Capitalization of Interest

Federal RegisterDec 29, 1994

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[T.D. 8584]

RIN 1545-AK03

Capitalization of Interest

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the

requirement to capitalize interest with respect to the production of

property. The regulations provide guidance necessary for taxpayers to

comply with the requirement to capitalize interest with respect to

certain produce property.

EFFECTIVE DATE: January 1, 1995.

FOR FURTHER INFORMATION CONTACT:

Jan L. Skelton, (202) 622-4970 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in these final regulations

have been reviewed and approved by the Office of Management and Budget

in accordance with the Paperwork Reduction Act (44 U.S.C. 3504(h))

under control number 1545-1265. The estimated average annual burden per

recordkeeper is 14 minutes. The estimated average annual reporting

burden per respondent is 2 hours.

Comments concerning the accuracy of this burden estimate and

suggestions for reducing this burden should be sent to the Internal

Revenue Service, Attn: IRS Reports Clearance Officer PC:FP, Washington

DC 20224, and to the Office of Management and Budget, Attention: Desk

Officer for the Department of the Treasury, Office of Information and

Regulatory Affairs, Washington DC 20503.

Background

On Friday, August 16, 1991, the Federal Register published proposed

amendments (56 FR 40815) to the Income Tax Regulations (26 CFR part 1)

under section 263A(f) of the Internal Revenue Code (Code). Written

comments responding to the notice were received and a public hearing

was held on November 20, 1991. After careful consideration of all the

comments, the proposed amendments are adopted, except as revised and

renumbered by this document.

In General

The uniform capitalization rules of section 263A generally require

the capitalization of certain costs relating to the acquisition of

property for resale or the production of property. Interest is a cost

subject to section 263A. Section 263A(f) provides special rules for

capitalizing interest.

In general, section 263A(f) limits the capitalization of interest

to interest that is paid or incurred during the production period of

certain property (referred to as designated property). Designated

property includes all real property and certain tangible personal

property.

The amount of interest required to be capitalized is determined

using the avoided cost method. Under the avoided cost method, interest

on any indebtedness directly attributable to production expenditures

for designated property (traced debt) is capitalized first. If

production expenditures for designated property exceed the amount of

traced debt, interest on any other debt is capitalized to the extent

such interest could have been reduced if production expenditures had

not been incurred. The application of the avoided cost method does not

depend on whether the taxpayer actually would have used amounts

expended for production to repay or reduce debt. Instead, the avoided

cost method is based on the assumption that if production expenditures

had not been incurred, debt of the taxpayer would have been repaid or

reduced without regard to the taxpayer's subjective intentions or to

restrictions against repayment or use of the debt proceeds.

For example, if Corporation X has incurred $1.5 million of

production expenditures for a unit of real property it is constructing,

and has an outstanding $1 million loan (from an unrelated party) for

the construction of the real property, Corporation X must capitalize

interest on the loan as provided in section 263A(f). In addition,

because Corporation X has production expenditures ($1.5 million) that

exceed traced debt ($1 million), Corporation X must capitalize interest

on any other debt (subject to certain limitations) as provided in

section 263A(f). In general, to determine the amount of interest it

must capitalize on its other debt, Corporation X multiplies its excess

production expenditures ($.5 million) by a weighted average interest

rate for its other debt.

Public Comments

Simplification

The proposed regulations include several provisions designed to

reduce administrative complexity without undermining the principles of

section 263A(f). These provisions include (1) a de minimis rule

exempting certain insignificant production activities from the

requirement to capitalize interest; (2) an exception from the

requirement to capitalize interest for inventory property that has a

class life of 20 years or more but does not satisfy the other

classification thresholds for tangible personal property; (3) an

election not to trace debt to designated property; (4) an election to

calculate interest under the avoided cost method on a taxable year

basis in lieu of a monthly or more frequent basis; and (5) a simplified

method to calculate the amount of interest required to be capitalized

with respect to certain inventory property.

Commentators made several suggestions for further simplifying the

proposed rules. As discussed in more detail below, the final

regulations add a number of these simplifying suggestions. For example,

the final regulations permit certain small taxpayers to use a specified

external rate as a substitute for the weighted average interest rate.

In addition, the final rules make the 3-month, $10,000 de minimis rule

of the proposed regulations more flexible by increasing the dollar

threshold for production expenditures to $1 million divided by the

number of days in the production period. Further, the final regulations

shorten the time required to qualify for the suspension rule from 12

months to 120 consecutive days and apply the suspension rule

retroactively.

Designated Property

In General

Designated property includes all real property produced by the

taxpayer. Tangible personal property produced by the taxpayer is also

designated property, but only if it has a class life of 20 years or

more, an estimated production period of more than 1 year and total

production costs of more than $1 million, or an estimated production

period of more than 2 years.

De Minimis Exception

The proposed regulations provide a de minimis exception from

interest capitalization for property that would otherwise be designated

property. This exception applies if the property has a production

period that does not exceed 3 months and a total cost of production

that does not exceed $10,000.

Commentators recommended a number of changes to this de minimis

rule. Several commentators argued that the proposed de minimis rule

should be liberalized by either applying the production period and cost

thresholds in the disjunctive or increasing the thresholds. One

commentator recommended that, in addition to a de minimis rule for

property, the final regulations should provide a ``small taxpayer''

exception.

The final regulations revise the 3-month, $10,000 de minimis rule.

The revised rule liberalizes the de minimis rule and provides more

flexibility in its application by adopting a dollar-day rule. As

revised the de minimis rule excepts from interest capitalization

property with a production period of not more than 90 days and a total

cost of production that does not exceed $1,000,000 divided by the

number of days in the production period. The final regulations,

however, do not adopt a small taxpayer exception.

Commentators also recommended that interest that would be

capitalized if property were designated property be excluded from

production costs in determining whether the $10,000 threshold of the

proposed de minimis rule is met. The final regulations adopt this

recommendation for purposes of determining production expenditures

under the revised de minimis rule.

Definition of Real Property

The proposed regulations provide that real property includes land,

unsevered natural products of land, buildings, and inherently permanent

structures. An inherently permanent structure is property that is

affixed to real property and that will ordinarily remain affixed for an

indefinite period of time.

Certain commentators believed that the proposed definition of real

property is too broad. They argued that the section 263A(f) regulations

should define real property to exclude property classified as section

1245 property, as well as property classified or treated as personal

property for investment tax credit purposes (former section 48).

Neither section 263A(f) nor its legislative history expressly

defines ``real property.'' Nevertheless, the IRS and Treasury do not

believe it is necessary or appropriate to define ``real property'' as

narrowly as some commentators have suggested.

Section 1245 provides for the recapture of the benefit of

accelerated depreciation on, or amortization with respect to, certain

property. Congress clearly intended to classify certain real property

as property subject to the section 1245 rules. See section

1245(a)(3)(B) and (C). Nothing in either section 263A(f) or its

legislative history (or in section 189, the predecessor of section

263A(f), and its legislative history) suggests Congress intended to

exclude real property subject to section 1245 from the definition of

real property for purposes of interest capitalization. See S. Rep. No.

169, 98th Cong., 2d Sess. I-280 n. 19 (1984).

Congress intended that the benefit of the investment tax credit

apply expansively under former section 48. See H. Rep. No. 1447, 87th

Cong., 2d Sess. (1962) 1962-3 C.B. 405, 415. Consistent with this

intent, tangible personal property was not to be defined narrowly and

was not to follow state law. Id. Nothing in the legislative history of

section 263A(f) suggests, however, that Congress intended that such a

broad definition of personal property be adopted for interest

capitalization purposes.

Some commentators interpreted certain language in proposed

Sec. 1.263A(f)-1 (relating to the classification of property for

purposes of former section 48 and Sec. 1.48-1(c) and Sec. 1.48-1(d)) to

provide that property that would otherwise be an inherently permanent

structure under section 263A(f) (i.e., because it is affixed to real

property and will ordinarily remain affixed for an indefinite period of

time) is not an inherently permanent structure under section 263A(f) if

such property would constitute property in the nature of machinery

under the principles of former section 48 and Sec. 1.48-1(c).

As indicated above, however, the IRS and Treasury do not believe

that the classification or treatment of property as personal property

for purposes of former section 48 should be determinative of the

classification of property as personal property for purposes of section

263A(f). Accordingly, the final regulations provide that a structure

may be an inherently permanent structure, and not property in the

nature of machinery or essentially an item of machinery, even if the

structure is necessary to operate or use, supports, or is otherwise

associated with machinery.

Classification Thresholds for Personal Property

Under the proposed regulations, designated property includes

tangible personal property that is (i) property with a class life of 20

years or more, but only if produced for self-use, (ii) property with an

estimated production period exceeding 2 years (2-year property), or

(iii) property with an estimated production period exceeding 1 year and

a cost exceeding $1 million (1-year property). Commentators made

recommendations regarding the $1 million cost threshold for 1-year

property and the production period thresholds for 1-year and 2-year

property produced under a contract.

One commentator recommended the final regulations clarify whether

interest that would be required to be capitalized if property were

designated property is taken into account in determining whether the

production costs for property exceed the $1 million production costs

threshold. The final regulations clarify that such interest is not

taken into account in determining whether property is designated

property.

Classification Thresholds for Personal Property Produced Under a

Contract

In the case of tangible personal property produced under a

contract, the proposed regulations require the contractor and the

customer each to determine whether the 1-year and 2-year production

period thresholds are satisfied. For this purpose, the proposed

regulations require the customer to treat the production period as

beginning on the earlier of the date the contract is executed or the

date the customer's accumulated production expenditures are at least 5

percent of the customer's total estimated production expenditures

(contract date rule). One commentator recommended that a customer be

allowed to elect to use the contract date rule, and in the absence of

an election, treat the production period as beginning when the

customer's accumulated production expenditures are at least 5 percent

of the total estimated production expenditures.

The final regulations retain the contract date rule. However, to

address commentators' concerns, the final regulations provide that a

customer may elect to determine the 1- and 2-year production period

thresholds by treating the customer's production period as beginning on

the date that aggregate accumulated production expenditures for both

the contractor and the customer are at least 5 percent of the

customer's estimated production expenditures for the property. The IRS

and Treasury believe that a 5-percent rule based only on production

expenditures incurred by a customer could be abused (e.g., a customer

could avoid designated property classification and, thus, interest

capitalization by simply withholding payments to the contractor).

Definition of a Contract

Section 263A(g)(2) provides that the taxpayer shall be treated as

producing any property produced for the taxpayer under a contract with

the taxpayer. The final regulations under section 263A (relating to the

capitalization of costs other than interest) published in the Federal

this purpose.

The preamble to those regulations stated that the definition of a

contract was being studied under the section 263A(f) regulations.

Commentators believed that the definition of a contract provided in the

proposed regulations under section 263A(f) should be modified, for

example, to exclude routine purchase orders.

For purposes of determining whether property is produced under a

contract, the final regulations define a contract as any agreement

providing for the production of property if the agreement is entered

into before the production of the property to be delivered under the

contract is completed. Whether an agreement exists depends on all the

facts and circumstances. Facts and circumstances to be taken into

account include making a prepayment, or entering into an arrangement to

make a prepayment, for property prior to the date of completion of the

production of property or incurring significant expenditures for

property of specialized design or specialized application.

In response to commentators' concerns, the amendments to the final

regulations provide that a routine purchase order for the production of

fungible property is not a contract for purposes of section 263A(g)(2).

Under this rule, an agreement will not be treated as a routine purchase

order for the production of fungible property if the seller is required

to make more than de minimis modifications to the property to tailor it

to the customer's specific needs, or if at the time the agreement is

entered into, the customer knows or has reason to know that the seller

cannot satisfy the agreement within 30 days out of existing stocks and

normal production of finished goods.

The Avoided Cost Method

In General

The proposed regulations require taxpayers to use the avoided cost

method described in proposed Sec. 1.263A(f)-(2) to calculate the amount

of interest required to be capitalized under section 263A(f). A number

of commentators argued that, for purposes of capitalizing interest

under section 263A(f), taxpayers should be permitted to elect to use

Statement of Financial Accounting Standards No. 34 (SFAS 34), which

establishes standards for capitalizing interest for financial statement

purposes.

Congress indicated that it intended interest to be capitalized

under the avoided cost method, using rules similar to those applicable

under former section 189. See S. Rep. No. 313, 99th Cong., 2d Sess. 144

(1986). Former section 189 applied rules similar to those contained in

Financial Accounting Standards Board (FASB) Statement No. 34. H.R.

Conf. Rep. No. 760, 97th Cong., 2d Sess. 484-85 (1982). The proposed

section 263A(f) regulations adopt an approach similar to the rules in

SFAS 34 in that they treat interest that would have been avoided if

production expenditures had been used to repay indebtedness of the

taxpayer as interest subject to capitalization.

Although the proposed regulations use an approach similar to SFAS

34, the IRS and Treasury are not persuaded that the regulations should

be changed to permit the use of the financial accounting rules of SFAS

34 instead of the avoided cost method in the proposed regulations. The

IRS and Treasury believe that the results obtained by applying SFAS 34

could diverge significantly from the results obtained by applying tax

principles. For example, differences in the amount of interest

capitalized could result because: the bases of assets for book and tax

purposes differ; SFAS 34 allows more discretion and subjectivity (e.g.,

in identifying borrowings used to determine interest capitalization)

that does the statute; and materiality standards used for financial

accounting rules may not be acceptable for tax purposes. Accordingly,

the final regulations do not permit the use of SFAS 34 as an

alternative to the avoided cost method set forth in the regulations.

Accounts Payable and Simplification Rule for Tracing

Under the proposed regulations, the calculation of the amount of

interest required to be capitalized is made by reference to eligible

debt. Eligible debt generally includes all debt of the taxpayer on

which interest is deductible in computing taxable income. However,

noninterest bearing debt is excluded from the definition of eligible

debt unless the debt is traced debt (or, if the taxpayer makes an

election not to trace debt, is debt that would have been treated as

traced debt in the absence of such an election).

Commentators indicated that noninterest bearing debt such as

accounts payable should be treated as eligible debt whether or not the

debt is traced to the accumulated production expenditures of designated

property.

The IRS and Treasury continue to believe that treating all

noninterest bearing debt as eligible debt is inconsistent with

Congressional intent. Such treatment is not similar to the FASB 34 rule

and would distort the interest capitalization rate. The final

regulations, therefore, maintain the treatment prescribed in the

proposed regulations.

Some commentators believed that it is administratively

impracticable or virtually impossible for certain taxpayers to

determine the noninterest bearing debt traced to the accumulated

production expenditures of designated property. These commentators

recommended that, if the regulations do not treat all accounts payable

as eligible debt, the regulations should provide a simplification

measure under which a taxpayer may ``deem'' a certain portion of

noninterest bearing debt as constituting traced debt.

One commentator suggested a safe harbor under which the amount of

noninterest bearing debt deemed to be traced debt would be that portion

of accounts payable equal to the ratio of the production expenditures

for designated property over the production expenditures for all

property. IRS and Treasury believe that this recommendation would not

sufficiently approximate the portion of noninterest bearing debt that

is traced debt for all or certain segments of taxpayers. Moreover, the

IRS and Treasury were unable to establish a workable safe harbor.

Finally, except for immaterial amounts, taxpayers must perform the same

sort of tracing to adjust production expenditures for noninterest

bearing accounts payable when they prepare financial statements. Under

SFAS 34, the expenditures that attract interest capitalization include

only expenditures requiring the payment of cash, the transfer of other

assets, or the incurring of a liability on which interest is charged.

Accordingly, the final regulations do not adopt a safe harbor under

which a certain portion of noninterest bearing debt would be deemed

traced debt.

Interest Capitalized on Traced Debt

Under the avoided cost method in the proposed regulations, the

interest capitalized on debt traced to the accumulated production

expenditures for a unit of designated property includes the interest on

the traced debt for the entire measurement period for any measurement

period in which production occurs (traced debt amount).

Commentators objected to this rule because the production period of

a unit may not begin on the first day of the first measurement period

of the production period and may not end on the last day of the last

measurement period of the production period. In these situations, the

commentators argued that only interest incurred on traced debt for the

actual number of days encompassing the production period of a unit

should constitute the traced debt amount.

The IRS and Treasury believe that the proposed traced debt amount

rule is an appropriate simplification measure. Moreover, a taxpayer

desiring a more precise traced debt amount can effect greater precision

by choosing more frequent measurement dates. Under the proposed rule,

taxpayers can choose their measurement periods, the choice is not a

method of accounting, and taxpayers may change measurement periods each

taxable year. Accordingly, the final regulations adopt the proposed

traced debt amount rule without change.

External Rate--Substitute for Weighted Average Interest Rate

The avoided cost method involves the capitalization of two amounts

of interest with respect to a unit of property: (1) an amount of

interest with respect to traced debt and (2) an amount of interest with

respect to nontraced debt. The amount of interest required to be

capitalized with respect to nontraced debt is determined by multiplying

the accumulated production expenditures that exceed traced debt for a

unit (excess expenditures) by the weighted average interest rate

determined on all eligible debt of a taxpayer other than traced debt

(nontraced debt).

To simplify the interest capitalization computation with respect to

nontraced debt, commentators suggested that the final regulations

permit taxpayers to elect to use an external rate as a substitute for

the weighted average interest rate. Most commentators suggested the

election of a rate based on the applicable federal rate (AFR). Certain

commentators believed that small taxpayers, at a minimum, should be

allowed this simplifying election.

The IRS and Treasury believe that an election to use an external

rate as a substitute for the weighted average interest rate on

nontraced debt would generally be inappropriate because of the

difficulty in establishing a suitable external rate for all taxpayers.

Accordingly, the final regulations do not adopt the recommendation to

permit all taxpayers to elect to use an external rate as a substitute

for the weighted average interest rate.

The final regulations do, however, permit certain small taxpayers

to elect to use the highest AFR under section 1274(d) in effect during

the computation period plus 3 percentage points (AFR plus 3) as a

substitute for the weighted average interest rate. A taxpayer may elect

to use the AFR plus 3 for a taxable year if the average annual gross

receipts of the taxpayer (or any predecessor) for the preceding 3

taxable years do not exceed $10,000,000 (the $10,000,000 gross receipts

test), and the taxpayer has met the $10,000,000 gross receipts test for

all prior taxable years beginning after December 31, 1994. The rules of

Sec. 1.263A-3(b) apply in determining whether a taxpayer satisfies the

$10,000,000 gross receipts test. A taxpayer making the AFR plus 3

election may not trace debt.

Notional Principal Contracts

The treatment of notional principle contracts and other derivatives

under section 263A(f) is reserved in the final regulations.

Definition of Unit of Property

The proposed regulations provide that a unit includes any

components owned by the taxpayer or a related party that are

functionally interdependent. Components of property are functionally

interdependent when the placing in service of one component is

dependent on the placing in service of one or more other components.

Certain commentators recommended that the final regulations adopt

the definition of a unit provided under Sec. 1.167(a)-11(d)(2)(vi),

which defines a unit of property for purposes of applying the elective

alternative depreciation (ADR) repair allowance provisions. Section

1.167(a)-11(d)(2)(vi) defines a unit to include each operating unit

that performs a discrete function and that a taxpayer customarily

acquires for original installation and retires as a unit. Commentators

argued that taxpayers are already familiar with this definition of a

unit.

The IRS and Treasury believe that section 263A(f) and its

legislative history indicate that property includes the functionally

interdependent components of property. Congress repealed former section

189 (relating to the capitalization of interest and taxes during the

construction period of real property) and enacted the more expansive,

uniform capitalization rules under section 263A(f). Under former

section 189, an entire building (including the land component) was

property to which interest was capitalized. See H.R. Conf. Rep. No.

760, 97th Cong., 2d Sess. 48 (1982). The IRS and Treasury believe that

Congress did not intend that property be defined more narrowly under

section 263A(f) than under former section 189. Accordingly, under

section 263A(f), property also includes an entire building (including

the land component), as the aggregation of functionally interdependent

components of property. Section 263A(f) defines property uniformly, and

therefore, property in all circumstances includes the functionally

interdependent components of property.

Treating the functionally interdependent components of property as

a single property for interest capitalization is consistent with the

concept of a single property that applies under section 167 in

determining the date on which components of a single property are

placed in service. As the commentators recognized, this concept of a

single property may differ from the concept of a single or separate

property that taxpayers use for other purposes (e.g., for computing

amounts of depreciation deductions or separately tracking the bases of

assets).

The Sec. 1.167(a)-11(d)(2)(vi) definition of a unit may not

encompass the functionally interdependent components of property. This

definition of a unit applied for purposes of applying the alternative

depreciation (ADR) repair allowance provisions, which were elective.

The provisions provided a simplification procedure for treating a

taxpayer's expenditures as either capitalized expenditures or

deductible expenses. Taxpayers that elected the provisions, and used

this Sec. 1.167(a)-11(d)(2)(vi) definition of a unit, we required to

use the same standard that other taxpayers used in determining the date

on which property was placed in service (i.e., the standard consistent

with the concept of a single property as an aggregation of functionally

interdependent components). Accordingly, the final regulations do not

adopt commentators' recommendation to modify the definition of a unit

of property.

Common Feature Rules

Land Attributable to Benefitted Property

Under the proposed regulations, an allocable share of a common

feature that benefits real property and the real property being

benefitted are a single unit of real property (common feature rule).

The production period for the entire unit begins when production begins

on either the benefitted real property or a common feature allocable to

the unit. Thus, commencing production on only a common feature results

in interest being capitalized not only on the costs of the common

feature but also on the costs of land underlying the benefitted

property.

Commentators argued that the proposed common feature rule produces

harsh consequences. For example, when construction commences on a

single common feature that benefits each house in a housing

development, interest capitalization commences on all land in the

housing development even if no direct production activity has been

undertaken on any house. Commentators also indicated that the proposed

interest suspension rule provides insufficient relief in these

circumstances. Under the proposed regulations, interest capitalization

may be suspended prospectively for a unit only when production

activities have ceased for the unit for at least a 12-month period.

Thus, in the case of the housing development described above, the

proposed regulations would require interest on land costs attributable

to the houses to be capitalized from the commencement of construction

of the common feature until the 13th month after its completion.

Interest capitalization would be required with respect to those costs

for that period even if no direct production activity will be

undertaken on the houses for several years.

The final regulations continue to provide that the allocable share

of a common feature and the benefitted property are a single unit of

real property, but provide two new rules in response to the

commentators' concerns. Under the first new rule, the land costs of the

benefitted property are not treated as included in the accumulated

production expenditures for the unit (i.e., are not treated as included

in the costs that attract interest capitalization) until a direct

production activity commences on the benefitted property. Thus, for

example, if no direct production activities have been undertaken on

planned houses, such as clearing and grading activities on the land

underlying the houses, the cost of the land underlying the houses is

not treated as included in the accumulated production expenditures for

the unit. This treatment is permitted until direct production

activities begin on the houses, even though the production periods for

the house units have begun because production has begun on common

features benefitting the houses.

The second new rule provides that if after clearing and grading has

been undertaken with respect to the land attributable to the benefitted

property (the land underlying the houses in the above example), there

is no direct production activity taken with respect to the benefitted

property for a period of at least 120 consecutive days, the accumulated

production expenditures attributable to the benefitted property are

treated as not included in the accumulated production expenditures of

the unit from the first measurement period after the beginning on the

120-day period until the measurement period in which direct production

activity resumes with respect to the benefitted property.

Benefitted Property Completed

The proposed regulations indicate that, when benefitted property is

sold or placed in service prior to the completion of a common feature

allocable to a unit, the costs of the benefitted property and allocable

common features no longer attract interest capitalization. See

Sec. 1.263A-10(b)(6), Example 5.

Commentators suggested that the final regulations provide a rule

under which the costs of a benefitted property would not be included in

accumulated production expenditures when the benefitted property is

completed prior to the completion of a common feature included in the

unit, irrespective of whether such benefitted property is sold or

placed in service.

The IRS and Treasury believe the exception provided in the proposed

regulations should not be extended to cases where a benefitted property

is not sold or placed in service prior to the completion of the common

feature. Accordingly, the final regulations do not adopt the

commentators' recommendation.

Rev. Proc. 92-29, 1992-1 C.B. 748, permits a developer to include

in the basis of properties sold their allocable share of the estimated

cost of common improvements without regard to whether the costs are

incurred under section 461(h) of the Code, relating to economic

performance. As of the end of any taxable year, however, the total

amount of common improvement costs included in the basis of the

properties sold may not exceed the amount of common improvement costs

that have been incurred under section 461(h) (``the alternative cost

limitation''). The final regulations clarify that Rev. Proc. 92-29 does

not affect the determination of accumulated production expenditures of

unsold units even if the costs of common improvements for those unsold

units have been used to determine the alternative cost limitation for

purposes of including common improvement costs in the basis of sold

units.

Utilities--Construction Work in Process

Under the proposed regulations, the accumulated production

expenditures for a unit of property (i.e, the costs that attract

interest capitalization) generally include the amount of the direct and

indirect costs that are required to be capitalized with respect to the

unit.

Certain commentators indicated that if construction work in process

(CWIP) is included in rate base for ratemaking purposes (of utilities,

for example), the CWIP should be excluded from the accumulated

production expenditures. These commentators pointed out that in

enacting section 263A(f), Congress intended to match the interest

incurred in producing property with the related income from property.

These commentators argued that by including CWIP in rate base for

ratemaking purposes, income is currently taken into account, and that

to match interest with its related income, the interest attributable to

CWIP should be currently deductible. They believed that to achieve this

match, CWIP should be excluded from accumulated production

expenditures.

Under the avoided cost method of section 263A(f), CWIP expenditures

are incurred with respect to property produced, and no statutory

exception excludes them from the production expenditures for property.

The legislative history of section 263A(f) indicates that the avoided

cost method is intended to apply to a taxpayer, such as a regulated

utility company, irrespective of whether the method is required,

authorized, or considered appropriate under financial or regulatory

accounting principles. See H.R. Conf. Rep. No. 841, 99th Cong., 2d

Sess. II-309 (1986). CWIP is therefore intended to be included in the

production expenditures for property produced, and interest capitalized

with respect to CWIP is intended to become a cost of the property

produced, which is recovered as the property is used in the taxpayer's

trade or business. Moreover, the suggestion that the commentators urge

the IRS and Treasury to adopt in the final regulations is inconsistent

with the rules that apply to determine the date on which CWIP is placed

in service for depreciation purposes and is inconsistent with the rules

that apply under broader section 263A provisions to capitalize other

direct and indirect costs to CWIP during periods for which the

commentators argue the CWIP is generating income.

Further, the commentators' suggestion would not present a

consistent resolution to the matching concerns that the commentators

argue exist with respect to the treatment of CWIP within regulated

utilities industries. Interest incurred prior to the beginning of the

production period on CWIP that is not included in rate base, for

example, presents matching concerns that would not be resolved by the

commentators' suggestion. For this and the other reasons summarized

above, the commentators' suggestion has not been adopted in the final

regulations.

As an alternative suggestion, commentators urged the IRS and

Treasury to adopt a book conformity rule for the treatment of interest

on CWIP. This suggestion was not adopted, however, for principally the

same reasons that the use of the FAS 34 computation as a substitute for

section 263A(f) avoided cost computations was not adopted.

Additionally, the difference between the regulatory accounting for CWIP

and the required statutory treatment of CWIP under section 263A(f) is

but one example of the many inconsistencies between regulatory and tax

accounting (some of which were illustrated above). Therefore, the IRS

and Treasury believe it would be inappropriate to adopt a book

conformity rule for interest capitalization alone given the existence

of these other inconsistencies.

Improvements to Real Property

Property Taken Out of Service

The proposed regulations provide special rules for determining the

accumulated production expenditures for an improvement to existing real

property. The accumulated production expenditures for an improvement

include all direct and indirect costs required to be capitalized with

respect to the improvement, plus an allocable portion of the cost of

associated land. Additionally, the adjusted bases of any existing

structure or common features that directly benefit or are incurred by

reason of the improvement are included in the accumulated production

expenditures if they either are not already placed in service or must

be taken out of service in order to complete the improvement.

Commentators indicated that sometimes property must be temporarily

disconnected or otherwise taken out of service for health, safety, or

regulatory reasons in order to make certain improvements (e.g., a power

generating facility must be taken out of service in order to make

capital improvements). Commentators suggested that the regulations

provide that property is taken out of service only if the property is

taken out of service for depreciation purposes.

The final regulations do not adopt the suggestion concerning when

property should be considered taken out of service. However, the final

regulations provide a de minimis rule for property taken out of

service. Under the de minimis rule, the aggregate costs of all property

or common features taken out of service to complete an improvement

(associated property costs) are excluded from the accumulated

production expenditures for the improvement unit during its production

period if, on the date the production period of the unit begins, the

taxpayer reasonably expects that on no date during the production

period of the unit will the accumulated production expenditures for the

unit, determined without regard to associated property costs, exceed 5

percent of associated property costs.

Inclusion of Land

The proposed regulations provide that an improvement to existing

real property includes the allocable portion of land associated with

the improvement. As such, the basis of land may be included in the

accumulated production expenditures for more than one unit of

designated property. For example, a portion of the basis of land

included in the accumulated production expenditures for a building unit

must also be included in the accumulated production expenditures for a

separate tenant improvement unit.

Commentators objected to this rule. They suggested that, once land

was included in the accumulated production expenditures for a unit of

property, it should not be included in the accumulated production

expenditures for any other unit of property.

Section 263A(f)(4)(C) provides that the production expenditures for

property include all capitalized costs of property, whether or not

those costs are incurred during the production period of property. Land

expenditures are part of the capitalized costs of property, and land

costs should be included in the accumulated production expenditures for

property during its production period, even if they are incurred before

the production period. Accordingly, the final regulations do not adopt

the commentators' recommendation.

End of the Production Period--Customizing Activities

The proposed regulations provide that the production period

generally ends for a unit of property that will be held for sale on the

date the unit is ready to be held for sale and all production

activities reasonably expected to be undertaken with respect to the

unit are completed. The proposed regulations provide that the

production period generally ends for a unit of property produced for

self-use on the date the unit is ready to be placed in service and all

production activities reasonably expected to be undertaken with respect

to the unit are completed.

Commentators believe it is unfair for the production period to

continue for a residential or commercial unit that is complete except

for activities relating to ``de minimis'' production expenditures for

customized features chosen by a buyer or lessee. These features, which

include carpeting, cabinets, appliances, wall coverings, and flooring,

are often not added to a unit until an identified buyer or lessee

selects the features, or the unit is sold. These commentators

recommended that the production period should end for a unit when only

``de minimis'' customizing activities remain to be performed.

The final regulations do not adopt this recommendation, however,

because the IRS and Treasury continue to believe that customizing

activities are production activities and that the production period

does not end until these activities are completed. Nevertheless, a

shortened, retroactive suspension period rule adopted in the final

regulations (and explained below) will provide relief in situations

that involve long periods of delay in the performance of customizing

activities.

Suspension Period

The proposed regulations provide that, when production activities

related to the production of a unit of designated property cease for a

period of 12 consecutive months, the capitalization of interest is not

required (i.e., is suspended) for the period beginning with the 13th

month of cessation. The suspension period ends when production

activities resume. For administrative convenience, the proposed

regulations use an objective time test, and therefore, the reasons for

suspending production are not considered.

Commentators believed that the rule in the proposed regulations

unduly delays the suspension of interest capitalization. They argued

that a taxpayer should not have to wait 12 months before suspending

interest capitalization if production activities cease for reasons such

as strikes, fires, or natural disasters. Some commentators believed

that the determination of whether activities have ceased should be a

facts and circumstances test and that interest capitalization should be

suspended in the month following the cessation of production

activities. Others argued that the cessation period should be only 3 or

4 months. Still others argued that, if the 12-month cessation period is

retained, the suspension of interest capitalization should apply

retroactively as of the first month of cessation.

In response to these comments, the final regulations shorten the

cessation period from 12 consecutive months to 120 consecutive days

and, once the cessation period is satisfied, permit taxpayers to

retroactively suspend interest capitalization as of the first

measurement period following the measurement period in which production

activities ceased. Alternatively, if the cessation period spans more

than one taxable year, and a taxpayer does not want to file an amended

return for the prior year, the taxpayer may suspend the capitalization

of interest with respect to its units of designated property beginning

with the first measurement period of the taxable year in which the 120-

day period is satisfied.

In connection with the shorter 120-day cessation period, however,

the final regulations introduce several new criteria for determining

whether production activities are considered to have ceased. Production

activities are not considered to have ceased under the final

regulations if they cease because of any delays inherent in the asset

production process.

Oil and Gas Provisions

Section 614 Costs in Accumulated Production Expenditures

Under the proposed regulations, the costs with respect to a section

614 property (section 614 costs) are included in the accumulated

production expenditures for the first well in a multi-phase

development. Each subsequent well includes a pro rata share of these

undepleted costs based on total wells that the taxpayer could feasibly

drill on the section 614 property. However, the taxpayer may partition

the section 614 costs among the number of wells to be drilled on the

section 614 property if the taxpayer can devise a ``definite plan''

upfront that identifies the number and location of wells to be drilled.

Commentators indicated that the ``definite plan'' requirement is

impracticable. According to them, the number and location of wells to

be drilled on a property may not be known on the date that a first

drilling activity is undertaken on the section 614 property.

Commentators, therefore, suggested that the final regulations allow

taxpayers to partition the section 614 costs among the number of wells

``feasibly expected'' to be drilled on the section 614 property.

Alternatively, commentators suggested that the final regulations

require taxpayers to include the section 614 costs only in the

accumulated production expenditures for a first well drilled on the

section 614 property.

The final regulations retain the definite plan rule. In light of

the unique nature of a mineral interest and the circumstances

surrounding the development of such an interest, however, the final

regulations revise the rule for taxpayers unable to establish a

definite plan. Under the revised rule, the section 614 costs are

generally only included once in the accumulated production expenditures

for a first productive well unit on the section 614 property. (However,

the final regulations provide that the undepleted portion of section

614 costs allocated to the first productive well unit must be included

in the accumulated production expenditures for an improvement to the

unit.) The final regulations provide that a first productive well unit

generally includes all wells that are drilled on a section 614 property

prior to the date the first productive well on the property is placed

in service and all production activities reasonably expected to be

undertaken are completed. Accordingly, the section 614 costs are

included in a unit (to attract interest capitalization) from the date

the first physical site activity is undertaken with respect to the

section 614 property until the date the first productive well on the

section 614 property is placed in service and all production activities

reasonably expected to be undertaken are completed. Generally, each

well on a section 614 property that is drilled subsequent to such date

comprises a separate unit of property. The IRS and Treasury believe

this rule is more objective and practical than a rule that would

require the section 614 costs to be partitioned among the number of

wells ``feasibly expected'' to be drilled on a section 614 property.

The final regulations provide a rule for common feature costs

similar to the rule provided for section 614 property costs. Under the

final regulations, the costs of the common features are generally

included only in the accumulated production expenditures for the first

productive well unit.

Beginning of Production Period

The proposed regulations provide that the production period begins

for an oil or gas well on the first date physical site preparation

activities are undertaken with respect to the property.

Certain commentators believed that the production period should

begin for an onshore oil or gas well unit on the ``spud date,'' rather

than on the first date of physical site preparation activity.

Commentators indicated that taxpayers often do not separately track the

first date of physical site activity on a property, but do maintain

records with respect to the spud date for purposes of applying other

provisions of the Code, such as section 291(b).

The IRS and Treasury do not believe that the spud date is an

appropriate date to adopt as the beginning of the production period for

an onshore oil or gas well unit. The spud date may occur long after the

first date that a physical site preparation activity is undertaken on a

section 614 property. Using the spud date could, therefore, be too

great a deviation from the general rule that treats site preparation as

the beginning of the production period of other real property.

Accordingly, the final regulations do not adopt the commentators'

recommendation regarding the spud date.

Surface Equipment and End of Production Period

The proposed regulations provide that the production period

generally ends for an oil or gas well on the date that surface

production equipment is installed and the well is placed in service.

Commentators argued that the production period for a well unit

should not continue beyond the date a ``Christmas tree'' is installed

on the well and that the accumulated production expenditures for the

well should not include the costs of surface production equipment.

The final regulations provide that the production period generally

ends for a productive well unit on the date that the productive well

included in the unit is placed in service and all production activities

reasonably expected to be undertaken are completed. These rules are

consistent with the general rules that apply in the case of other types

of produced property.

Casing Point

The proposed regulations provide that the production period

generally ends for a nonproductive well on the date that the

nonproductive well is plugged and abandoned.

Commentators believed that the production period for a

nonproductive well unit should end at the casing point, which they

indicate is the date that a decision is made not to complete the well

for production.

The final regulations do not address the date on which the

production period ends for a nonproductive well. The IRS and Treasury

believe, however, that the general standards that apply in the case of

other types of abandoned property should be used to determine the date

on which the production period ends for a nonproductive well.

Allocation of Capitalized Interest to Depreciable or Depletable Unit

Components

The proposed regulations provide that the interest required to be

capitalized with respect to a unit is added to the basis of designated

property, rather than to the bases of any assets used to produce the

designated property. Additionally, interest required to be capitalized

with respect to the production of land is added to the basis of any

related depreciable improvement.

Commentators believed that the final regulations should provide

that interest required to be capitalized with respect to an oil or gas

well unit is first capitalized into the basis of the unit's depreciable

property components, if any, prior to the bases of the unit's

depletable property components. The commentators believed that this

rule is substantially similar to the rule in the proposed regulations

with respect to the allocation of capitalized interest to components of

a land improvement unit.

The IRS and Treasury believe that interest capitalized with respect

to components of a unit of property that are not subject to an

allowance for depreciation or depletion is appropriately added to the

basis of the components of a unit of property that are subject to an

allowance for depreciation or depletion. Thus, the proposed regulations

provided that interest capitalized with respect to land, the cost of

which is not depreciable or depletable, is added to the basis of

related depreciable improvements, if any. However, interest capitalized

with respect to the depletable property components of a well unit is

subject to an allowance for depletion. Accordingly, the final

regulations do not adopt the commentators' suggestions.

Independent Producer Onshore Well Exemption

Certain commentators suggested that independent producer onshore

wells should be exempted from interest capitalization based on their

belief that the compliance costs for these wells outweigh the tax

revenues to be gained.

Under section 263A(c)(3), Congress exempted from the uniform

capitalization rules certain costs incurred with respect to oil and gas

activities, but did not exempt oil and gas activities themselves. Thus,

the IRS and Treasury do not believe that a specific exemption for all

independent onshore wells is appropriate. Accordingly, the final

regulations do not provide a specific exemption for independent onshore

wells.

Examples

The final regulations provide examples, but delete the

comprehensive real estate example. The IRS anticipates providing

illustrations of interest capitalization in other guidance.

Related Person Rules

In General

Section 263A(i) provides that the Secretary shall prescribe such

regulations as may be necessary or appropriate to carry out the

purposes of the uniform capitalization rules, including regulations to

prevent the use of related persons, pass-through entities, or

intermediaries to avoid these rules.

Notice 88-99, issued August 17, 1998, provides the principal source

of guidance concerning the application of related person rules under

section 263A(f). Notice 88-99 generally provides that if a taxpayer is

producing designated property and has accumulated production

expenditures that exceed the total amount of its eligible debt, one or

more related persons (generally members of the same parent-subsidiary

controlled group as defined in section 1563(a)(1), whether or not

filing consolidated returns) must capitalize interest with respect to

the excess expenditures. Under Notice 88-99, the related persons, in

effect, capitalize interest with respect to the excess expenditures as

if the related persons had incurred those expenditures directly. The

notice provides similar rules in the case of flow through entities

(i.e., partnerships or S corporations).

The proposed regulations also provide certain related person rules

and direct taxpayers to follow applicable administrative pronouncements

in applying the rules. More comprehensive related person rules will be

proposed at a future date under a separate regulations project. Until

more specific rules are provided under related person regulations,

however, Notice 88-99 generally indicates the position of the IRS with

respect to the application of related persons rules under section

263A(f). To the extent that Notice 88-99 rules are modified by specific

provisions in, or principles of, these final regulations, the rules and

principles of the final regulations are controlling.

Consolidated Return Interest Rule

Consistent with the purposes of section 263A(f), the proposed

regulations provide that to the extent of a consolidated group's

outside interest deduction, the consolidated group must currently

report, rather than defer, the interest income on intragroup debt on

which it capitalizes interest (consolidated section 263A(f) interest

rule). Without this rule, a consolidated group could effectively avoid

capitalizing interest under section 263A(f) if the group were to

capitalize interest intragroup debt, but at the same time defer

reporting the associated interest income and deduct outside interest

equal to or less than the interest capitalized.

Certain taxpayers believed that the consolidated section 263A(f)

interest rule does not apply unless and until final regulations are

issued under section 263A or section 1502. The IRS and Treasury

believe, however, that a consolidated group that effectively deducts

interest by capitalizing interest on intragroup debt under section

263A(f) and deferring the associated interest income on the debt adopts

an unreasonable interpretation of the statute and legislative history

of section 263A(f) to the extent the associated interest income on the

intragroup debt is less than or equal to the group's outside interest

expense deductions.

Comments on Related Person Rules

Commentators submitted comments on certain related persons issues.

In particular, commentators believed that, under Notice 88-99 and the

proposed rules, capitalizing interest on the intragroup debt of an

affiliated group that is not a consolidated group may create an

overcapitalization of interest. According to the commentators,

overcapitalization may occur, for example, if two or more members

capitalize interest with respect to the same debt (e.g., back-to-back

loans). Additionally, one commentator believed that interest on debt

owed to a producing member by a nonproducing member should not be

subject to capitalization.

In response to commentator concerns, the IRS and Treasury are

studying whether the amount of interest capitalized by the related

person members of an affiliated group should be limited to the interest

incurred by all affiliated group members on outside debt, less any

interest capitalized by the producing member on outside and intragroup

debt. It is generally the intent of Rev. Proc. 88-99 and the final

regulations to prevent taxpayers from avoiding the purposes of interest

capitalization through the use of related persons. The IRS and Treasury

welcome additional comments on this and other related person issues

that should be addressed in future related person regulations.

Accounting Method Changes

The final section 263A(f) regulations are generally effective for

taxable years beginning on or after January 1, 1995. Taxpayers that

have previously adopted methods of accounting under section 263A(f) may

be required to change their methods of accounting under section 263A(f)

to comply with the final regulations. Within 30 days, the IRS will

issue a revenue procedure prescribing the procedures, terms, and

conditions for effecting method changes necessary due to the

promulgation of these regulations.

The revenue procedure will facilitate election of early application

of the regulations to the first taxable year beginning on or after

January 1, 1994 so that taxpayers may combine, within the same taxable

year, changes under the final section 263A(f) regulations and changes

under the final general section 263A regulations.

Clarification of Mixed Service Costs De Minimis Rules

The final regulations clarify the application of the 90 percent de

minimis rule for mixed service department costs contained in the final

main section 263A regulations. Under that rule, an electing taxpayer is

not required to allocate any portion of a mixed service department's

costs to property produced or acquired for resale if 90 percent or more

of the department's costs are deductible service costs. The final

regulations clarify that if this election is made, the taxpayer must

also allocate all of a mixed service department's costs to property

produced or acquired for resale if 90 percent or more of the

department's costs are capitalizable service costs.

Special Analyses

It has been determined that this Treasury decision is not a

significant regulatory action as defined in EO 12866. Therefore, a

regulatory assessment is not required. It also has been determined that

section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)

and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to

these regulations, and, therefore, a Regulatory Flexibility Analysis is

not required. Pursuant to section 7805(f) of the Internal Revenue Code,

the notice of proposed rulemaking preceding these regulations was

submitted to the Small Business Administration for comment on its

impact on small business.

Drafting Information

The principal author of these final regulations is Mary E. Goode of

the Office of Assistant Chief Counsel, Internal Revenue Service.

However, personnel from other offices of the Internal Revenue Service

and Treasury Department participated in their development.

List of Subjects

26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

Paragraph 1. The authority citation for part 1 is amended by adding

the following citation:

Authority: 26 U.S.C. 7805 * * * Sections 1.263A-8 through

1.263A-15 also issued under 26 U.S.C. 263A(i).

Par. 2. Section 1.263A-0 is amended by revising the introductory

text, removing the word ``Reserved'' after Sec. 1.263A-

2(a)(1)(ii)(B)(2), removing the word ``Reserved'' after Secs. 1.263A-

3(c)(4)(vi) (A) through (C) to reflect issuance of T.D. 8559 on August

5, 1994, and adding the following headings for Secs. 1.263A-8 through

1.263A-15 to read as follows:

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

This section lists the paragraphs in Secs. 1.263A-1 through 1.263A-

3 and Secs. 1.263A-8 through 1.263A-15.

* * * * *

Sec. 1.263A-8 Requirement to capitalize interest.

(a) In general.

(1) General rule.

(2) Treatment of interest required to be capitalized.

(3) Methods of accounting under section 263A(f).

(4) Special definitions.

(i) Related person.

(ii) Placed in service.

(b) Designated property.

(1) In general.

(2) Special rules.

(i) Application of thresholds.

(ii) Relevant activities and costs.

(iii) Production period and cost of production.

(3) Excluded property.

(4) De minimis rule.

(i) In general.

(ii) Determination of total production expenditures.

(1) In general.

(2) Unsevered natural products of land.

(3) Inherently permanent structures.

(4) Machinery.

(i) Treatment.

(ii) Certain factors not determinative.

(d) Production.

(1) Definition of produce.

(2) Property produced under a contract.

(i) Customer.

(ii) Contractor.

(iii) Definition of a contract.

(iv) Determination of whether thresholds are satisfied.

(A) Customer.

(B) Contractor.

(v) Exclusion for property subject to long-term contract rules.

(3) Improvements to existing property.

(i) In general.

(ii) Real property.

(iii) Tangible personal property.

Sec. 1.263A-9 The avoided cost method.

(a) In general.

(1) Description.

(2) Overview.

(i) In general.

(ii) Rules that apply in determining amounts.

(3) Definitions of interest and incurred.

(4) Definition of eligible debt.

(b) Traced debt amount.

(1) General rule.

(2) Identification and definition of traced debt.

(3) Example.

(1) General rule.

(2) Interest required to be capitalized.

(3) Example.

(4) Treatment of interest subject to a deferral provision.

(5) Definitions.

(i) Nontraced debt.

(A) Defined.

(B) Example.

(ii) Average excess expenditures.

(A) General rule.

(B) Example.

(iii) Weighted average interest rate.

(A) Determination of rate.

(B) Interest incurred on nontraced debt.

(D) Special rules if taxpayer has no nontraced debt or rate is

contingent.

(6) Examples.

(7) Special rules where the excess expenditure amount exceeds

incurred interest.

(i) Allocation of total incurred interest to units.

(ii) Application of related person rules to average excess

expenditures.

(iii) Special rule for corporations.

(d) Election not to trace debt.

(1) General rule.

(2) Example.

(e) Election to use external rate.

(1) In general.

(2) Eligible taxpayer.

(f) Selection of computation period and measurement dates and

application of averaging conventions.

(1) Computation period.

(i) In general.

(ii) Method of accounting.

(iii) Production period beginning or ending during the computation

period.

(2) Measurement dates.

(i) In general.

(ii) Measurement period.

(iii) Measurement dates on which accumulated production

expenditures must be taken into account.

(iv) More frequent measurement dates.

(3) Examples.

(g) Special rules.

(1) Ordering rules.

(i) Provisions preempted by section 263A(f).

(ii) Deferral provisions applied before this section.

(2) Application of section 263A(f) to deferred interest.

(i) In general.

(ii) Capitalization of deferral amount.

(iii) Deferred capitalization.

(iv) Substitute capitalization.

(A) General rule.

(B) Capitalization of amount carried forward.

(v) Examples.

(3) Simplified inventory method.

(i) In general.

(ii) Segmentation of inventory.

(A) General rule.

(B) Example.

(iii) Aggregate interest capitalization amount.

(A) Computation period and weighted average interest rate.

(B) Computation of the tentative aggregate interest capitalization

amount.

(1) In general.

(2) Deferred interest.

(3) Other coordinating provisions.

(D) Treatment of increases or decreases in the aggregate interest

capitalization amount.

(E) Example.

(iv) Method of accounting.

(4) Financial accounting method disregarded.

(5) Treatment of intercompany transactions.

(i) General rule.

(ii) Special rule for consolidated group with limited outside

borrowing.

(iii) Example.

(6) Notional principal contracts and other derivatives.

(7) 15-day repayment rule.

Sec. 1.263A-10 Unit of property.

(a) In general.

(b) Units of real property.

(1) In general.

(2) Functional interdependence.

(3) Common features.

(4) Allocation of costs to unit.

(5) Treatment of costs when a common feature is included in a unit

of real property.

(i) General rule.

(ii) Production activity not undertaken on benefitted property.

(A) Direct production activity not undertaken.

(1) In general.

(2) Land attributable to a benefitted property.

(B) Suspension of direct production activity after clearing and

grading undertaken.

(1) General rule.

(2) Accumulated production expenditures.

(iii) Common feature placed in service before the end of production

of a benefitted property.

(iv) Benefitted property sold before production completed on common

feature.

(v) Benefitted property placed in service before production

completed on common feature.

(6) Examples.

(d) Treatment of installations.

Sec. 1.263A-11 Accumulated production expenditures.

(a) General rule.

(b) When costs are first taken into account.

(1) In general.

(2) Dedication rule for materials and supplies.

(1) Customer.

(2) Contractor.

(d) Property used to produce designated property.

(1) In general.

(2) Example.

(3) Excluded equipment and facilities.

(e) Improvements.

(1) General rule.

(2) De minimis rule.

(f) Mid-production purchases.

(g) Related person costs.

(h) Installation.

Sec. 1.263A-12 Production period.

(a) In general.

(b) Related person activities.

(1) In general.

(2) Real property.

(3) Tangible personal property.

(d) End of production period.

(1) In general.

(2) Special rules.

(3) Sequential production or delivery.

(4) Examples.

(e) Physical production activities.

(1) In general.

(2) Illustrations.

(f) Activities not considered physical production.

(1) Planning and design.

(2) Incidental repairs.

(g) Suspension of production period.

(1) In general.

(2) Special rule.

(3) Method of accounting.

(4) Example.

Sec. 1.263A-13 Oil and gas activities.

(a) In general.

(b) Generally applicable rules.

(1) Beginning of production period.

(i) Onshore activities.

(ii) Offshore activities.

(2) End of production period.

(3) Accumulated production expenditures.

(i) Costs included.

(ii) Improvement unit.

(1) In general.

(2) Oil and gas units.

(i) First productive well unit.

(ii) Subsequent units.

(3) Beginning of production period.

(i) First productive well unit.

(ii) Subsequent wells.

(4) End of production period.

(5) Accumulated production expenditures.

(i) First productive well unit.

(ii) Subsequent well unit.

(6) Allocation of interest capitalized with respect to first

productive well unit.

(7) Examples.

Sec. 1.263A-14 Rules for related persons.

Sec. 1.263A-15 Effective dates, transitional rules, and anti-abuse

rule.

(a) Effective dates.

(b) Transitional rule for accumulated production expenditures.

(1) In general.

(2) Property used to produce designated property.

Par. 3. Section 1.263A-1 is amended by revising the third sentence

of paragraph (g)(4)(ii) to read as follows:

Sec. 1.263A-1 Uniform capitalization of costs.

* * * * *

(g) * * *

(4) * * *

(ii) * * * Under this election, however, if 90 percent or more of a

mixed service department's costs are capitalizable service costs, a

taxpayer must allocate 100 percent of the department's costs to the

production or resale activity benefitted. * * *

* * * * *

Par. 4. Section 1.263A-2 is amended by revising paragraph

(a)(1)(ii)(B)(2) to read as follows:

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

(a) * * *

(1) * * *

(ii) * * *

(B) * * *

(2) Definition of a contract--(i) General rule. Except as provided

under paragraph (a)(1)(ii)(B)(2)(ii) of this section, a contract is any

agreement providing for the production of property if the agreement is

entered into before the production of the property to be delivered

under the contract is completed. Whether an agreement exists depends on

all the facts and circumstances. Facts and circumstances indicating an

agreement include, for example, the making of a prepayment, or an

arrangement to make a prepayment, for property prior to the date of the

completion of production of the property, or the incurring of

significant expenditures for property of specialized design or

specialized application that is not intended for self-use.

(ii) Routine purchase order exception. A routine purchase order for

fungible property is not treated as a contract for purposes of this

section. An agreement will not be treated as a routine purchase order

for fungible property, however, if the contractor is required to make

more than de minimis modifications to the property to tailor it to the

customer's specific needs, or if at the time the agreement is entered

into, the customer knows or has reason to know that the contractor

cannot satisfy the agreement within 30 days out of existing stocks and

normal production of finished goods.

* * * * *

Par. 5. Section 1.263A-7 is added and reserved and Sections 1.263A-

8 through 1.263A-15 are added reading as follows:

Sec. 1.263A-8 Requirement to capitalize interest.

(a) In general--(1) General rule. Capitalization of interest under

the avoided cost method described in Sec. 1.263A-9 is required with

respect to the production of designated property described in paragraph

(b) of this section.

(2) Treatment of interest required to be capitalized. In general,

interest that is capitalized under this section is treated as a cost of

the designated property and is recovered in accordance with

Sec. 1.263A-1(c)(4). Interest capitalized by reason of assets used to

produce designated property (within the meaning of Sec. 1.263A-11(d))

is added to the basis of the designated property rather than the bases

of the assets used to produce the designated property. Interest

capitalized with respect to designated property that includes both

components subject to an allowance for depreciation or depletion and

components not subject to an allowance for depreciation or depletion is

ratably allocated among, and is treated as a cost of, components that

are subject to an allowance for depreciation or depletion.

(3) Methods of accounting under section 263A(f). Except as

otherwise provided, methods of accounting and other computations under

Secs. 1.263A-8 through 1.263A-15 are applied on a taxpayer, as opposed

to a separate and distinct trade or business, basis.

(4) Special definitions--(i) Related person. Except as otherwise

provided, for purposes of Secs. 1.263A-8 through 1.263A-15, a person is

related to a taxpayer if their relationship is described in section

267(b) or 707(b).

(ii) Placed in service. For purposes of Secs. 1.263A-8 through

1.263A-15, placed in service has the same meaning as set forth in

Sec. 1.46-3(d).

(b) Designated property--(1) In general. Except as provided in

paragraphs (b)(3) and (b)(4) of this section, designated property means

any property that is produced and that is either:

(i) Real property; or

(ii) Tangible personal property (as defined in Sec. 1.263A-2(a)(2))

which meets any of the following criteria:

(A) Property with a class life of 20 years or more under section

168 (long-lived property), but only if the property is not property

described in section 1221(l) in the hands of the taxpayer or a related

person,

(B) Property with an estimated production period (as defined in

Sec. 1.263A-12) exceeding 2 years (2-year property), or

and an estimated cost of production exceeding $1,000,000 (1-year

property).

(2) Special rules--(i) Application of thresholds. The thresholds

described in paragraphs (b)(l)(ii)(A), (B), and (C) of this section are

applied separately for each unit of property (as defined in

Sec. 1.263A-10).

(ii) Relevant activities and costs. For purposes of determining

whether property is designated property, all activities and costs are

taken into account if they are performed or incurred by, or for, the

taxpayer or any related persons and they directly benefit or are

incurred by reason of the production of the property.

(iii) Production period and cost of production. For purposes of

applying the thresholds under paragraphs (b)(l)(ii) (B) and (C) of this

section to a unit of property, the taxpayer is required, at the

beginning of the production period, to reasonably estimate the

production period and the total cost of production for the unit of

property. The taxpayer must maintain contemporaneous written records

supporting the estimates and classification. If the estimates are

reasonable based on the facts in existence at the beginning of the

production period, the taxpayer's classification of the property is not

modified in subsequent periods, even if the actual length of the

production period or the actual cost of production differs from the

estimates. To be considered reasonable, estimates of the production

period and the total cost of production must include anticipated

expense and time for delay, rework, change orders, and technological,

design or other problems. To the extent that several distinct

activities related to the production of the property are expected to

occur simultaneously, the period during which these distinct activities

occur is not counted more than once. The bases of assets used to

produce a unit of property (within the meaning of Sec. 1.263A-11(d))

and any interest that would be required to be capitalized if a unit of

property were designated property are disregarded in making estimates

of the total cost of production for purposes of this paragraph

(b)(2)(iii).

(3) Excluded property. Designated property does not include:

(i) Timber and evergreen trees that are more than 6 years old when

severed from the roots, or

(ii) Property produced by the taxpayer for use by the taxpayer

other than in a trade or business or an activity conducted for profit.

(4) De minimis rule--(i) In general. Designated property does not

include property for which--

(A) The production period does not exceed 90 days; and

(B) The total production expenditures do not exceed $1,000,000

divided by the number of days in the production period.

(ii) Determination of total production expenditures. For purposes

of determining whether the condition of paragraph (b)(4)(i)(B) of this

section is met with respect to property, the cost of land, the adjusted

basis of property used to produce property, and interest that would be

capitalized with respect to property if it were designated property are

excluded from total production expenditures.

includes land, unsevered natural products of land, buildings, and

inherently permanent structures. Any interest in real property of a

type described in this paragraph (c), including fee ownership, co-

ownership, a leasehold, an option, or a similar interest is real

property under this section. Real property includes the structural

components of both buildings and inherently permanent structures, such

as walls, partitions, doors, wiring, plumbing, central air conditioning

and heating systems, pipes and ducts, elevators and escalators, and

other similar property. Tenant improvements to a building that are

inherently permanent or otherwise classified as real property within

the meaning of this paragraph (c)(1) are real property under this

section. However, property produced for sale that is not real property

in the hands of the taxpayer or a related person, but that may be

incorporated into real property by an unrelated buyer, is not treated

as real property by the producing taxpayer (e.g., bricks, nails, paint,

and windowpanes.)

(2) Unsevered natural products of land. Unsevered natural products

of land include growing crops and plants, mines, wells, and other

natural deposits. Growing crops and plants, however, are real property

only if the preproductive period of the crop or plant exceeds 2 years.

(3) Inherently permanent structures. Inherently permanent

structures include property that is affixed to real property and that

will ordinarily remain affixed for an indefinite period of time, such

as swimming pools, roads, bridges, tunnels, paved parking areas and

other pavements, special foundations, wharves and docks, fences,

inherently permanent advertising displays, inherently permanent outdoor

lighting facilities, railroad tracks and signals, telephone poles,

power generation and transmission facilities, permanently installed

telecommunications cables, broadcasting towers, oil and gas pipelines,

derricks and storage equipment, grain storage bins and silos. For

purposes of this section, affixation to real property may be

accomplished by weight alone. Property may constitute an inherently

permanent structure even though it is not classified as a building for

purposes of former section 48(a)(1)(B) and Sec. 1.48-1. Any property

not othewise described in this paragraph (c)(3) that constitutes other

tangible property under the principles of former section 48(a)(1)(B)

and Sec. 1.48-1(d) is treated for the purposes of this section as an

inherently permanent structure.

(4) Machinery--(i) Treatment. A structure that is property in the

nature of machinery or is essentially an item of machinery or equipment

is not an inherently permanent structure and is not real property. In

the case, however, of a building or inherently permanent structure that

includes property in the nature of machinery as a structural component,

the property in the nature of machinery is real property.

(ii) Certain factors not determinative. A structure may be an

inherently permanent structure, and not property in the nature of

machinery or essentially an item of machinery, even if the structure is

necessary to operate or use, supports, or is otherwise associated with,

machinery.

(d) Production--(1) Definition of produce. Produce is defined as

provided in section 263A(g) and Sec. 1.263A-2(a)(1)(i).

(2) Property produced under a contract--(i) Customer. A taxpayer is

treated as producing any property that is produced for the taxpayer

(the customer) by another party (the contractor) under a contract with

the taxpayer or an intermediary. Property produced under a contract is

designated property to the customer if it is real property or tangible

personal property that satisfies the classification thresholds

described in paragraph (b)(1)(ii) of this section. If property produced

under a contract will become part of a unit of designated property

produced by the customer in the customer's hands, the property produced

under the contract is designated property to the customer.

(ii) Contractor. Property produced under a contract is designated

property to the contractor if it is real property, 2-year property, or

1-year property and the property produced under the contract is not

excluded by reason of paragraph (d)(2)(v) of this section.

(iii) Definition of a contract. For purposes of this paragraph

(d)(2), contract has the same meaning as under Sec. 1.263A-

2(a)(1)(ii)(B)(2).

(iv) Determination of whether thresholds are satisfied. In the case

of tangible personal property produced under a contract, the customer

and the contractor each determine under this paragraph (d)(2), whether

the property satisfies the classification thresholds described in

paragraph (b)(1)(ii) of this section. Thus, tangible personal property

may be designated property with respect to either, or both, the

customer and the contractor. The provisions of paragraph (b)(2)(iii) of

this section are modified as set forth in this paragraph (d)(2)(iv) for

purposes of determining whether tangible personal property produced

under a contract is 2-year property or 1-year property.

(A) Customer. In determining a customer's estimated cost of

production, the customer takes into account costs and payments that are

reasonably expected to be incurred by the customer, but does not take

into account costs incurred (or to be incurred) by an unrelated

contractor. In determining the customer's estimated length of the

production period, the production period is treated as beginning on the

earlier of the date the contract is executed or the date that the

customer's accumulated production expenditures for the unit are at

least 5 percent of the customer's total estimated production

expenditures for the unit. The customer, however, may elect to treat

the production period as beginning on the date the sum of the

accumulated production expenditures of the contractor (or contractors

if more than one contractor is producing components for the unit of

property) and of the customer are at least 5 percent of the customer's

estimated production expenditures for the unit.

(B) Contractor. In determining a contractor's estimated cost of

production, the contractor takes into account only the costs that are

reasonably expected to be incurred by the contractor, without any

reduction for payments from the customer. In determining the

contractor's estimated length of the production period, the production

period is treated as beginning on the date the contractor's accumulated

production expenditures (without any reduction for payments from the

customer) are at least 5 percent of the contractor's total estimated

accumulated production expenditures.

(v) Exclusion for property subject to long-term contract rules.

Property described in paragraph (b) of this section is designated

property with respect to a contractor only if--

(A) The contract is not a long-term contract (within the meaning of

section 460(f)); or

(B) The contract is a home construction contract (within the

meaning of section 460(e)(6)(A) with respect to which the requirements

of section 460(d)(1)(B) (i) and (ii) are not met.

(3) Improvements to existing property--(i) In general. Any

improvement to property described in Sec. 1.263(a)-1(b) constitutes the

production of property. Generally, any improvement to designated

property constitutes the production of designated property. An

improvement is not treated as the production of designated property,

however, if the de minimis exception described in paragraph (b)(4) of

this section applies to the improvement. In addition, paragraph

(d)(3)(iii) of this section provides an exception for certain

improvements to tangible personal property. Incidental maintenance and

repairs are not treated as improvements under this paragraph (d)(3).

See Sec. 1.162-4.

(ii) Real property. The rehabilitation or preservation of a

standing building, the clearing of raw land prior to sale, and the

drilling of an oil well are activities constituting improvements to

real property and, therefore, the production of designated property.

Similarly, the demolition of a standing building generally constitutes

an activity that is an improvement to real property and, therefore, the

production of designated property. See the exceptions, however, in

paragraphs (b)(3) and (b)(4) of this section.

(iii) Tangible personal property. If the taxpayer has treated a

unit of tangible personal property as designated property under this

section, an improvement to such property constitutes the production of

designated property regardless of the remaining useful life of the

improved property (or the improvement) and, except as provided in

paragraph (b)(4) of this section, regardless of the estimated length of

the production period or the estimated cost of the improvement. If the

taxpayer has not treated a unit of tangible personal property as

designated property under this section, an improvement to such property

constitutes the production of designated property only if the

improvement independently meets the classification thresholds described

in paragraph (b)(1)(ii) of this section.

Sec. 1.263A-9 The avoided cost method.

(a) In general--(1) Description. The avoided cost method described

in this section must be used to calculate the amount of interest

required to be capitalized under section 263A(f). Generally, any

interest that the taxpayer theoretically would have avoided if

accumulated production expenditures (as defined in Sec. 1.263A-11) had

been used to repay or reduce the taxpayer's outstanding debt must be

capitalized under the avoided cost method. The application of the

avoided cost method does not depend on whether the taxpayer actually

would have used the amounts expended for production to repay or reduce

debt. Instead, the avoided cost method is based on the assumption that

debt of the taxpayer would have been repaid or reduced without regard

to the taxpayer's subjective intentions or to restrictions (including

legal, regulatory, contractual, or other restrictions) against

repayment or use of the debt proceeds.

(2) Overview--(i) In general. For each unit of designated property

(within the meaning of Sec. 1.263A-8(b)), the avoided cost method

requires the capitalization of--

(A) The traced debt amount under paragraph (b) of this section, and

(B) The excess expenditure amount under paragraph (c) of this

section.

(ii) Rules that apply in determining amounts. The traced debt and

excess expenditure amounts are determined for each taxable year or

shorter computation period that includes the production period (as

defined in Sec. 1.263A-12) of a unit of designated property. Paragraph

(d) of this section provides an election not to trace debt to specific

units of designated property. Paragraph (f) of this section provides

rules for selecting the computation period, for calculating averages,

and for determining measurement dates within the computation period.

Special rules are in paragraph (g) of this section.

(3) Definitions of interest and incurred. Except as provided in the

case of certain expenses that are treated as a substitute for interest

under paragraphs (c)(2)(iii) and (g)(2)(iv) of this section, interest

refers to all amounts that are characterized as interest expense under

any provision of the Code, including, for example, sections 482, 483,

1272, 1274, and 7872. Incurred refers to the amount of interest that is

properly accruable during the period of time in question determined by

taking into account the loan agreement and any applicable provisions of

the Internal Revenue laws and regulations such as section 163,

Sec. 1.446-2, and sections 1271 through 1275.

(4) Definition of eligible debt. Except as provided in this

paragraph (a)(4), eligible debt includes all outstanding debt (as

evidenced by a contract, bond, debenture, note, certificate, or other

evidence of indebtedness). Eligible debt does not include--

(i) Debt (or the portion thereof) bearing interest that is

disallowed under a provision described in Sec. 1.163-8T(m)(7)(ii);

(ii) Debt, such as accounts payable and other accrued items, that

bears no interest, except to the extent that such debt is traced debt

(as defined in paragraph (b)(2) of this section);

(iii) Debt that is borrowed directly or indirectly from a person

related to the taxpayer and that bears a rate of interest that is less

than the applicable Federal rate in effect under section 1274(d) on the

date of issuance;

(iv) Debt (or the portion thereof) bearing personal interest within

the meaning of section 163(h)(2);

(v) Debt (or the portion thereof) bearing qualified residence

interest within the meaning of section 163(h)(3);

(vi) Debt incurred by an organization that is exempt from Federal

income tax under section 501(a), except to the extent interest on such

debt is directly attributable to an unrelated trade or business of the

organization within the meaning of section 512;

(vii) Reserves, deferred tax liabilities, and similar items that

are not treated as debt for Federal income tax purposes, regardless of

the extent to which the taxpayer's applicable financial accounting or

other regulatory reporting principles require or support treating these

items as debt; and

(viii) Federal, State, and local income tax liabilities, deferred

tax liabilities under section 453A, and hypothetical tax liabilities

under the look-back method of section 460(b) or similar provisions.

(b) Traced debt amount--(1) General rule. Interest must be

capitalized with respect to a unit of designated property in an amount

(the traced debt amount) equal to the total interest incurred on the

traced debt during each measurement period (as defined in paragraph

(f)(2)(ii) of this section) that ends on a measurement date described

in paragraph (f)(2)(iii) of this section. See the example in paragraph

(b)(3) of this section. If any interest incurred on the traced debt is

not taken into account for the taxable year that includes the

measurement period because of a deferral provision, see paragraph

(g)(2) of this section for the time and manner for capitalizing and

recovering that amount. This paragraph (b)(1) does not apply if the

taxpayer elects under paragraph (d) of this section not to trace debt.

(2) Identification and definition of traced debt. On each

measurement date described in paragraph (f)(2)(iii) of this section,

the taxpayer must identify debt that is traced debt with respect to a

unit of designated property. On each such date, traced debt with

respect to a unit of designated property is the outstanding eligible

debt (as defined in paragraph (a)(4) of this section) that is

allocated, on that date, to accumulated production expenditures with

respect to the unit of designated property under the rules of

Sec. 1.163-8T Traced debt also includes unpaid interest that has been

capitalized with respect to such unit under paragraph (b)(1) of this

section and that is included in accumulated production expenditures on

the measurement date.

(3) Example. The provisions of paragraphs (b)(1) and (b)(2) of this

section are illustrated by the following example.

Example. Corporation X, a calendar year taxpayer, is engaged in

the production of a single unit of designated property during 1995

(unit A). Corporation X adopts a taxable year computation period and

quarterly measurement dates. Production of unit A starts on January

14, 1995, and ends on June 16, 1995. On March 31, 1995 and on June

30, 1995, Corporation X has outstanding a $1,000,000 loan that is

allocated under the rules of Sec. 1.163-8T to production

expenditures with respect to unit A. During the period January 1,

1995, through June 30, 1995, Corporation X incurs $50,000 of

interest related to the loan. Under paragraph (b)(1) of this

section, the $50,000 of interest Corporation X incurs on the loan

during the period January 1, 1995, through June 30, 1995, must be

capitalized with respect to

unit A.

accumulated production expenditures in excess of traced debt with

respect to a unit of designated property on any measurement date

described in paragraph (f)(2)(iii) of this section, the taxpayer must,

for the computation period that includes the measurement date,

capitalize with respect to this unit the excess expenditure amount

calculated under this paragraph (c)(1). However, if the sum of the

excess expenditure amounts for all units of designated property of a

taxpayer exceeds the total interest described in paragraph (c)(2) of

this section, only a prorata amount (as determined under paragraph

(c)(7) of this section) of such interest must be capitalized with

respect to each unit. For each unit of designated property, the excess

expenditure amount for a computation period equals the production of--

(i) The average excess expenditures (as determined under paragraph

(c)(5)(ii) of this section) for the unit of designated property for

that period, and

(ii) The weighted average interest rate (as determined under

paragraph (c)(5)(iii) of this section) for that period.

(2) Interest required to be capitalized. With respect to an excess

expenditure amount, interest incurred during the computation period is

capitalized from the following sources and in the following sequence

but not in excess of the excess expenditure amount for all units of

designated property:

(i) Interest incurred on nontraced debt (as defined in paragraph

(c)(5)(i) of this section);

(ii) Interest incurred on borrowings described in paragraph

(a)(4)(iii) of this section (relating to certain borrowings from

related persons); and

(iii) In the case of a partnership, guaranteed payments for the use

of capital (within the meaning of section 707(c)) that would be

deductible by the partnership if section 263A(f) did not apply.

(3) Example. The provisions of paragraph (c)(1) and (2) of this

section are illustrated by the following example.

Example. (i) P, a partnership owned equally by Corporation A and

Individual B, is engaged in the construction of an office building

during 1995. Average excess expenditures for the office building for

1995 are $2,000,000. When P was formed, A and B agreed that A would

be entitled to an annual guaranteed payment of $70,000 in exchange

for A's capital contribution. The only borrowing of P, A, and B for

1995 is a loan to P from an unrelated lender of $1,000,000 (loan #).

The loan is nontraced debt and bears interest at an annual rate of

10 percent. Thus, P's weighted average interest rate (determined

under paragraph (c)(5)(iii) of this section) is 10 percent and

interest incurred during 1995 is $100,000.

(ii) In accordance with paragraph (c)(1) of this section, the

excess expenditure amount is $200,000 ($2,000,000 x 10%). The

interest capitalized under paragraph (c)(2) of this section is

$170,000 ($100,000 of interest plus $70,000 of guaranteed payments).

(4) Treatment of interest subject to a deferral provision. If any

interest described in paragraph (c)(2) of this section is not taken

into account for the taxable year that includes the computation period

because of a deferral provision described in paragraph (g)(1)(ii) of

this section, paragraph (c)(2) of this section is first applied without

regard to the amount of the deferred interest. After applying paragraph

(c)(2) without regard to the deferred interest, if the amount of

interest capitalized with respect to all units of designated property

for the computation period is less than the amount that would have been

capitalized if a deferral provision did not apply, see paragraph (g)(2)

of this section for the time and manner for capitalizing and recovering

the difference (the shortfall amount).

(5) Definitions--(i) Nontraced debt--(A) Defined. Nontraced debt

means all eligible debt on a measurement date other than any debt that

is treated as traced debt with respect to any unit of designated

property on that measurement date. For example, nontraced debt includes

eligible debt that is allocated to expenditures that are not

capitalized under section 263A(a) (e.g., expenditures deductible under

section 174(a) or 263(c)). Similarly, even if eligible debt is

allocated to a production expenditure for a unit of designated

property, the debt is included in nontraced debt on measurement dates

before the first or after the last measurement date for that unit of

designated property. Thus, nontraced debt may include debt that was

previously treated as traced debt or that will be treated as traced

debt on a future measurement date.

(B) Example. The provisions of paragraph (c)(5)(i)(A) of this

section are illustrated by the following example.

Example. In 1995, Corporation X begins, but does not complete,

the construction of two office buildings that are separate units of

designated property as defined in Sec. 1.263A-10 (Property D and

Property E). At the beginning of 1995, X borrows $2,500,00 (the

$2,500,000 loan), which will be used exclusively to finance

production expenditures for Property D. Although interest is paid

currently, the entire principal amount of the loan remains

outstanding at the end of 1995. Corporation X also has outstanding

during all of 1995 a long-term loan with a principal amount of

$2,000,000 (the $2,000,000 loan). The proceeds of the $2,000,000

loan were used exclusively to finance the production of Property C,

a unit of designated property that was completed in 1994. Under the

rules of paragraph (b)(2) of this section, the portion of the

$2,500,000 loan allocated to accumulated production expenditures for

property D at each measurement date during 1995 is treated as traced

debt for that measurement date. The excess, if any, of $2,500,000

over the amount treated as traced debt at each measurement date

during 1995 is treated as nontraced debt for that measurement date,

even though it is expected that the entire $2,500,000 will be

treated as traced debt with respect to Property D on subsequent

measurement dates as more of the proceeds of the loan are used to

finance additional production expenditures. In addition, the entire

principal amount of the $2,000,000 loan is treated as nontraced debt

for 1995, even though it was treated as traced debt with respect to

Property C in a previous period.

(ii) Average excess expenditures--(A) General rule. The average

excess expenditures for a unit of designated property for a computation

period are computed by--

(1) Determining the amount (if any) by which accumulated production

expenditures exceed traced debt at each measurement date during the

computation period; and

(2) Dividing the sum of these amounts by the number of measurement

dates during the computation period.

(B) Example. The provisions of paragraph (c)(5)(ii)(A) of this

section are illustrated by the following example.

Example. Corporation X, a calendar year taxpayer, is engaged in

the production of a single unit of designated property during 1995

(unit A). Corporation X adopts the taxable year as the computation

period and quarterly measurement dates. The production period for

unit A begins on January 14, 1995, and ends on June 16, 1995. On

March 31, 1995, and on June 30, 1995, Corporation X has outstanding

$1,000,000 of traced debt with respect to unit A. Accumulated

production expenditures for unit A on March 31, 1995, are $1,400,000

and on June 30, 1995, are $1,600,000. Accumulated production

expenditures in excess of traced debt for unit A on March 31, 1995,

are $400,000 and on June 30, 1995, are $600,000. Average excess

expenditures for unit A during 1995 are therefore $250,000

([$400,000 + $600,000 + $0 +$0] 4).

(iii) Weighted average interest rate--(A) Determination of rate.

The weighted average interest rate for a computation period is

determined by dividing interest incurred on nontraced debt during the

period by average nontraced debt for the period.

(B) Interest incurred on nontraced debt. Interest incurred on

nontraced debt during the computation period is equal to the total

amount of interest incurred during the computation period on all

eligible debt minus the amount of interest incurred during the

computation period on traced debt. Thus, all interest incurred on

nontraced debt during the computation period is included in the

numerator of the weighted average interest rate, even if the underlying

nontraced debt is repaid before the end of a measurement period and

excluded from nontraced debt outstanding for measurement dates after

repayment, in determining the denominator of the weighted average

interest rate. However, see paragraph (g)(7) of this section for an

election to treat eligible debt that is repaid within the 15-day period

immediately preceding a quarterly measurement date as outstanding on

that measurement date. See paragraph (a)(3) of this section for the

definitions of interest and incurred.

computation period is computed by--

(1) Determining the amount of nontraced debt outstanding on each

measurement date during the computation period; and

(2) Dividing the sum of these amounts by the number of measurement

dates during the computation period.

(D) Special rules if taxpayer has no nontraced debt or rate is

contingent--If the taxpayer does not have nontraced debt outstanding

during the computation period, the weighted average interest rate for

purposes of applying paragraphs (c)(1) and (c)(2) of this section is

the highest applicable Federal rate in effect under section 1274(d)

during the computation period. If interest is incurred at a rate that

is contingent at the time the return for the year that includes the

computation period is filed, the amount of interest is determined using

the higher of the fixed rate of interest (if any) on the underlying

debt or the applicable Federal rate in effect under section 1274(d) on

the date of issuance.

(6) Examples. The following examples illustrate the principles of

this paragraph (c):

Example 1. (i) W, a calendar year taxpayer, is engaged in the

production of a unit of designated property during 1995. For

purposes of applying the avoided cost method of this section, W uses

the taxable year as the computation period. During 1995, W's only

debt is a $1,000,000 loan bearing interest at a rate of 7 percent

from Y, a person that is related to W. Assuming the applicable

Federal rate in effect under section 1274(d) on the date of issuance

of the loan is 10 percent, the loan is not eligible debt under

paragraph (a)(4) of this section. However, even though W has no

eligible debt, W incurs $70,000 ($1,000,000 x 7%) of interest during

the computation period. This interest is described in paragraph

(c)(2) of this section and must be capitalized under paragraph

(c)(1) of this section to the extent it does not exceed W's excess

expenditure amount for the unit of property.

(ii) W determines, under paragraph (c)(5)(ii) of this section,

that average excess expenditures for the unit of property are

$600,000. Assuming the highest applicable Federal rate in effect

under section 1274(d) during the computation period is 10 percent, W

uses 10 percent as the weighted average interest rate for purposes

of determining the excess expenditure amount. See paragraph

(c)(5)(iii)(D) of this section. In accordance with paragraph (c)(1)

of this section, the excess expenditure amount is therefore $60,000.

Because this amount does not exceed the total amount of interest

described in paragraph (c)(2) of this section ($70,000), W is

required to capitalize $60,000 of interest with respect to the unit

of designated property for the 1995 computation period.

Example 2. (i) Corporation X, a calendar year taxpayer, is

engaged in the production of a single unit of designated property

during 1955 (unit A). Corporation X adopts the taxable year as the

computation period and quarterly measurement dates. Production of

unit A begins in 1994 and ends on June 30, 1995. On March 31, 1995,

and on June 30, 1995, Corporation X has outstanding $1,000,000 of

eligible debt (loan #1) that is allocated under the rules of

Sec. 1.163-8T to production expenditures for unit A. During each of

the first two quarters of 1995, $30,000 of interest is incurred on

loan #1. The loan is repaid on July 1, 1995. Throughout 1995,

Corporation X also has outstanding $2,000,000 of eligible debt (loan

#2) which is not allocated under the rules of Sec. 1.163-8T to the

production of unit A. During 1995, $200,000 of interest is incurred

on this nontraced debt. Accumulated production expenditures on March

31, 1995, are $1,400,000 and on June 30, 1995, are $1,600,000.

Accumulated production expenditures in excess of traced debt on

March 31, 1995, are $400,000 and on June 30, 1995, are $600,000.

(ii) Under paragraph (b)(1) of this section, the amount of

interest capitalized with respect to traced debt is $60,000 ($30,000

for the measurement period ending March 31, 1995, and $30,000 for

the measurement period ending June 30, 1995). Under paragraph

(c)(5)(ii) of this section, average excess expenditures for unit A

are $250,000 ([$1,400,000-$1,000,000) + ($1,600,000-$1,000,000) + $0

+ $0]4). Under paragraph (c)(5)(iii)(C) of this section,

average nontraced debt is $2,000,000 ([$2,000,000 + $2,000,000 +

$2,000,000 + $2,000,000]4). Under paragraph (c)(5)(iii)(B)

of this section, interest incurred on nontraced debt is $200,000

($260,000 of interest incurred on all eligible debt less $60,000 of

interest incurred on traced debt). Under paragraph (c)(5)(iii)(A) of

this section, the weighted average interest rate is 10 percent

($200,000$2,000,000). Under paragraph (c)(1) of this

section, Corporation X capitalizes the excess expenditure amount of

$25,000 ($250,000 x 10%), because it does not exceed the total

amount of interest subject to capitalization under paragraph (c)(2)

of this section ($200,000). Thus, the total interest capitalized

with respect to unit A during 1995 is $85,000 ($60,000+$25,000).

(7) Special rules where the excess expenditure amount exceeds

incurred interest.--(i) Allocation of total incurred interest to units.

For a computation period in which the sum of the excess expenditure

amounts under paragraph (c)(1) of this section for all units of

designated property exceeds the total amount of interest (including

deferred interest) available for capitalization, as determined under

paragraph (c)(2) of this section, the amount of interest that is

allocated to a unit of designated property is equal to the product of--

(A) The total amount of interest (including deferred interest)

available for capitalization, as determined under paragraph (c)(2) of

this section; and

(B) A fraction, the numerator of which is the average excess

expenditures for the unit of designated property and the denominator of

which is the sum of the average excess expenditures for all units of

designated property.

(ii) Application of related person rules to average excess

expenditures. Certain excess expenditures must be taken into account by

the persons (if any) required to capitalize interest with respect to

production expenditures of the taxpayer under applicable related person

rules. For each computation period, the amount of average excess

expenditures that must be taken into account by such persons for each

unit of the taxpayer's property is computed by--

(A) Determining, for the computation period, the amount (if any) by

which the excess expenditures amount for the unit exceeds the amount of

interest allocated to the unit under paragraph (c)(7)(i) of this

section; and

(B) Dividing the excess by the weighted average interest rate for

the period.

(iii) Special rule for corporations. If a corporation is related to

another person for the purposes of the applicable related party rules,

the District Director upon examination may require that the corporation

apply this paragraph (c)(7) and other provisions of the regulations by

excluding deferred interest from the total interest available for

capitalization.

(d) Election not to trace debt.--(1) General rule. Taxpayers may

elect not to trace debt. If the election is made, the average excess

expenditures and weighted average interest rate under paragraph (c)(5)

of this section are determined by treating all eligible debt as

nontraced debt. For this purpose, debt specified in paragraph

(a)(4)(ii) of this section (e.g., accounts payable) may be included in

eligible debt, provided it would be treated as traced debt but for an

election under this paragraph (d). The election not to trace debt is a

method of accounting that applies to the determination of capitalized

interest for all designated property of the taxpayer. The making or

revocation of the election is a change in method of accounting

requiring the consent of the Commissioner under section 446(e) and

Sec. 1.446-1(e).

(2) Example. The provisions of paragraph (d)(1) of this section are

illustrated by the following example.

Example. (i) Corporation X, a calendar year taxpayer, is engaged

in the production of a single unit of designated property during

1995 (unit A). Corporation X adopts the taxable year as the

computation period and quarterly measurement dates. At each

measurement date (March 31, June 30, September 30, and December 31)

Corporation X has the following outstanding indebtedness:

Noninterest-bearing accounts payable traced to unit A........ $100,000

Noninterest-bearing accounts payable that are not traced to

unit A...................................................... $300,000

Interest-bearing loans that are eligible debt within the

meaning of paragraph (a)(4) of this section................. $900,000

(ii) Corporation X elects under this paragraph (d) not to trace

debt. Eligible debt at each measurement date for purposes of

calculating the weighted average interest rate under paragraph

(c)(5)(iii) of this section is $1,000,000 ($100,000 + $900,000).

(e) Election to use external rate--(1) In general. An eligible

taxpayer may elect to use the highest applicable Federal rate (AFR)

under section 1274(d) in effect during the computation period plus 3

percentage points (AFR plus 3) as a substitute for the weighted average

interest rate determined under paragraph (c)(5)(iii) of this section. A

taxpayer that makes this election may not trade debt. The use of the

AFR plus 3 as provided under this paragraph (e)(1) constitutes a method

of accounting. A taxpayer makes the election to use the AFR plus 3

method by using the AFR plus 3 as the taxpayer's weighted average

interest rate, and any change to the AFR plus 3 method by a taxpayer

that has never previously used the method does not require the consent

of the Commissioner. Any other change to or from the use of the AFR

plus 3 method under this paragraph (e)(1) (other than by reason of a

taxpayer ceasing to be an eligible taxpayer) is a change in method of

accounting requiring the consent of the Commissioner under section

446(e) and Sec. 1.446-1(e). All changes to or from the AFR plus 3

method are effected on a cut-off basis.

(2) Eligible taxpayer. A taxpayer is an eligible taxpayer for a

taxable year for purposes of this paragraph (e) if the average annual

gross receipts of the taxpayer for the three previous taxable years do

not exceed $10,000,000 (the $10,000,000 gross receipts test for all

prior taxable years beginning after December 31, 1994. For purposes of

this paragraph (e)(2), the principles of section 263A(b)(2)(B) and (C)

and Sec. 1.263A-3(b) apply in determining whether a taxpayer is an

eligible taxpayer for a taxable year.

(f) Selection of computation period and measurement dates and

application of averaging conventions.--(1) Computation period--(i) In

general. A taxpayer may (but is not required to) make the avoided cost

calculation on the basis of a full taxable year. If the taxpayer uses

the taxable year as the computation period, a single avoided cost

calculation is made for each unit of designated property for the entire

taxable year. If the taxpayer uses a computation period that is shorter

than the full taxable year, an avoided cost calculation is made for

each unit of designated property for each shorter computation period

within the taxable year. If the taxpayer uses a shorter computation

period, the computation period may not include portions of more than

one taxable year and, except as provided in the case of short taxable

years, each computation period within a taxable year must be the same

length. In the case of a short taxable year, a taxpayer may treat a

period shorter than the taxpayer's regular computation period as the

first or last computation period, or as the only computation period for

the year if the year is shorter than the taxpayer's regular computation

period. A taxpayer must use the same computation periods for all

designated property produced during a single taxable year.

(ii) Method of accounting. The choice of a computation period is a

method of accounting. Any change in the computation period is a change

in method of accounting requiring the consent of the Commissioner under

section 446(e) and Sec. 1.446-1(e).

(iii) Production period beginning or ending during the computation

period. The avoided cost method applies to the production of a unit of

designated property on the basis of a full computation period,

regardless of whether the production period for the unit of designated

property begins or ends during the computation period.

(2) Measurement dates--(i) In general. If a taxpayer uses the

taxable year as the computation period, measurement dates must occur at

quarterly or more frequent regular intervals. If the taxpayer uses

computation periods that are shorter than the taxable year, measurement

dates must occur at least twice during each computation period and at

least four times during the taxable year (or consecutive 12-month

period in the case of a short taxable year). The taxpayer must use the

same measurement dates for all designated property produced during a

computation period. Except in the case of a computation period that

differs from the taxpayer's regular computation period by reason of a

short taxable year (see paragraph (f)(1)(i) of this section),

measurement dates must occur at equal intervals during each computation

period that falls within a single taxable year. For any computation

period that differs from the taxpayer's regular computation period by

reason of a short taxable year, the measurement dates used by the

taxpayer during that period must be consistent with the principles and

purposes of section 263A(f). A taxpayer is permitted to modify the

frequency of measurement dates from year to year.

(ii) Measurement period. For purposes of this section, measurement

period means the period that begins on the first day following the

preceding measurement date and that ends on the measurement date.

(iii) Measurement dates on which accumulated production

expenditures must be taken into account. The first measurement date on

which accumulated production expenditures must be taken into account

with respect to a unit of designated property is the first measurement

date following the beginning of the production period for the unit of

designated property. The final measurement date on which accumulated

production expenditures with respect to a unit of designated property

must be taken into account is the first measurement date following the

end of the production period for the unit of designated property.

Accumulated production expenditures with respect to a unit of

designated property must also be taken into account on all intervening

measurement dates. See Sec. 1.263A-12 to determine when the production

period begins and ends.

(iv) More frequent measurement dates. When in the opinion of the

District Director more frequent measurement dates are necessary to

determine capitalized interest consistent with the principles and

purposes of section 263A(f) for a particular computation period, the

District Director may require the use of more frequent measurement

dates. If a significant segment of the taxpayer's production activities

(the first segment) requires more frequent measurement dates than

another significant segment of the taxpayer's production activities,

the taxpayer may request a ruling from the Internal Revenue Service

permitting, for a taxable year and all subsequent taxable years, a

segregation of the two segments and, notwithstanding paragraph

(f)(2)(i) of this section, the use of the more frequent measurement

dates for only the first segment. The request for a ruling must be made

in accordance with any applicable rules relating to submissions of

ruling requests. The request must be filed on or before the due date

(including extensions) of the original Federal income tax return for

the first taxable year to which it will apply.

(3) Examples. The following examples illustrate the principles of

this paragraph (f):

Example 1. Corporation X, a calendar year taxpayer, is engaged

in the production of designated property during 1995. Corporation X

adopts the taxable year as the computation period and quarterly

measurement dates. Corporation X must identify traced debt,

accumulated production expenditures, and nontraced debt at each

quarterly measurement date (March 31, June 30, September 30, and

December 31). Under paragraph (c)(5)(ii) of this section,

Corporation X must calculate average excess expenditures for each

unit of designated property by determining the amount by which

accumulated production expenditures exceed traced debt for each unit

at the end of each quarter and dividing the sum of these amounts by

four. Under paragraph (c)(5)(iii) (C) of this section, Corporation X

must calculate average nontraced debt by determining the amount of

nontraced debt outstanding at the end of each quarter and dividing

the sum of these amounts by four.

Example 2. Corporation X, a calendar year taxpayer, is engaged

in the production of designated property during 1995. Corporation X

adopts a 6-month computation period with two measurement dates

within each computation period. Corporation X must identify traced

debt, accumulated production expenditures, and nontraced debt at

each measurement date (March 31 and June 30 for the first

computation period and September 30 and December 31 for the second

computation period). Under paragraph (c)(5)(ii) of this section,

Corporation X must, for each computation period, calculate average

excess expenditures for each unit of designated property by

determining the amount by which accumulated production expenditures

exceed traced debt for each unit at each measurement date during the

period and dividing the sum of these amounts by two. Under paragraph

(c)(5)(iii)(C) of this section, Corporation X must calculate average

nontraced debt for each computation period by determining the amount

of nontraced debt outstanding at each measurement date during the

period and dividing the sum of these amounts by two.

Example 3. (i) Corporation X, a calendar year taxpayer, is

engaged in the production of two units of designated property during

1995. Production of Unit A starts in 1994 and ends on June 20, 1995.

Production of Unit B starts on April 15, 1995, but does not end

until 1996. Corporation X adopts the taxable year as its computation

period and does not elect under paragraph (d) of this section not to

trace debt. Corporation X uses quarterly measurement dates and pays

all interest on eligible debt in the quarter in which the interest

is incurred. During 1995, Corporation X has two items of eligible

debt. The debt and the manner in which it is used are as follows:

------------------------------------------------------------------------

Annual

No. Principal rate Period Use of proceeds

(percent) outstanding

------------------------------------------------------------------------

1......... $1,000,000 9 1/01-9/01 Unit A.

2......... 2,000,000 11 6/01-12/31 Nontrace.

------------------------------------------------------------------------

(ii) Based on the annual 9 percent rate of interest, Corporation

X incurs $7,500 of interest during each month that Loan #1 is

outstanding.

(iii) Accumulated production expenditures at the end of each

quarter during 1995 are as follows:

------------------------------------------------------------------------

Measurement date Unit A Unit B

------------------------------------------------------------------------

March 31................................ $1,200,000 $0

June 30................................. 1,800,000 500,000

Sept. 30................................ 0 1,000,000

Dec. 31................................. 0 1,600,000

------------------------------------------------------------------------

(iv) Corporation X must first determine the amount of interest

incurred on traced debt and capitalize the interest incurred on this

debt (the traced debt amount). Loan #1 is allocated to Unit A on the

March 31 and June 30 measurement dates. Accordingly, Loan #1 is

treated as traced debt with respect to unit A for the measurement

periods beginning January 1 and ending June 30. The interest

incurred on Loan #1 during the period that Loan #1 is treated as

traced debt must be capitalized with respect to Unit A. Thus,

$45,000 ($7,500 per month for 6 months) is capitalized with respect

to Unit A.

(v) Second, Corporation X must determine average excess

expenditures for Unit A and Unit B. For Unit A, this amount is

$250,000 ([$200,000 + $800,000 + $0 +$0] 4). For Unit B,

this amount is $775,000 ([$0 + $500,000 + $1,000,000 + $1,600,000

4).

(vi) Third, Corporation X must determine the weighted average

interest rate and apply that rate to the average excess expenditures

for Units A and B. The rate is equal to the total amount of interest

incurred on nontraced debt (i.e., interest incurred on all eligible

debt reduced by interest incurred on traced debt) divided by the

average nontraced debt. The interest incurred on nontraced debt

equals $143,333 ([$1,000,000 x 9% x \8/12\] + [$2,000,000 x

11% x \7/12\] - $45,000). The average nontraced debt equals

$1,500,000 ([$0 + $2,000,000 + $2,000,000 + $2,000,000] 4).

The weighted average interest rate of 9.56 percent ($143,333 '

$1,500,000), is then applied to average excess expenditures for

Units A and B. Accordingly, Corporation X capitalizes an additional

$23,900 ($250,000 x 9.56%) with respect to Unit A and $74,090

($775,000 x 9.56%) with respect to Unit B (the excess expenditure

amounts).

(g) Special rules--(1) Ordering rules--(i) Provisions preempted by

section 263A(f). Interest must be capitalized under section 263A(f)

before the application of section 163(d) (regarding the investment

interest limitation), section 163(j) (regarding the limitation on

interest paid to a tax-exempt related person), section 266 (regarding

the election to capitalize carrying charges), section 469 (regarding

the limitation on passive losses), and section 861 (regarding the

allocation of interest to United States sources). Any interest that is

capitalized under section 263A(f) is not taken into account as interest

under those sections. However, in applying section 263A(f) with respect

to the excess expenditure amount, the taxpayer must capitalize all

interest that is neither investment interest under section 163(d),

exempt related person interest under section 163(j), nor passive

interest under section 469 before capitalizing any interest that is

either investment interest, exempt related person interest, or passive

interest. Any interest that is not required to be capitalized after the

application of section 263A(f) is then taken into account as interest

subject to sections 163(d), 163(j), 266, 469, and 861. If, after the

application of section 263A(f), interest is deferred under sections

163(d), 163(j), 266, or 469, that interest is not subject to

capitalization under section 263A(f) in any subsequent taxable year.

(ii) Deferral provisions applied before this section. Interest

(including contingent interest) that is subject to a deferral provision

described in this paragraph (g)(1)(ii) is subject to capitalization

under section 263A(f) only in the taxable year in which it would be

deducted if section 263A(f) did not apply. Deferral provisions include

sections 163(e)(3), 267, 446, and 461, and all other deferral or

limitation provisions that are not described in paragraph (g)(1)(i) of

this section. In contrast to the provisions of paragraph (g)(1)(i) of

this section, deferral provisions are applied before the application of

section 263A(f).

(2) Application of section 263A(f) to deferred interest--(i) In

general. This paragraph (g)(2) describes the time and manner of

capitalizing and recovering the deferral amount. The deferral amount

for any computation period equals the sum of--

(A) The amount of interest that is incurred on traced debt that is

deferred during the computation period and is not deductible for the

taxable year that includes the computation period because of a deferral

provision described in paragraph (g)(1)(ii) of this section, and

(B) The shortfall amount described in paragraph (c)(4) of this

section.

(ii) Capitalization of deferral amount. The rules described in

paragraph (g)(2)(iii) of this section apply to the deferral amount

unless the taxpayer elects under paragraph (g)(2)(iv) of this section

to capitalize substitute costs.

(iii) Deferred capitalization. If the taxpayer does not elect under

paragraph (g)(2)(iv) of this section to capitalize substitute costs,

deferred interest to which the deferral amount is attributable

(determined under any reasonable method) is capitalized in the year or

years in which the deferred interest would have been deductible but for

the application of section 263A(f) (the capitalization year). For this

purpose, any interest that is deferred from a prior computation period

is taken into account in subsequent capitalization years in the same

order in which the interest was deferred. If a unit of designated

property to which previously deferred interest relates is sold before

the capitalization year, the deferred interest applicable to that unit

of property is taken into account in the capitalization year and

treated as if recovered from the sale of the property. If the taxpayer

continues to hold, throughout the capitalization year, a unit of

depreciable property to which previously deferred interest relates, the

adjusted basis and applicable recovery percentages for the unit of

property are redetermined for the capitalization year and subsequent

years so that the increase in basis is accounted for over the remaining

recovery periods beginning with the capitalization year. See Example 2

of paragraph (g)(2)(v) of this section.

(iv) Substitute capitalization--(A) General rule. In lieu of

deferred capitalization under paragraph (g)(2)(iii) of this section,

the taxpayer may elect the substitute capitalization method described

in this paragraph (g)(2)(iv). Under this method, the taxpayer

capitalizes for the computation period in which interest is incurred

and deferred (the deferral period) costs that would be deducted but for

this paragraph (g)(2)(iv) (substitute costs). The taxpayer must

capitalize an amount of substitute costs equal to the deferral amount

for each unit of designated property, or if less, a prorata amount

(determined in accordance with the principles of paragraph (c)(7)(i) of

this section) of the total substitute costs that would be deducted but

for this paragraph (g)(2)(iv) during the deferral period. If the entire

deferral amount is capitalized pursuant to this paragraph (g)(2)(iv) in

the deferral period, any interest incurred and deferred in the deferral

period is neither capitalized nor deducted during the deferral period

and, unless subsequently capitalized as a substitute cost under this

paragraph (g)(2)(iv), is deductible in the appropriate subsequent

period without regard to section 263A(f).

(B) Capitalization of amount carried forward. If the taxpayer has

an insufficient amount of substitute costs in the deferral period, the

amount by which substitute costs are insufficient with respect to each

unit of designated property is a deferral amount carryforward to

succeeding computation periods beginning with the next computation

period. In any carryforward year, the taxpayer must capitalize an

amount of substitute costs equal to the deferral amount carryforward

or, if less, a prorata amount (determined in accordance with the

principles of paragraph (c)(7)(i) of this section) of the total

substitute costs that would be deducted during the carryforward year or

years (the carryforward capitalization year) but for this paragraph

(g)(2)(iv) (after applying the substitute cost method of this paragraph

(g)(2)(iv) to the production of designated property in the carryforward

period). If a unit of designated property to which the deferral amount

carryforward relates is sold prior to the carryforward capitalization

year, substitute costs applicable to that unit of property are taken

into account in the carryforward capitalization year and treated as if

recovered from the sale of the property. If the taxpayer continues to

hold, throughout the capitalization year, a unit of depreciable

property to which a deferral amount carryforward relates, the adjusted

basis and applicable recovery percentages for the unit of property are

redetermined for the carryforward capitalization year and subsequent

years so that the increase in basis is accounted for over the remaining

recovery periods beginning with the carryforward capitalization year.

See Example 2 of paragraph (g)(2)(v) of this section.

under this paragraph (g)(2)(iv) is a method of accounting that applies

to all designated property of the taxpayer. A change to or from the

substitute capitalization method is a change in method of accounting

requiring the consent of the Commissioner under section 446(e) and

Sec. 1.446-1(e).

(v) Examples. The following examples illustrate the application of

the avoided cost method when interest is subject to a deferral

provisions:

Example 1. (i) Corporation X is a calendar year taxpayer and

uses the taxable year as it computation period. During 1995, X is

engaged in the construction of a warehouse which X will use in its

storage business. The warehouse is completed and placed in service

in December 1995. X's average excess expenditures for 1995 equal

$1,000,000. Throughout 1995, X's only outstanding debt is nontraced

debt of $900,000 and $1,200,000, bearing interest at 15 percent and

9 percent, respectively, per year. Of the $243,000 interest incurred

during the year ([$900,000 x 15%] + [$1,200,000 x 9%] =

[$135,000 x $108,000]), $75,000 is deferred under section 267(a)(2).

(ii) X must first determine the amount of interest required to

be capitalized under paragraph (c)(1) of this section for 1995 (the

deferral period) without applying section 267(a)(2). The weighted

average interest rate is 11.6 percent ([$135,000 x $108,000]

$2,100,000), and the excess expenditure amount under paragraph

(c)(1) of this section is $116,000 ($1,000,000 x 11.6%). Under

paragraph (c)(4) of this section, X must then determine the amount

of interest that would be capitalized by applying paragraph (c)(2)

of this section without regard to the amount of deferred interest.

Disregarding deferred interest, the amount of interest available for

capitalization is $168,000 ([$900,000 x 15%] + [$1,200,000 x 9%]-

$75,000). Thus, the full excess expenditure amount ($116,000) is

capitalized from interest that is not deferred under section

267(a)(2) and there is no shortfall amount.

Example 2. (i) The facts are the same as in Example 1, except

that $140,000 of interest is deferred under section 267 (a)(2) in

1995. The taxpayer does not elect to use the substitute

capitalization method. This interest is also deferred in 1996 but

would be deducted in 1997 if section 263A(f) did not apply. As in

Example 1, the excess expenditure amount is $116,000. However, the

amount of interest available for capitalization after excluding the

amount of deferred interest is $103,000 ([$900,000 x 15%] +

[$1,200,000 x 9%]- $140,000). Thus, only $103,000 of interest is

capitalized with respect to the warehouse in 1995. Since $116,000 of

interest would be capitalized if section 267(a)(2) did not apply,

the deferral amount determined under paragraphs (c)(2) and (g)(2)(i)

of this section is $13,000 ($116,000 -$103,000), and $13,000 of

deferred interest must be capitalized in the year in which it would

be deducted if section 263A(f) did not apply.

(ii) The $140,000 of interest deferred under section 267(a)(2)

in 1995 would be deducted in 1997 if section 263A(f) did not apply.

X is therefore required to capitalize an additional $13,000 of

interest with respect to the warehouse in 1997 and must redetermine

its basis and recovery percentage.

(3) Simplified inventory method--(i) In general. This paragraph

(g)(3) provides a simplified method of capitalizing interest expense

with respect to designated property that is inventory. Under this

method, the taxpayer determines beginning and ending inventory and cost

of goods sold applying all other capitalization provisions, including,

for example, the simplified production method of Sec. 1.263A-2(b), but

without regard to the capitalization of interest with respect to

inventory. The taxpayer must establish a separate capital asset,

however, in an amount equal to the aggregate interest capitalization

amount (as defined in paragraph (g)(3)(iii)(C) of this section). Under

the simplified inventory method, increases in the aggregate interest

capitalization amount from one year to the next generally are treated

as reductions in interest expense, and decreases in the aggregate

interest capitalization amount from one year to the next are treated as

increases to cost of goods sold.

(ii) Segmentation of inventory--(A) General rule. Under the

simplified inventory method, the taxpayer first separates its total

ending inventory value into segments that are equal to the total ending

inventory value divided by the inverse inventory turnover rate. Each

inventory segment is then assigned an age starting with one year and

increasing by one year for each additional segment. The inverse

inventory turnover rate is determined by finding the average of

beginning and ending inventory, dividing the average by the cost of

goods sold for the year, and rounding the result to the nearest whole

number. Beginning and ending inventory amounts are determined using

total current cost of inventory for the year (rather than carrying

value). Cost of goods sold, however, may be determined using either

total current cost or the taxpayer's inventory method. In addition, for

purposes of this paragraph (g)(3)(ii), current costs for a year (and,

if applicable, the cost of goods sold for the year under the taxpayer's

inventory method) are determined without regard to the capitalization

of interest with respect to inventory.

(B) Example. The provisions of paragraph (g)(3)(ii)(A) of this

section are illustrated by the following example.

Example. X, a taxpayer using the FIFO inventory method,

determines that total cost of goods sold for 1995 equals $900, and

the cost of both beginning and ending inventory equals $3,000. Thus,

X's inverse inventory turnover rate equals 3 (3.33 rounded to the

nearest whole number). Total ending inventory of $3,000 is divided

into three segments of $1,000 each. One segment is treated as 3-

year-old inventory, one segment is treated as 2-year-old inventory,

and one segment is treated as 1-year-old inventory.

(iii) Aggregate interest capitalization amount--(A) Computation

period and weighted average interest rate. If a taxpayer elects the

simplified inventory method, the taxpayer must use the taxable year as

its computation period and use the weighted average interest rate

determined under this paragraph (g)(3)(iii)(A) in determining the

aggregate interest capitalization amount defined in paragraph

(g)(3)(iii)(C) of this section and in determining the amount of

interest capitalized with respect to any designated property that is

not inventory. Under the simplified inventory method, the taxpayer

determines the weighted average interest rate in accordance with

paragraph (c)(5)(iii) of this section, treating all eligible debt

(other than debt traced to noninventory property in the case of a

taxpayer tracing debt) as nontraced debt (i.e., without tracing debt to

inventory). A taxpayer that has elected under paragraph (e) of this

section to use an external rate as a substitute for the weighted

average interest rate determined under paragraph (c)(5)(iii) of this

section uses the rate described in paragraph (e)(1) as the weighted

average interest rate.

(B) Computation of the tentative aggregate interest capitalization

amount. The weighted average interest rate is compounded annually by

the number of years assigned to a particular inventory segment to

produce an interest factor (applicable interest factor) for that

segment. The amounts determined by multiplying the value of each

inventory segment by its applicable interest factor are then combined

to produce a tentative aggregate interest capitalization amount.

(1) In general. If the tentative aggregate interest capitalization

amount for a year exceeds the aggregate interest capitalization amount

(defined in paragraph (g)(3)(iii)(D) of this section) as of the close

of the preceding year, then, for purposes of applying the rules of

paragraph (c)(7) of this section, the excess is treated as an excess

expenditure amount and the inventory to which the simplified inventory

method of this paragraph (g)(3) applies is treated as a single unit of

designated property. If, after these modifications, no paragraph (c)(7)

interest allocation is necessary (i.e., the excess expenditure amounts

for all units of designated property do not exceed the total amount of

interest (including deferred interest) available for capitalization),

the aggregate interest capitalization amount generally equals the

tentative aggregate interest capitalization amount. If, on the other

hand, a paragraph (c)(7) allocation is necessary, the tentative

aggregate interest capitalization amount is generally adjusted to

reflect the results of that allocation (i.e., the increase in the

aggregate interest capitalization amount is limited to the amount of

interest allocated to inventory, reduced, however, by any substitute

costs that are capitalized with respect to inventory under applicable

related party rules).

(2) Deferred interest. In determining the aggregate interest

capitalization amount, the tentative aggregate interest capitalization

amount is adjusted (after the application of paragraph (c)(7) of this

section) as appropriate to reflect the deferred interest rules of

paragraph (g)(2) of this section. The tentative aggregate interest

capitalization amount would be reduced, for example, by the amount of a

taxpayer's deferred interest for a taxable year unless the taxpayer has

elected the substitute capitalization method under paragraph

(g)(2)(iv).

(3) Other coordinating provisions. The Commissioner may prescribe,

by revenue ruling or revenue procedure, additional provisions to

coordinate the election and use of the simplified inventory method with

other interest capitalization requirements and methods. See

Sec. 601.601(d)(2)(ii)(b) of this chapter.

(D) Treatment of increases or decreases in the aggregate interest

capitalization amount. Except as otherwise provided in this paragraph

(g)(3)(iii)(D), increases in the aggregate interest capitalization

amount from one year to the next are treated as reductions in interest

expense, and decreases in the aggregate interest capitalization amount

from one year to the next are treated as increases to cost of goods

sold. To the extent a taxpayer capitalizes substitute costs under

either applicable related party rules or the deferred interest rules in

paragraph (g)(2) of this section, increases in the aggregate interest

capitalization amount are treated as reductions in applicable

substitute costs, rather than interest expense.

(E) Example. The provisions of this paragraph (g)(3)(iii) are

illustrated by the following example.

Example. The facts are the same as in the example in paragraph

(g)(3)(ii)(B) of this section, and, in addition, X determines that

its weighted average interest rate for 1995 is 10 percent.

Additionally, assume that X has no deferred interest in 1995 or 1996

and no deferral amount carryforward to either 1995 or 1996. (See

paragraph (g)(2) of this section.) Also assume that no allocation is

necessary under paragraph (c)(7) of this section in either 1995 or

1996. Under the rules of paragraph (g)(3)(ii) of this section, S

divides ending inventory into segments of $1,000 each. One segment

is 1-year old inventory, one segment is 2-year old inventory, and

one segment is 3-year inventory. Under paragraph (g)(3)(iii)(B) of

this section, X must compute the applicable interest factor for each

segment. The applicable interest factor for the 1-year old inventory

is not compounded. The applicable interest factor for the 2-year old

inventory is compounded for 1 year. The applicable interest factor

for the 3-year old inventory is compounded for 2 years. The interest

factor applied to the 1-year old inventory segment is .1. The

interest factor applied to the 2-year old inventory segment is .21

[(1.1 x 1.1)-1]. The interest factor applied to the 3-year old

inventory is .331 [(1.1 x 1.1 x 1.1)-1]. Thus, the tentative

aggregate interest capitalization amount for 1995 is $641 (1,000 x

[.1 + .21 + .331]). Because X has no deferred interest in 1995, no

deferral amount carryforward to 1995, and no required allocation

under paragraph (c)(7) of this section in 1995, X's aggregate

interest capitalization amount equals its $641 tentative aggregate

interest capitalization amount. If, in 1996, X computes an aggregate

interest capitalization amount of $750, the $109 increase in the

amount from 1995 to 1996 would be treated as a reduction in interest

expense for 1996.

(iv) Method of accounting. The simplified inventory method is a

method of accounting that must be elected for and applied to all

inventory within a single trade or business of the taxpayer (within

the meaning of section 446(d) and Sec. 1.446-1(d)). This method may

be elected only if the inventory in that trade or business consists

only of designated property and only if the taxpayer's inverse

inventory turnover rate for that trade or business (as defined in

paragraph (g)(3)(ii)(A) of this section) is greater than or equal to

one. A change from or to the simplified inventory method is a change

in method of accounting requiring the consent of the Commissioner

under section 446(e) and Sec. 1.446-(1)(e).

(4) Financial accounting method disregarded. The avoided cost

method is applied under this section without regard to any financial or

regulatory accounting principles for the capitalization of interest.

For example, this section determines the amount of interest that must

be capitalized without regard to Financial Accounting Standards Board

(FASB) Statement Nos. 34, 71, and 90, issued by the Financial

Accounting Standards Board, Norwalk, CT 06856-5116. Similarly,

taxpayers are not permitted to net interest income and interest expense

in determining the amount of interest that must be capitalized under

this section with respect to certain restricted tax-exempt borrowings

even though netting is permitted under FASB Statement No. 62.

(5) Treatment of intercompany transactions--(i) General rule. If

interest capitalized under section 263A(f) by a member of a

consolidated group (within the meaning of Sec. 1.1502-1(h)) with

respect to a unit of designated property is attributable to a loan from

another member of the group (the lending member), the intercompany

transaction provisions of the consolidated return regulations do not

apply to the lending member's interest income with respect to that

loan, except as provided in paragraph (g)(5)(ii) of this section. For

this purpose, the capitalized interest expense that is attributable to

a loan from another member is determined under any method that

reasonably reflects the principles of the avoided cost method,

including the traced and nontraced concepts. For purposes of this

paragraph (g)(5)(i) and paragraph (g)(5)(ii) of this section, in order

for a method to be considered reasonable it must be consistently

applied.

(ii) Special rule for consolidated group with limited outside

borrowing. If, for any year, the aggregate amount of interest income

described in paragraph (g)(5)(i) of this section for all members of the

group with respect to all units of designated property exceeds the

total amount of interest that is deductible for that year by all

members of the group with respect to debt of a member owed to

nonmembers (group deductible interest) after applying section 263A(f),

the intercompany transaction provisions of the consolidated return

regulations are applied to the excess, and the amount of interest

income that must be taken into account by the group under paragraph

(g)(5)(i) of this section is limited to the amount of the group

deductible interest. The amount to which the intercompany transaction

provisions of the consolidated return regulations apply by reason of

this paragraph (g)(5)(ii) is allocated among the lending members under

any method that reasonably reflects each member's share of interest

income described in paragraph (g)(5)(i) of this section. If a lending

member has interest income that is attributable to more than one unit

of designated property, the amount to which the intercompany

transaction provisions of the consolidated return regulations apply by

reason of this paragraph (g)(5)(ii) with respect to the member is

allocated among the units in accordance with the principles of

paragraph (c)(7)(i) of this section.

(iii) Example. The provisions of paragraph (g)(5)(ii) of this

section are illustrated by the following example.

Example. (i) P and S1 are the members of a consolidated group.

In 1995, S1 begins and completes the construction of a shopping

center and is required to capitalize interest with respect to the

construction. S1's average excess expenditures for 1995 are

$5,000,000. Throughout 1995, S1's only borrowings include a

$6,000,000 loan from P bearing interest at an annual rate of 10

percent ($600,000 per year). Under the avoided cost method, S1 is

required to capitalize interest in the amount of $500,000

([$600,000$6,000,000] x 5,000,000).

(ii) P's only borrowing from unrelated lenders is a $2,000,000

loan bearing interest at an annual rate of 10 percent ($200,000 per

year). Under the principles of paragraph (g)(5)(ii) of this section,

because the aggregate amount of interest described in paragraph

(g)(5)(i) of this section ($500,000) exceeds the aggregate amount of

currently deductible interest of the group ($200,000), the

intercompany transaction provisions of the consolidated return

regulations apply to the excess of $300,000 and the amount of P's

interest income that is subject to current inclusion by reason of

paragraph (g)(5)(i) of this section is limited to $200,000.

(6) Notional principal contracts and other derivatives.

[Reserved]

(7) 15-day repayment rule. A taxpayer may elect to treat any

eligible debt that is repaid within the 15-day period immediately

preceding a quarterly measurement date as outstanding as of that

measurement date for purposes of determining traced debt, average

nontraced debt, and the weighted average interest rate. This election

may be made or discontinued for any computation period and is not a

method of accounting.

Sec. 1.263-10 Unit of property.

(a) In general. The unit of property as defined in this section is

used as the basis to determine accumulated production expenditures

under Sec. 1.263A-11 and the beginning and end of the production period

under Sec. 1.263A-12. Whether property is 1-year or 2-year property

under Sec. 1.263A-8(b)(1)(ii) is also determined separately with

respect to each unit of property as defined in this section.

(b) Units of real property--(1) In general. A unit of real property

includes any components of real property owned by the taxpayer or a

related person that are functionally interdependent and an allocable

share of any common feature owned by the taxpayer or a related person

that is real property even though the common feature does not meet the

functional interdependence test. When the production period begins with

respect to any functionally interdependent component or any common

feature of the unit of real property, the production period has begun

for the entire unit of real property. See, however, paragraph (b)(5) of

this section for rules under which the costs of a common feature or

benefitted property are excluded from accumulated production

expenditures for one or more measurement dates. The portion of land

included in a unit of real property includes land on which real

property (including a common feature) included in the unit is situated,

land subject to setback restrictions with respect to such property, and

any other contiguous portion of the tract of land other than land that

the taxpayer holds for a purpose unrelated to the unit being produced

(e.g., investment purposes, personal use purposes, or specified future

development as a separate unit of real property).

(2) Functional interdependence. Components of real property

produced by, or for, the taxpayer, for use by the taxpayer or a related

person are functionally interdependent if the placing in service of one

component is dependent on the placing in service of the other component

by the taxpayer or a related person. In the case of property produced

for sale, components of real property are functionally interdependent

if they are customarily sold as a single unit. For example, the real

property components of a single-family house (e.g., the land,

foundation, and walls) are functionally interdependent. In contrast,

components of real property that are expected to be separately placed

in service or held for resale are not functionally interdependent.

Thus, dwelling units within a multi-unit building that are separately

placed in service or sold (within the meaning of Sec. 1.263A-12(d)(1))

are treated as functionally independent of any other units, even though

the units are located in the same building.

(3) Common features. For purposes of this section, a common feature

generally includes any real property (as defined in Sec. 1.263A-8(c))

that benefits real property produced by, or for, the taxpayer or a

related person, and that is not separately held for the production of

income. A common feature need not be physically contiguous to the real

property that it benefits. Examples of common features include streets,

sidewalks, playgrounds, clubhouses, tennis courts, sewer lines, and

cables that are not held for the production of income separately from

the units of real property that they benefit.

(4) Allocation of costs to unit. Except as provided in paragraph

(b)(5) of this section, the accumulated production expenditures for a

unit of real property include, in all cases, the costs that directly

benefit, or are incurred by reason of the production of, the unit of

real property. Accumulated production expenditures also include the

adjusted basis of property used to produce the unit of real property.

The accumulated costs of a common feature or land that benefits more

than one unit of real property, or that benefits designated property

and property other than designated property, is apportioned among the

units of designated property, or among the designated property and

property other than designated property, in determining accumulated

production expenditures. The apportionment of the accumulated costs of

the common feature (allocable share) or land (attributable land costs)

generally may be made using any method that is applied on a consistent

basis and that reasonably reflects the benefits provided. For example,

an apportionment based on relative costs to be incurred, relative space

to be occupied, or relative fair market values may be reasonable.

(5) Treatment of costs when a common feature is included in a unit

of real property--(i) General rule. Except as provided in this

paragraph (b)(5), the accumulated production expenditures of a unit of

real property include the costs of functionally interdependent

components (benefitted property) and an allocable share of the cost of

common features throughout the entire production period of the unit.

See Sec. 1.263A-12, relating to the production period of a unit of

property.

(ii) Production activity not undertaken on benefitted property--(A)

Direct production activity not undertaken--(1) In general. The costs of

land attributable to a benefitted property may be treated as not

included in accumulated production expenditures for a unit of real

property for measurement dates prior to the first date a production

activity (direct production activity), including the clearing and

grading of land, has been undertaken with respect to the land

attributable to the benefitted property. Thus, the costs of land

attributable to a benefitted property (as opposed to land attributable

to the common features) with respect to which no direct production

activities have been undertaken may be treated as not included in the

accumulated production expenditures of a unit of real property even

though a production activity has begun on a common feature allocable to

the unit.

(2) Land attributable to a benefitted property. For purposes of

this paragraph (b)(5)(ii), land attributable to a benefitted property

includes all land in the unit of real property that includes the

benefitted property other than land for a common feature. (Thus, land

attributable to a benefitted property does not include land

attributable to a common feature.)

(B) Suspension of direct production activity after clearing and

grading undertaken--(1) General rule. This paragraph (b)(5)(ii)(B) may

be used to determine the accumulated production expenditures for a unit

of real property, if the only production activity with respect to a

benefitted property has been clearing and grading and no further direct

production activity is undertaken with respect to the benefitted

property for at least 120 consecutive days (i.e., direct production

activity has ceased). Under this paragraph (b)(5)(ii)(B), the

accumulated production expenditures attributable to a benefitted

property qualifying under this paragraph (b)(5)(ii)(B) may be excluded

from the accumulated production expenditures of the unit of real

property even though production continues on a common feature allocable

to the unit. For purposes of this paragraph (b)(5)(ii)(B), production

activity is considered to occur during any time which would not qualify

as a cessation of production activities under the suspension period

rules of Sec. 1.263A-12(g).

(2) Accumulated production expenditures. If this paragraph

(b)(5)(ii)(B) applies, accumulated production expenditures attributable

to the benefitted property of the unit of real property may be treated

as not included in the accumulated production expenditures for the unit

starting with the first measurement period beginning after the first

day of the 120 consecutive day period, but must be included in the

accumulated production expenditures for the unit beginning in the

measurement period in which direct production activity has resumed on

the benefitted property. Accumulated production expenditures with

respect to common features allocable to the unit of real property may

not be excluded under this paragraph (b)(5)(ii)(B).

(iii) Common feature placed in service before the end of production

of a benefitted property. To the extent that a common feature with

respect to which all production activities to be undertaken by, or for,

a taxpayer or a related person are completed is placed in service

before the end of the production period of a unit that includes an

allocable share of the costs of the common feature, the costs of the

common feature are not treated as included in accumulated production

expenditures of the unit for measurement periods beginning after the

date the common feature is placed in service.

(iv) Benefitted property sold before production completed on common

feature. If a unit of real property is sold before common features

included in the unit are completed, the production period of the unit

ends on the date of sale. Thus, common feature costs actually incurred

and properly allocable to the unit as of the date of sale are excluded

from accumulated production expenditures for measurement period

beginning after the date of sale. Common feature costs properly

allocable to the unit and actually incurred after the sale are not

taken into account in determining accumulated production expenditures.

(v) Benefitted property placed in service before production

completed on common feature. Where production activities remain to be

undertaken on a common feature allocable to a unit of real property

that includes benefitted property, the costs of the benefitted property

are not treated as included in the accumulated production expenditures

for the unit for measuremen

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