sect. 263a: allocating direct and indirect...
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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
Jan. 10, 2013
Ross Margelefsky, PricewaterhouseCoopers
Kristine Mora, Ernst & Young
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
Slide 28 – Slide 40
Slide 41 – Slide 51
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
Jan Skelton, Deloitte Tax
Kristine Mora, Ernst & Young
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
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RELEVANT SECT. 263A GUIDANCE
Kristine Mora, Ernst & Young
Page 29 © 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
Page 30 © 2012 Ernst & Young LLP
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.
Page 31 © 2012 Ernst & Young LLP
Relevant Sect. 263A Guidance: Sales-Based Royalties Proposed Regulations (Cont.)
► 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.
Page 32 © 2012 Ernst & Young LLP
Relevant Sect. 263A Guidance: Sales-Based Royalties Proposed Regulations (Cont.)
► 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
Page 33 © 2012 Ernst & Young LLP
Relevant Sect. 263A Guidance: Sales-Based Royalties Proposed Regulations (Cont.)
► 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.
Page 34 © 2012 Ernst & Young LLP
Relevant Sect. 263A Guidance: Sales-Based Royalties Proposed Regulations (Cont.)
► 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.
Page 35 © 2012 Ernst & Young LLP
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.
Page 36 © 2012 Ernst & Young LLP
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.
Page 37 © 2012 Ernst & Young LLP
► 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.
Relevant Sect. 263A Guidance: Negative 263A Costs Proposed Regulations (Cont.)
Page 38 © 2012 Ernst & Young LLP
► 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.
Relevant Sect. 263A Guidance: Negative 263A Costs Proposed Regulations (Cont.)
Page 39 © 2012 Ernst & Young LLP
► 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.
Relevant Sect. 263A Guidance: Negative 263A Costs Proposed Regulations (Cont.)
Slide Intentionally Left Blank
ONGOING COMPLIANCE CHALLENGES UNDER SECT. 263A
Jan Skelton, Deloitte Tax
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
Deloitte Development LLC. All rights reserved. 43
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.
Deloitte Development LLC. All rights reserved. 44
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.
Deloitte Development LLC. All rights reserved. 45
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.
Deloitte Development LLC. All rights reserved. 46
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
Deloitte Development LLC. All rights reserved. 47
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
Deloitte Development LLC. All rights reserved. 48
Miscellaneous Issues
• Expansive definition of handing activities
• Application of 1/3-2/3 rule on a person-by-person basis
• Schedule M adjustments
Deloitte Development LLC. All rights reserved. 49
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
Deloitte Development LLC. All rights reserved. 50