Special Rules Regarding the Simplified Production and Resale Methods with Historic Absorption Ratio Election

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-113910-98]

RIN 1545-AW54

Special Rules Regarding the Simplified Production and Resale

Methods with Historic Absorption Ratio Election

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations under section 263A

that relate to accounting for costs incurred in producing property and

acquiring property for resale. The proposed regulations are necessary

to address specific problems in the current section 263A regulations

and affect persons who elect to use the simplified production or resale

methods with historic absorption ratio election. This document also

provides notice of a public hearing on these proposed regulations.

DATES: Written and electronic comments must be received by August 23,

1999. Outlines of topics to be discussed at the public hearing

scheduled for September 1, 1999, at 10 a.m., must be received by August

11, 1999.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-113910-98), room

5226, Internal Revenue Service, POB 7604, Ben Franklin Station,

Washington, DC 20044. Submissions may be hand delivered Monday through

Friday between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-

113910-98), Courier's Desk, Internal Revenue Service, 1111 Constitution

Avenue, NW., Washington, DC. Alternatively, taxpayers may submit

comments electronically via the Internet by selecting the ``Tax Regs''

option on the IRS Home Page, or by submitting comments directly to the

IRS Internet site at http://www.irs.ustreas.gov/tax__regs/

regslist.html. The public hearing will be held in room 2615, Internal

Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Jennifer

Nuding, (202) 622-4970; concerning submissions of comments, the

hearing, and/or to be placed on the building access list to attend the

hearing, LaNita Van Dyke at (202) 622-7180 (not toll-free calls).

SUPPLEMENTARY INFORMATION:

Background

Section 263A provides uniform rules for capitalization of certain

expenses. Section 263A requires the capitalization of the direct, and

an allocable portion of the indirect, costs of real or tangible

personal property produced by a taxpayer or real and personal property

described in section 1221(1) that is acquired by the taxpayer for

resale. The rules under section 263A, which were added by the Tax

Reform Act of 1986, Public Law 99-514, section 803, 100 Stat. 2085,

2350, were designed, in part, to properly match income with related

expenses and, thus, more accurately reflect income. They also were

intended to make the tax system more neutral by eliminating the

differences in capitalization rules that created distortions in the

allocation of economic resources and the manner in which certain

economic activity was organized. See S. Rep. No. 313, 99th Cong., 2d

Sess. 140 (1986), 1986-3 C.B. Vol. 3 140. However, the legislative

history provides authority to the Secretary to prescribe simplifying

methods and assumptions where the costs and other burdens of literal

compliance with section 263A may outweigh the benefits of the provision

(e.g., matching and neutrality). S. Rep. No. 313, 99th Cong., 2d Sess.

142 (1986).

Section 263A costs are the costs that a taxpayer must capitalize

under section 263A and equal the sum of a taxpayer's section 471 costs,

its additional section 263A costs, and interest capitalizable under

section 263A(f). Additional section 263A costs are the costs, other

than interest, that were not capitalized under the taxpayer's method of

accounting immediately prior to the effective date of section 263A, but

that are required to be capitalized under section 263A.

Sections 1.263A-1 through 1.263A-3 of the final regulations (T.D.

8482) were published in the Federal Register for August 9, 1993 (58 FR

42207) and amended by T.D. 8559 (59 FR 39958), T.D. 8584 (59 FR 67187),

T.D. 8597 (60 FR 36671), T.D. 8728 (62 FR 42051) and T.D. 8729 (62 FR

44542). The final regulations provide simplified methods for

determining the additional section 263A costs properly allocable to

eligible property on hand at the end of the taxable year, including

ending inventories of property produced and property acquired for

resale. The final regulations include the simplified production method

contained in the temporary regulations issued under 263A, Sec. 1.263A-

1T(b)(5), T.D. 8131 (58 FR 151), and the simplified resale method, a

redesignation of the modified resale method set forth in Notice 89-67,

1989-1 C.B. 723. A taxpayer using either the simplified production

method or the simplified resale method determines the additional

section 263A costs properly allocable to eligible property on hand at

the end of the taxable year by multiplying its absorption ratio by the

section 471 costs on hand at year-end. Under both the simplified

production method and the simplified resale method, an absorption ratio

is calculated annually and applied to determine the additional section

263A costs allocated to ending inventory.

In response to requests for additional simplification, the final

regulations provide an election to use an historic absorption ratio to

determine additional section 263A costs allocable to eligible property

on hand at year-end that may be used in connection with either the

simplified production method or the simplified resale method.

The final regulations permit a taxpayer that properly elects to use

the historic absorption ratio to determine the additional section 263A

costs allocable to eligible property on hand at the end of the taxable

year by using an historic absorption ratio in lieu of an

[[Page 27937]]

actual absorption ratio, i.e., by multiplying the historic absorption

ratio by section 471 costs on hand at year-end. The historic absorption

ratio is based on costs capitalized by a taxpayer during its test

period, generally the three taxable-year period immediately prior to

the taxable year that the taxpayer elects the historic absorption

ratio. The historic absorption ratio equals the taxpayer's additional

section 263A costs incurred during the test period divided by the

section 471 costs incurred by the taxpayer during the test period.

Under the final regulations, taxpayers are required to test the

accuracy of the historic absorption ratio every six years. If the test

of the ratio indicates more than one-half of one percentage point

difference (plus or minus) from the historic absorption ratio, the

taxpayer must redetermine its historic absorption ratio using a new

updated test period. The final regulations provide that, if elected,

the historic absorption ratio must be used for each taxable year within

the qualifying period. Generally, the qualifying period includes each

of the first five taxable years beginning with the first taxable year

after a test period (or an updated test period).

Explanation of Provisions

This document contains proposed amendments to the Income Tax

Regulations (26 CFR part 1) that relate to the capitalization of

certain costs under section 263A. More specifically, this document

contains proposed amendments with respect to the historic absorption

ratio election that are necessary to carry out the purpose of section

263A. The rules under section 263A were designed to properly match

income with related expenses by requiring all of the costs relating to

an item produced or acquired for resale to be included in the basis or

inventoriable cost of that item. The simplified production method and

the simplified resale method were included in the regulations to

provide taxpayers with a simplified method for determining the

additional section 263A costs allocable to items on hand at year end.

The historic absorption ratio election was provided in response to

commentators' concerns that computations under the simplified

production method and the simplified resale method are costly and time

consuming because taxpayers must determine absorption ratios annually,

even though there may have been little or no change in the taxpayers'

business operations that would cause the absorption ratios to vary from

year to year.

The historic absorption ratio election in the final regulations is

intended to permit taxpayers to determine additional section 263A costs

allocable to items on hand at year-end without calculating actual

absorption ratios while still capitalizing the costs properly allocable

to property produced or acquired for resale. The historic absorption

ratio was selected in lieu of an industry-based ratio because the IRS

and Treasury Department believed that a ratio based on taxpayer

specific historical data would more reasonably approximate the

taxpayer's annual absorption ratio than an industry-based ratio.

The IRS and Treasury Department have become aware that the historic

absorption ratio may become materially inaccurate generally as the

result of a significant change in a taxpayer's circumstances during the

qualifying period, thus resulting in a failure to allocate the proper

amount of additional section 263A costs to items on hand at year-end.

Although the regulations provide that a taxpayer must test its historic

absorption ratio every six years, a significant deviation from the

taxpayer's actual absorption ratio could result in a substantial

mismatching of the taxpayer's income and related expenses during the

qualifying period.

The IRS and Treasury Department considered many alternate

approaches to revising the historic absorption ratio regulations in

order to prevent a substantial mismatching of income and related

expenses. Among the approaches considered and rejected were the

following: (1) Eliminate the historic absorption ratio election

entirely; (2) limit use of the historic absorption ratio election to

small taxpayers; (3) require taxpayers to retest their historic

absorption ratio more frequently, e.g., every three years; and (4)

provide a general anti-abuse rule.

These proposed regulations provide for early termination of the

qualifying period if the taxpayer's historic absorption ratio is

materially inaccurate. In such a case, the taxpayer must calculate a

new historic absorption ratio beginning with the year in which the

taxpayer's historic absorption ratio became materially inaccurate.

Generally, a taxpayer's historic absorption ratio may become

materially inaccurate when the taxpayer experiences a significant

change in the taxpayer's normal business operations and that change has

an effect on the taxpayer's section 263A absorption ratio. For example,

the following changes may cause a taxpayer's historic absorption ratio

to become materially inaccurate: a significant change in the taxpayer's

manufacturing process, e.g. implementation of a new inventory

management system; a significant change in the taxpayer's product

offering; a significant addition or retirement of equipment used for

manufacturing; a significant change in the taxpayer's components of

cost, e.g., a manufacturing operation that becomes significantly more

or less labor intensive; a significant change in the taxpayer's

overhead costs, e.g. a new plant, building or building addition; and a

significant change in the taxpayer's trade or business, e.g., the sale

or acquisition of a division.

The proposed regulations establish a high threshold for when the

historic absorption ratio will be regarded as materially inaccurate.

The regulations provide a definition of materially inaccurate that

incorporates both a percentage test and a specific dollar amount test.

The regulations provide that the historic absorption ratio is

materially inaccurate if: (1) the taxpayer's actual absorption ratio

deviates by more than 50% and by more than one-half of one percentage

point from the taxpayer's historic absorption ratio; and (2) the amount

of additional section 263A costs capitalizable to items on hand at

year-end using the actual absorption ratio deviates by more than

$100,000 from the amount of additional section 263A costs capitalizable

to items on hand at year-end using the historic absorption ratio. This

high threshold is provided so that annual actual absorption ratio

computations will be unnecessary in the overwhelming majority of

situations. For example, the placement in service of a significant

amount of property may have a significant effect on a taxpayer's actual

absorption ratio. However, it may not be necessary for a taxpayer to

compute its actual absorption ratio for a year that the taxpayer placed

property in service if, based on the taxpayer's knowledge of the

difference between its tax depreciation and book depreciation, and its

inventory turnover, the taxpayer knows that it would be impossible for

the amount of additional section 263A costs allocable to items on hand

at year-end to increase by $100,000 if the taxpayer used the simplified

production method without the historic absorption ratio election.

Therefore, the taxpayer would not need to calculate an actual

absorption ratio for that year.

Proposed Effective Date

The provisions of these regulations are proposed to be effective

for taxable years beginning after May 24, 1999.

[[Page 27938]]

Special Analyses

It has been determined that this notice of proposed rulemaking 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) does not apply to

these regulations, and because the regulations do not impose a

collection of information on small entities, the Regulatory Flexibility

Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of

the Internal Revenue Code, this notice of proposed rulemaking will be

submitted to the Chief Counsel for Advocacy of the Small Business

Administration for comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments (a signed original

and eight (8) copies) and electronic comments that are submitted timely

to the IRS. The IRS and Treasury Department request comments on the

clarity of the proposed rules and how they can be made easier to

understand. All comments will be available for public inspection and

copying.

A public hearing has been scheduled for Wednesday, September 1,

1999, in room 2615, Internal Revenue Building, 1111 Constitution

Avenue, NW., Washington, DC. Due to building security procedures,

visitors must enter at the 10th Street entrance, located between

Constitution and Pennsylvania Avenues, NW. In addition, all visitors

must present photo identification to enter the building. Because of

access restrictions, visitors will not be admitted beyond the immediate

entrance area more than 15 minutes before the hearing starts. For

information about having your name placed on the building access list

to attend the hearing, see the FOR FURTHER INFORMATION CONTACT section

of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons who wish to present oral comments at the hearing must

submit written or electronic comments by August 23, 1999 and submit an

outline of the topics to be discussed and the time to be devoted to

each topic (a signed original and eight (8) copies) by August 11, 1999.

A period of 10 minutes will be allocated to each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information: The principal author of these regulations is

Jennifer Nuding of the Office of Assistant Chief Counsel (Income Tax

and Accounting). However, other personnel from the IRS and Treasury

Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

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

PART 1--INCOME TAXES

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

part as follows:

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

Par. 2. Section 1.263A-2 is amended as follows:

1. Paragraphs (b)(4)(ii)(C)(1) and (2) are revised;

2. New paragraphs (b)(4)(ii)(C)(3) and (4) are added;

3. Paragraph (b)(4)(vi) is amended by:

a. Revising the paragraph heading and introductory text;

b. Redesignating the Example as Example 1;

c. Adding new Example 2 and Example 3.

The revisions and additions read as follows:

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

* * * * *

(b) * * *

(4) * * *

(ii) * * *

(C) Qualifying period--(1) In general. A qualifying period

generally includes each of the first five taxable years beginning with

the first taxable year after a test period (or an updated test period).

However, a qualifying period may be extended under the provisions of

paragraph (b)(4)(ii)(C)(2) of this section or may terminate early under

the provisions of paragraph (b)(4)(ii)(C)(3) of this section.

(2) Extension of qualifying period. In the first taxable year

following the close of each qualifying period, (e.g., the sixth taxable

year following the test period), the taxpayer must compute the actual

absorption ratio under the simplified production method. If the actual

absorption ratio computed for this taxable year (the recomputation

year) is within one-half of one percentage point (plus or minus) of the

historic absorption ratio used in determining capitalizable costs for

the qualifying period (e.g., the previous five taxable years), the

qualifying period is extended to include the recomputation year and the

following five taxable years (or a shorter period if the qualifying

period is terminated early under the provisions of paragraph

(b)(4)(ii)(C)(3) of this section), and the taxpayer must continue to

use the historic absorption ratio throughout the extended qualifying

period. If, however, the actual absorption ratio computed for the

recomputation year is not within one-half of one percentage point (plus

or minus) of the historic absorption ratio, the taxpayer must use

actual absorption ratios beginning with the recomputation year under

the simplified production method and throughout the updated test

period. The taxpayer must resume using the historic absorption ratio

(determined with reference to the updated test period) in the third

taxable year following the recomputation year.

(3) Earlier termination of the qualifying period. For taxable years

beginning after May 24, 1999, a qualifying period closes immediately

prior to a taxable year in which the taxpayer's historic absorption

ratio becomes materially inaccurate (early recomputation year). If the

taxpayer's historic absorption ratio is materially inaccurate, as

defined in paragraph (b)(4)(ii)(C)(4) of this section, the taxpayer

must use its actual absorption ratios computed using the simplified

production method beginning with the early recomputation year and

throughout the updated test period. The taxpayer must resume using the

historic absorption ratio (determined with reference to the updated

test period) in the third taxable year following the early

recomputation year.

(4) Materially inaccurate. For purposes of this paragraph (b)(4), a

historic absorption ratio becomes materially inaccurate in a taxable

year that--

(i) The taxpayer's actual absorption ratio computed using the

simplified production method deviates by more than 50 percent and by

more than one-half of one percentage point from the taxpayer's historic

absorption ratio for that year; and

(ii) The amount of additional section 263A costs capitalizable to

eligible property remaining on hand at the close of that year under the

simplified production method (using the taxpayer's actual absorption

ratio) deviates by more than $100,000 from the amount of

[[Page 27939]]

additional section 263A costs capitalizable to that property under the

simplified production method with historic absorption ratio election

for that year.

* * * * *

(vi) Examples. The provisions of this paragraph (b)(4) are

illustrated by the following examples:

Example 1. * * *

Example 2. (i) Taxpayer K uses the FIFO method of accounting for

inventories and properly elects to use the historic absorption ratio

with the simplified production method for 1998. K identifies the

following costs incurred during the test period:

1995:

Add'l section 263A costs--$3,500,000 Section 471 costs--

$75,000,000

1996:

Add'l section 263A costs--$4,000,000 Section 471 costs--

$80,000,000

1997:

Add'l section 263A costs--$4,500,000 Section 471 costs--

$85,000,000

(ii) Therefore, K computes a 5% historic absorption ratio as

follows:

[GRAPHIC] [TIFF OMITTED] TP24MY99.000

(iii) In 1998, K incurs $90,000,000 of section 471 costs of

which $15,000,000 remain in inventory at the end of the year. In

addition, K places $50,000,000 of plant and equipment into service.

K's book depreciation on the new plant and equipment is $5,000,000,

while K's tax depreciation on the new plant and equipment is

$10,000,000. K's book depreciation is a section 471 cost as

described in Sec. 1.263A-1(d)(2) and the excess of K's tax

depreciation over K's book depreciation, $5,000,000, is an

additional section 263A cost. K also has $4,500,000 in other

additional section 263A costs.

(iv) K must determine whether K's historic absorption ratio is

materially inaccurate in 1998. Under the simplified production

method without the historic absorption ratio election, K determines

its actual absorption ratio for 1998 as follows:

[GRAPHIC] [TIFF OMITTED] TP24MY99.001

(v) The difference between K's actual absorption ratio (10%)

under the simplified production method for 1998 and K's historic

absorption ratio (5%) is 5%, which is greater than 50 percent of K's

historic absorption ratio for that year (5% x 50% = 2.5%). Under the

simplified production method without the historic absorption ratio

election, K determines the additional section 263A costs allocable

to its ending inventory by multiplying its actual absorption ratio

(10%) by the section 471 costs remaining in its ending inventory as

follows:

Add'l section 263A costs = 10% x $15,000,000 = $1,500,000

(vi) Under the simplified production method using the historic

absorption ratio, K determines the additional section 263A costs

allocable to its ending inventory by multiplying its historic

absorption ratio (5%) by the section 471 costs remaining in its

ending inventory as follows:

Add'l section 263A costs = 5% x $15,000,000 = $750,000

(vii) The difference between the amount of additional section

263A costs allocable to eligible property remaining on hand at the

close of 1998 under the simplified production method using the

taxpayer's actual absorption ratio and the amount of additional

section 263A costs allocable to that property under the simplified

production method with historic absorption ratio election

($1,500,000-$750,000 = $750,000) exceeds $100,000. Accordingly, K's

historic absorption ratio is materially inaccurate for 1998.

(viii) Since K's historic absorption ratio is materially

inaccurate in 1998, K's qualifying period closes immediately prior

to the beginning of K's 1998 taxable year. Therefore, K must update

its test period beginning in 1998. K must use actual absorption

ratios under the simplified production method beginning in 1998 and

throughout the updated test period (1999 and 2000). K must resume

using the historic absorption ratio (determined with reference to

the updated test period) in 2001, the third taxable year following

1998.

Example 3. (i) Taxpayer L properly elects to use the historic

absorption ratio with the simplified production method for 1999. L

computes a 10% historic absorption ratio. On average, L's inventory

turns over approximately fifteen times a year.

(ii) In 1999, L incurs $8,000,000 of section 471 costs of which

$500,000 remain in inventory at the end of the year. In addition, L

places $5,000,000 of plant and equipment into service. The

difference between L's tax depreciation on the new plant and

equipment and L's book depreciation on that plant and equipment for

1999 is $500,000, which is an additional section 263A cost. There

were no other changes in L's additional 263A costs.

(iii) L can determine, without calculating an actual absorption

ratio, that its historic absorption ratio is not materially

inaccurate for 1999. The difference between the amount of additional

section 263A costs allocated to its ending inventory using its

actual absorption ratio and the amount of additional section 263A

costs allocated to its ending inventory using its historic

absorption ratio will not exceed $100,000 and, therefore, L does not

fall within the specific dollar amount test of paragraph

(b)(4)(ii)(C)(4)(ii) of this section. Although L's additional

section 263A costs increased by over $100,000 in 1999 (they

increased by $500,000) as a result of placing the plant and

equipment into service, only a portion of that amount will be

allocated to ending inventory. L's inventory turns over

approximately fifteen times a year. Of the $500,000 of additional

section 263A costs incurred as the result of placing the plant and

equipment into service in 1999, only about $33,000 ($500,000

15) will be allocated to ending inventory. Since $33,000 is

well below the $100,000 threshold, L can determine without

calculating an actual absorption ratio for 1999 that its historic

absorption ratio is not materially inaccurate. Since L's historic

absorption ratio is not materially inaccurate in 1999, L's

qualifying period does not terminate early.

* * * * *

Par. 3. Section 1.263A-3 is amended as follows:

1. Paragraphs (d)(4)(ii)(C)(1) and (2) are revised;

2. New paragraphs (d)(4)(ii)(C)(3) and (4) are added;

3. Paragraph (d)(4)(vi) is amended by:

a. Revising the paragraph heading and introductory text;

b. Redesignating the Example as Example 1;

c. Adding new Example 2.

The revisions and additions read as follows:

Sec. 1.263A-3 Rules relating to property acquired for resale.

* * * * *

(d) * * *

(4) * * *

(ii) * * *

(C) Qualifying period--(1) In general. A qualifying period

generally includes each of the first five taxable years beginning with

the first taxable year after a test period (or an updated test period).

However, a qualifying period may be extended under the provisions of

paragraph (d)(4)(ii)(C)(2) of this section or may terminate early under

the provisions of paragraph (d)(4)(ii)(C)(3) of this section.

[[Page 27940]]

(2) Extension of qualifying period. In the first taxable year

following the close of each qualifying period, (e.g., the sixth taxable

year following the test period), the taxpayer must compute the actual

combined absorption ratio under the simplified resale method. If the

actual combined absorption ratio computed for this taxable year (the

recomputation year) is within one-half of one percentage point (plus or

minus) of the historic absorption ratio used in determining

capitalizable costs for the qualifying period (e.g., the previous five

taxable years), the qualifying period is extended to include the

recomputation year and the following five taxable years (or a shorter

period if the qualifying period is terminated early under the

provisions of paragraph (d)(4)(ii)(C)(3) of this section), and the

taxpayer must continue to use the historic absorption ratio throughout

the extended qualifying period. If, however, the actual combined

absorption ratio computed for the recomputation year is not within one-

half of one percentage point (plus or minus) of the historic absorption

ratio, the taxpayer must use actual combined absorption ratios

beginning with the recomputation year under the simplified resale

method and throughout the updated test period. The taxpayer must resume

using the historic absorption ratio (determined with reference to the

updated test period) in the third taxable year following the

recomputation year.

(3) Earlier termination of the qualifying period. For taxable years

beginning after May 24, 1999, a qualifying period closes immediately

prior to a taxable year in which the taxpayer's historic absorption

ratio becomes materially inaccurate (early recomputation year). If the

taxpayer's historic absorption ratio is materially inaccurate, as

defined in paragraph (d)(4)(ii)(C)(4) of this section, the taxpayer

must use its actual combined absorption ratios computed using the

simplified resale method beginning with the early recomputation year

and throughout the updated test period. The taxpayer must resume using

the historic absorption ratio (determined with reference to the updated

test period) in the third taxable year following the early

recomputation year.

(4) Materially inaccurate. For purposes of this paragraph (d)(4), a

historic absorption ratio becomes materially inaccurate in a taxable

year that--

(i) The taxpayer's actual combined absorption ratio computed using

the simplified resale method deviates by more than 50 percent and by

more than one-half of one percentage point from the taxpayer's historic

absorption ratio for that year; and

(ii) The amount of additional section 263A costs capitalizable to

eligible property remaining on hand at the close of that year under the

simplified resale method (using the taxpayer's actual combined

absorption ratio) deviates by more than $100,000 from the amount of

additional section 263A costs capitalizable to that property under the

simplified resale method with historic absorption ratio election for

that year.

* * * * *

(vi) Examples. The provisions of this paragraph (d)(4) are

illustrated by the following examples:

Example 1. * * *

Example 2. (i) Taxpayer W operates a mail-order retail business

and uses the FIFO method of accounting for inventories. In 1996,

1997 and 1998, W used the simplified resale method without the

historic absorption ratio election with the variation permitted in

paragraph (d)(3)(iii)(A) of this section, exclusion of beginning

inventories from the denominator in the storage and handling costs

absorption ratio formula. Taxpayer W elects to use the historic

absorption ratio with the simplified resale method for 1999. W

identifies the following costs incurred during the test period:

1996:

Add'l section 263A costs--$2,000,000 Section 471 costs--

$45,000,000

1997:

Add'l section 263A costs--$2,500,000 Section 471 costs--

$50,000,000

1998:

Add'l section 263A costs--$3,000,000 Section 471 costs--

$55,000,000

(ii) Therefore, W computes a 5% historic absorption ratio as

follows:

[GRAPHIC] [TIFF OMITTED] TP24MY99.002

(iii) In 1999, W decides to automate part of its repackaging

activities. Accordingly, W places new repackaging equipment into

service. The repackaging equipment has a basis of $15,000,000 for

tax purposes. W's tax depreciation on the new equipment for 1999 is

$3,000,000. This depreciation allowance is an additional section

263A cost and is a handling cost as defined in paragraph (c)(4) of

this section. As a result of the new equipment, W's direct labor

costs with respect to its repackaging activities decrease by

$500,000 during 1999. In 1999, W incurs $60,000,000 of section 471

costs, of which $6,000,000 remain on hand at the end of the year. W

identifies $6,000,000 of storage and handling costs, including W's

tax depreciation on the new equipment and taking into account the

reduction in direct labor costs, and $450,000 of purchasing costs

incurred in 1999.

(iv) W must determine whether W's historic absorption ratio is

materially inaccurate in 1999. In order to do so, W calculates W's

actual combined absorption ratio for 1999 as follows:

[GRAPHIC] [TIFF OMITTED] TP24MY99.003

Combined absorption ratio = 10% + 0.75% = 10.75%

(v) The difference between W's actual combined absorption ratio

(10.75%) under the simplified resale method for 1999 and W's

historic absorption ratio (5%) is 5.75%, which is greater than 50

percent of W's historic absorption ratio for that year (5% x 50% =

2.5%). Under the simplified resale method without the historic

absorption ratio election, W determines the additional section 263A

costs allocable to its ending inventory by multiplying its actual

combined absorption ratio (10.75%) by the section 471 costs

remaining in its ending inventory as follows:

Add'l section 263A costs = 10.75% x $6,000,000 = $645,000

(vi) Under the simplified resale method using the historic

absorption ratio, W determines the additional section 263A costs

allocable to its ending inventory by multiplying its historic

absorption ratio (5%) by the section 471 costs remaining in its

ending inventory as follows:

Add'l section 263A costs = 5% x $6,000,000 = $300,000

(vii) The difference between the amount of additional section

263A costs allocable to eligible property remaining on hand at the

close of 1999 under the simplified resale

[[Page 27941]]

method using the taxpayer's actual combined absorption ratio and the

amount of additional section 263A costs allocable to that property

under the simplified resale method with historic absorption ratio

election ($645,000-$300,000 = $345,000) exceeds $100,000.

Accordingly, W's historic absorption ratio is materially inaccurate

for 1999.

(viii) Since W's historic absorption ratio was materially

inaccurate in 1999, W's qualifying period closes immediately prior

to the beginning of W's 1999 taxable year. Therefore, W must update

its test period beginning in 1999. W must use actual combined

absorption ratios under the simplified resale method beginning in

1999 and throughout the updated test period (2000 and 2001). W must

resume using the historic absorption ratio (determined with

reference to the updated test period) in 2002, the third taxable

year following 1999.

* * * * *

Robert E. Wenzel,

Deputy Commissioner of Internal Revenue.

[FR Doc. 99-12898 Filed 5-21-99; 8:45 am]

BILLING CODE 4830-01-U