all years in the test 
period.
    (D) Total section 471 costs remaining on hand at each year end of 
the test period. Total section 471 costs remaining on hand at each year 
end of the test period are the sum of the total section 471 costs 
remaining on hand at year end described in paragraph (b)(3)(ii)(B) of 
this section, for all taxable years in the test period.
    (iv) Extension of qualifying period. In the first taxable year 
following the close of each qualifying period (for example, the sixth 
taxable year following the test period), a taxpayer must compute the 
actual absorption ratios under paragraph (c)(3) of this section 
(preproduction and production absorption ratios or, for LIFO taxpayers, 
the combined absorption ratio). If the actual combined absorption ratio 
or both the actual preproduction and production absorption ratios, as 
applicable, computed for this taxable year (the recomputation year) is 
within one-half of one percentage point (plus or minus) of the 
corresponding historic absorption ratio or ratios used in determining 
capitalizable costs for the qualifying period (the previous five 
taxable years), the qualifying period is extended to include the 
recomputation year and the following five taxable years, and the 
taxpayer must continue to use the historic absorption ratio or ratios 
throughout the extended qualifying period. If, however, the actual 
combined historic absorption ratio or either the actual preproduction 
absorption ratio or production absorption ratio, as applicable, is not 
within one-half of one percentage point (plus or minus) of the 
corresponding historic absorption ratio, the taxpayer must use the 
actual absorption ratio or ratios beginning with the recomputation year 
and throughout the updated test period. The taxpayer must resume using 
the historic absorption ratio or ratios based on the updated test 
period in the third taxable year following the recomputation year.
    (v) Transition rule. [Reserved].
    (vi) Examples. The provisions of this paragraph (c)(4) are 
illustrated by the following examples:

    Example 1. FIFO inventory method. (i) Taxpayer S uses the FIFO 
method of accounting for inventories and a calendar taxable year, 
and in 2010 elects to use the modified simplified production method. 
In 2013, S makes the historic absorption ratio election. S 
identifies the following costs incurred during the test period:

----------------------------------------------------------------------------------------------------------------
                                                                       2010            2011            2012
----------------------------------------------------------------------------------------------------------------
Preproduction additional section 263A costs.....................           $ 100           $ 200           $ 300
Production additional section 263A costs........................             200             350             450

[[Page 54489]]

 
Raw material costs..............................................           2,000           2,500           3,000
Production section 471 costs....................................           2,500           3,500           4,000
----------------------------------------------------------------------------------------------------------------

    In 2013, S incurs $10,000 of section 471 costs of which $1,000 
raw material costs and $2,000 production 471 costs remain in ending 
inventory.
    (ii) Under paragraph (c)(4)(ii)(B) of this section, in 2013 S 
computes the preproduction historic absorption ratio as follows:
[GRAPHIC] [TIFF OMITTED] TP05SE12.021

    (iii) Under paragraph (c)(4)(ii)(C) of this section, S computes 
the production historic absorption ratio as follows:
[GRAPHIC] [TIFF OMITTED] TP05SE12.022

    (iv) Under paragraph (c)(4)(ii)(A) of this section, S determines 
the preproduction additional section 263A costs allocable to its 
ending inventory for 2013 by multiplying its raw materials section 
471 costs incurred during the 2013 taxable year and remaining in its 
ending inventory by its preproduction historic absorption ratio. S 
allocates $80 preproduction additional section 263A costs to its 
ending inventory ($1,000 * 8 percent).
    (v) S determines the production additional section 263A costs 
allocable to its ending inventory for 2013 by multiplying its 
production section 471 costs incurred during the 2013 taxable year 
and remaining in its ending inventory by its production historic 
absorption ratio. S allocates $200 production additional section 
263A costs to its ending inventory ($2,000 * 10 percent).
    (vi) Under paragraph (c)(4)(ii) of this section, S's total 
additional section 263A costs allocable to ending inventory in 2013 
are $280, which is the sum of the allocable preproduction additional 
section 263A costs ($80) and the allocable production additional 
section 263A costs ($200). S's ending inventory in 2013 is $3,280, 
which is the sum of S's additional section 263A costs allocable to 
ending inventory and S's section 471 costs remaining in ending 
inventory ($280 + $3,000). S includes the balance of S's additional 
section 263A costs incurred during 2013 in S's cost of goods sold.
    Example 2. LIFO inventory method.  (i) The facts are the same as 
in Example 1, except that S uses the LIFO inventory method rather 
than the FIFO method. S calculates additional section 263A costs 
incurred during the taxable year and allocable to ending inventory 
under paragraph (c)(3)(iii) of this section and identifies the 
following costs incurred during the test period:

----------------------------------------------------------------------------------------------------------------
                                                                       2010            2011            2012
----------------------------------------------------------------------------------------------------------------
Additional section 263A costs incurred during the taxable year             $ 100           $ 150           $ 200
 allocable to ending inventory..................................
Section 471 costs incurred during the taxable year that remain             1,000           1,400           2,100
 in ending inventory............................................
----------------------------------------------------------------------------------------------------------------

    In 2013, the LIFO value of S's increment is $1,500.
    (ii) Under paragraph (c)(4)(iii) of this section, S computes a 
combined historic absorption ratio as follows:
[GRAPHIC] [TIFF OMITTED] TP05SE12.023

     (iii) S's additional section 263A costs allocable to its 2013 
LIFO increment is $150 ($1,500 beginning LIFO increment * 10 percent 
combined historic absorption ratio). S adds the $150 to the $1,500 
LIFO increment to determine a total 2013 LIFO increment of $1,650.
* * * * *
    (g) Effective/applicability date. Paragraphs (b)(2)(i)(D), and (f) 
of this section apply for taxable years ending on or after August 2, 
2005. Paragraph (c) of this section applies for taxable years ending on 
or after the date these

[[Page 54490]]

regulations are published as final regulations in the Federal Register.

Steven T. Miller,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2012-21743 Filed 9-4-12; 8:45 am]
BILLING CODE 4830-01-P