Treasury and IRS Finalize Negative Section 263A Regulations and Release Procedural Guidance to Comply With Final Regulations
IRS Section 263A - Summary
On November 18, the IRS released final regulations (TD 9843) modifying Sections 1.263A-1, -2 and -3 of the Income Tax Regulations to address the allocation of certain costs to property produced or acquired for resale by the taxpayer. The regulations clarify the treatment of negative adjustments related to certain costs (negative Section 263A costs) required to be capitalized to property produced or acquired for resale and also provide for a new simplified method of accounting, the modified simplified production method (MSPM), for taxpayers that are treated as producers under Section 263A. Further, the final regulations offer several safe harbors and de minimis rules to reduce the administrative burden and complexities associated with complying with the new rules. Taxpayers that must change their existing method of accounting to conform to the final regulations generally will be required to file an automatic Form 3115, Application for Change in Accounting Method under Rev. Procs. 2018-31 and 2018-56.
IRS Section 263A - Background
Section 263A requires taxpayers to capitalize direct and indirect costs properly allocable to real or tangible personal property produced by the taxpayer, as well as real property and personal property described in Section 1221(a)(1) acquired by the taxpayer, for resale. Generally, the costs required to be capitalized for tax purposes under Section 263A exceed the amounts required to be capitalized for financial accounting purposes (Section 471 costs). Accordingly, many taxpayers must capitalize “additional Section 263A” costs to property acquired or produced as an unfavorable book/tax adjustment (i.e., an addback to taxable income). The Section 263A regulations prescribe a variety of methods that taxpayers can use to identify and allocate additional Section 263A costs, including certain simplified methods for producers and resellers.
Although most additional Section 263A costs are positive, negative Section 263A costs may arise when a particular cost is capitalized for book purposes but is not required to be capitalized under Section 263A. For instance, a taxpayer may have negative Section 263A costs related to selling and marketing expenses (which are generally deductible under Section 263A) if such amounts are capitalized as Section 471 costs. Further, negative Section 263A costs may arise due to unfavorable book-tax differences related to certain expenses such as depreciation, bonuses and rent.
In recent years, the IRS has expressed concerns related to the potential distortion of income resulting from taxpayers including negative Section 263A costs in their simplified methods of accounting for allocating Section 263A costs to ending inventory. To address this issue, IRS and the Treasury released proposed negative Section 263A regulations in 2012 generally prohibiting the inclusion of negative Section 263A costs in a taxpayer’s computation, with certain exceptions. The final regulations largely conform to the proposed regulations, and retain the general rule that disallows taxpayers using the simplified production method from including negative Section 263A costs in their computations. Resellers using the simplified resale method to allocate additional Section 263A costs to ending inventory may continue to include negative Section 263A in their computation to the extent the capitalization of such costs is either optional or not permitted under tax law.
Consistent with the proposed regulations, the final regulations contain several simplifying conventions and exceptions from the general rule, including the following:
- A safe harbor for producers with average annual gross receipts of $50 million or less for three previous tax years.
- Several de minimis rules for certain direct materials and direct labor costs that are not capitalized in the taxpayer’s financial statement.
- A safe harbor for variances and under- or over-applied burdens.
- A new modified simplified production method (MSPM) for allocating negative Section 263A costs to ending inventory.
The MSPM allows larger producers (i.e., taxpayers with average annual gross receipts exceeding $50 million) to take into account negative Section 263A costs by computing two new absorption ratios, rather than the one absorption ratio required under the simplified production method. Under the MSPM, taxpayers will compute a pre-production absorption ratio and a production absorption ratio, and then apply each ratio to separate categories of costs in ending inventory to determine the total amount of additional Section 263A costs to capitalize for tax purposes. As the MSPM is generally more complicated than the simplified production method, larger producers must weigh the benefit of changing to the MSPM (e.g., the tax savings from being able to include negative Section 263A costs in the computation) against the additional compliance costs associated with using the new method.
The final regulations apply for taxable years beginning on or after November 20, 2018. For any taxable year that both begins before November 20, 2018, and ends after November 20, 2018 (e.g., the 2018 tax year for calendar year taxpayers), the IRS will not challenge return positions consistent with the final regulations.
Released concurrently with the final regulations, Rev. Proc. 2018-56 modifies Rev. Proc. 2018-31, the existing guidance governing automatic accounting method changes, to assist taxpayers with complying with the new rules. Specifically, Rev. Proc. 2018-56 expands the existing automatic method changes under Sections 12.01 and 12.02 of Rev. Proc. 2018-31 to include UNICAP methods specifically described in the final regulations, and adds two new sections, Sections 12.17 and 12.18. Section 12.17 provides a new automatic change in method of accounting for taxpayers using a simplified method or changing to a simplified method to recharacterize costs in accordance with the final regulations, and Section 12.18 temporarily permits taxpayers to make an automatic change to revoke a taxpayer’s historical absorption ratio election. Certain eligibility rules that would normally preclude a taxpayer from filing an automatic method change are waived for a limited time (e.g., for the taxpayer’s first, second or third taxable year ending on or after November 20, 2018).
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