Sect. 263A: Allocating Direct and Indirect Costs

Transcription

1 Presenting a live 110-minute teleconference with interactive Q&A Sect. 263A: Allocating Direct and Indirect Costs Mastering Established and Evolving Regs, Guidance and Rulings THURSDAY, JANUARY 10, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Jan Skelton, Tax Principal, Deloitte Tax, New York Ross Margelefsky, Manager, PricewaterhouseCoopers, New York Kristine Mora, Senior Manager, Ernst & Young, Washington, D.C. For this program, attendees must listen to the audio over the telephone. Please refer to the instructions ed to the registrant for the dial-in information. Attendees can still view the presentation slides online. If you have any questions, please contact Customer Service at ext. 10.

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5 Sect. 263A: Allocating Direct and Indirect Costs Seminar Jan. 10, 2013 Ross Margelefsky, PricewaterhouseCoopers Jan Skelton, Deloitte Tax Kristine Mora, Ernst & Young

6 Today s Program Fundamental Sect. 263A Concepts [Ross Margelefsky, Jan Skelton and Kristine Mora] Slide 8 Slide 27 Relevant Sect. 263A Guidance [Kristine Mora] Slide 28 Slide 40 Ongoing Compliance Challenges Under Sect. 263A [Jan Skelton] Slide 41 Slide 51

7 Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. 7

8 Ross Margelefsky, PricewaterhouseCoopers Jan Skelton, Deloitte Tax Kristine Mora, Ernst & Young FUNDAMENTAL SECT. 263A CONCEPTS

9 General Principles Of 263A I. Provides uniform rules for capitalization of costs to: A. Real and tangible personal property produced, and B. Real and personal property acquired for resale II. Applies to both inventory and self-constructed assets (i.e., assets produced for sale or use within the taxpayer s business) III. Generally requires taxpayers to capitalize costs over and above those that are being capitalized for book purposes 9

10 General Applicability I. Terms broadly defined: A. Produce is defined to include property produced under contract for the taxpayer. B. Tangible property is defined to include certain creative property (books, films, sound recordings). II. Exceptions are provided in 1.263A-1(b), including: A. Small resellers Average gross receipts of <$10M for past three years B. Producer Indirect material costs less than <$200K 10

11 Costs Required To Be Capitalized I. All direct costs must be capitalized. A. Producers: Direct material costs, direct labor costs B. Resellers: Acquisition costs ( ) II. Indirect costs must be capitalized when they directly benefit, or are incurred by reason of, the performance of production or (capitalizable) resale activities. 11

12 Overview Of Calculation I. Step 1: Identify costs capitalized for financial accounting II. Step 2: Identify additional costs required to be capitalized for tax purposes (whether positive or negative) III. Step 3: Allocate additional indirect costs to production activities IV. Step 4: Allocate mixed service costs to production activities V. Step 5: If inventory, allocate additional Sect. 263A costs between ending inventory and cost of goods sold, and if selfconstructed assets, capitalize into basis and depreciate capitalized costs 12

13 Typical Book/Tax UNICAP Cost Differences I. Practical capacity (FAS 151) II. Standard cost variances III. Distribution costs/pick-and-pack labor IV. Packaging material costs treated as handling costs (see TAM ) V. Sales-based royalties (see Robinson Knife & proposed regulations) vs. licensing costs and manufacturing-based royalties (see Plastic Engineering) VI. G&A (mixed-service) costs VII.Schedule M-3 adjustments (e.g., depreciation, pension, stock options/fas 123, bonuses) 13

14 Capitalizable Indirect Costs I. Treas. Reg A-1(e)(3)(ii): A. Indirect labor B. Officer s compensation C. Pension and other related costs D. Employee benefit expenses F. Purchasing costs G. Handling costs H. Storage costs I. Cost recovery J. Depletion K. Rent L. Taxes M. Insurance N. Utilities O. Repairs and maintenance P. Engineering and design Q. Spoilage R. Tools and equipment S. Quality and control T. Bidding (successful) U. Licensing and franchise V. Interest ( 263A(f) W. Capitalizable service costs 14

15 Indirect Costs Not Capitalized I. Treas. Reg A-1(e)(3)(iii): A. Selling and distribution B. Research and experimental C. 179 D. 165 losses E. Cost recovery allowances on temporarily idle equipment and facilities F. Taxes assessed on the basis of income G. Strike expenses H. Warranty and product liability costs I. On-site storage costs J. Unsuccessful bidding expenses K. Deductible service costs 15

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17 Service Costs I. Defined as a type of indirect costs (e.g., general and administrative costs) that can be identified specifically with a service department or function, or that directly benefit or are incurred by reason of a service department or function. Selling and distribution A. Capitalizable service costs B. Deductible service costs C. Mixed service costs A-1(g)(4)(ii): de minimis rule 2. CCA : Research and experimental expenditures 17

18 Cost Allocation Methodologies ( 1.263A-1(g)) I. Specific identification, such as A. Job costing systems II. Standard costs or burden rates III. Facts and circumstances, such as: A. Time spent on production vs. non-production activities for labor-type costs B. Square footage allocations for occupancy-type costs IV. Safe harbors A. 1/3-2/3 rule for purchasing costs 18

19 Mixed Service Cost Allocation Methods ( 1.263A-1(g)(4)) I. Direct reallocation II. III. Step allocation Simplified service cost methods (SSCM) IV. Other reasonable methods such as: A. Headcount B. Labor hours V. Filing requirement for Schedule M-3 filers A. Question 9 on Schedule B Form 1120: At any time during the tax year, did the corporation treat for tax purposes indirect costs, as defined in regulations sections 1.263A-1(e)(3)(ii)(F), (G) and (H) as mixed-service costs, as defined in regulations Sect A-1(e)(4)(ii)(C)? 1. Subparagraphs F, G and H relate to purchasing, storage and handling costs. 19

20 Simplified Service Cost Methods SSCM with production cost allocation ratio = ( 263A production costs*/total costs**) x MSC SSCM with labor-based allocation ratio = ( 263A labor costs*/total labor costs*) x MSC * Excluding MSC ** Excluding MSC, income taxes and interest 20

21 Additional 263A Cost Allocation Methods ( 1.263A-1(f)) I. Burden rate A. Pre-determined rates/allowances used to approximate cost B. Significant variances must be capitalized to ending inventory. II. Standard cost A. Standard/budgeted costs to purchase or produce items used to approximate cost B. Variances between standard and actual must be capitalized to ending inventory. C. Standards usually updated at least annually via revaluation reserve 21

22 Additional 263A Cost Allocation Methods ( 1.263A-1(f)), Cont. III. Simplified production/resale methods A. Treats all resale/production costs as applicable to all items purchased or produced B. Generally less favorable method, especially if significant 1. Raw materials 2. In-transit inventory 22

23 Simplified Production Method (SPM) Step 1: Compute absorption ratio Absorption ratio = Additional 263A costs incurred during the year Total 471 costs incurred during the year Step 2: Allocate additional 263A costs to ending inventory Absorption ratio x ending Inventory (or LIFO increment) 23

24 Simplified Resale Method (SRM) Step 1: Compute absorption ratios Purchasing costs ratio = Purchasing costs incurred during the year Purchases Storage and handling costs ratio = S&H costs incurred during the year Beginning inventory + purchases Step 2: Compute combined absorption ratio Purchasing costs ratio + S&H costs ratio = Combined absorption ratio Step 3: Allocate additional 263A costs to ending inventory Combined absorption ratio x ending inventory (or LIFO Increment) 24

25 Simplified Resale Method (SRM), Cont. I. More favorable than SPM, because denominator of S&H ratio diluted by beginning inventory II. Available to resellers and resellers with de minimis production activities A. Might not be available to some resellers because of broad interpretation of produce 25

26 Historic Absorption Ratio (HAR) I. Used in lieu of calculating actual absorption ratio each taxable year in qualifying period (generally five years); see Reg A-2(b)(4) II. Test period is three taxable years immediately prior to election (election without consent of commissioner using cut-off basis). III. At end of qualifying period (recomputation year), taxpayer calculates actual absorption ratio. IV. If absorption ratio is within 0.5% (plus or minus) of previous HAR, then qualifying period is extended. V. If not within 0.5% (plus or minus), establish new HAR based on new three-year test period VI. Must file Form 3115 to revoke election, which normally will not be granted during qualifying period; see Reg A-2(b)(4)(iii) 26

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28 Kristine Mora, Ernst & Young RELEVANT SECT. 263A GUIDANCE

29 Relevant Sect. 263A Guidance: Sales- Based Royalties Proposed Regulations What are sales-based royalties? Royalties that are incurred only upon the sale of property produced or property acquired for resale. IRS appears to take the position that minimum royalties are not included in this definition. Summary of issue Many taxpayers historically treated sales-based royalties as allocable directly to cost of goods sold, and did not capitalize the cost to goods still on hand at the end of the year. The IRS often challenged this treatment on exam, asserting that some royalties are capitalizable under Sect. 263A even if they are sales-based. Robinson Knife Manuf. Co. v. Commissioner, 600 F.3d 121 (2d Cir. 2010), rev g T.C. Memo Ernst & Young LLP Page 29

30 Relevant Sect. 263A Guidance: Sales-Based Royalties Proposed Regulations (Cont.) Current law Simplified production method Royalty expenses incurred by reason of, or to benefit production or resale activities, are production costs within the meaning of Sect. 263A. Royalty costs, including sales-based royalty costs, incurred in securing the contractual right to use a trademark, corporate plan, manufacturing procedure, special recipe or other similar right associated with property produced or property acquired for resale, are indirect costs that are properly allocable to the property produced or acquired for resale to the extent the costs directly benefit or are incurred by reason of production or resale activities. As discussed previously, under the simplified UNICAP methods, capitalizable costs are spread across all items of inventory, regardless of whether they are benefited by those costs. Any amounts capitalized as additional Sect. 263A costs, such as salesbased royalties, would become partially capitalized to ending inventory under those simplified methods, even though the sales-based royalties are not incurred until the goods are sold Ernst & Young LLP Page 30

31 Relevant Sect. 263A Guidance: Sales-Based Royalties Proposed Regulations (Cont.) Current law Facts-and-circumstances or burden rate methods Royalty expenses incurred by reason of, or to benefit production or resale activities, are production costs within the meaning of Sect A-1(e)(3)(i). Costs are generally allocated only to inventory items that have incurred those costs. Costs such as sales-based royalties are generally capitalized only to goods that have been sold and not to ending inventory Ernst & Young LLP Page 31

32 Relevant Sect. 263A Guidance: Sales-Based Royalties Proposed Regulations (Cont.) Example Simplified production method Additional Sect. 263A costs excluding sales-based royalties: $1,000 Sales-based royalties: $100 Sect. 471 costs incurred during the year: $10,000 Ending inventory: $500 Current law Additional Section 263A costs $1,100 ($1,000 + $100) = 11% Section 471 costs $10,000 Ending inventory $500 Additional Section 263A costs $55 Proposed regulations Additional Section 263A costs $1,000 = 10% Section 471 costs $10,000 Ending inventory $500 Additional Section 263A costs $ Ernst & Young LLP Page 32

33 Relevant Sect. 263A Guidance: Sales-Based Royalties Proposed Regulations (Cont.) Guidance was issued in the form of proposed regulations in December 2010 which generally require capitalization of the salesbased royalties to inventory, but allocate those costs to inventory that has already been sold. The proposed regulations achieve a similar result to that in Robinson Knife, but instead of determining that sales-based royalty costs are not capitalizable, they provide that the costs are capitalizable to goods that have been sold. The proposed regulations also address sales-based vendor allowances and provide that a sales-based vendor allowance is an adjustment to the cost of the merchandise sold or deemed sold under the taxpayer's cost flow assumption Ernst & Young LLP Page 33

34 Relevant Sect. 263A Guidance: Sales-Based Royalties Proposed Regulations (Cont.) If finalized, the regulations suggest that taxpayers incurring salesbased royalty costs will be able to recover such costs via cost of goods sold in the year products are sold, rather capitalize a portion of such costs to ending inventory. The regulations would be effective for tax years ending on or after publication as final regulations in the Federal Register. Some taxpayers have filed non-automatic accounting method changes or are working with IRS exam teams to adopt the methodology in the proposed regulations Ernst & Young LLP Page 34

35 Relevant Sect. 263A Guidance: Negative 263A Costs Proposed Regulations What are negative Sect. 263A costs? Negative amounts generally occur when a taxpayer capitalizes a cost as a Sect. 471 cost that is greater than the amount required to be capitalized for tax purposes. Examples include costs that are not capitalizable for tax purposes, such as qualified 174 costs, pick-and-pack costs, etc.; as well as book/tax differences related to inventoriable costs such as depreciation. Summary of issue Many taxpayers historically treated negative Sect. 263A costs as a reduction to the pool of total additional 263A costs. The IRS often challenged this treatment on exam in 2007 and prior years. In April 2007, the IRS issued Notice , which provided that, pending the issuance of additional guidance, it would not challenge the inclusion of negative amounts in calculating additional costs under Sect. 263A Ernst & Young LLP Page 35

36 Relevant Sect. 263A Guidance: Negative 263A Costs Proposed Regulations (Cont.) Guidance was issued in the form of proposed regulations in September 2012 which generally prohibit the inclusion of negative costs in additional 263A costs under the simplified methods, subject to the following exceptions: Small taxpayers (average annual gross receipts of $10 million or less) Taxpayers using the simplified resale method Taxpayers using a new modified simplified production method All other taxpayers must remove the negative costs from Sect. 471 costs, using a method that approximates the manner in which the taxpayer originally capitalized the costs. The proposed regulations would generally prohibit treating cash or trade discounts under Sect (b) as negative amounts under any simplified method Ernst & Young LLP Page 36

37 Relevant Sect. 263A Guidance: Negative 263A Costs Proposed Regulations (Cont.) New proposed modified simplified production method Two absorption ratios, rather than one as in the original SPM: Pre-production costs Production costs Reduces the distortions that result from the original SPM by allocating production costs, including negative 263A costs, to goods that have incurred those costs and not to raw materials. Pre-production cost absorption ratio applied to raw material and raw material content of WIP and finished goods. Many of the benefits of burden rate methods, but with less work. Some additional work could be required if SPM is currently used. Could reduce work if non-simplified method is currently used Ernst & Young LLP Page 37

38 Relevant Sect. 263A Guidance: Negative 263A Costs Proposed Regulations (Cont.) The proposed regulations also adopt a new definition of Sect. 471 costs. All costs, other than interest, that a taxpayer capitalizes to its inventory in its financial statements. However, Sect. 471 costs must include direct costs, regardless of the financial statement treatment. This definition is consistent with what most taxpayers are currently doing in practice. However some taxpayers, particularly retailers, currently reverse out book UNICAP and treat all indirect costs as additional 263A costs Ernst & Young LLP Page 38

39 Relevant Sect. 263A Guidance: Negative 263A Costs Proposed Regulations (Cont.) The regulations would be effective for tax years ending on or after publication as final regulations in the Federal Register. If finalized as written, many taxpayers would have to file accounting method changes to adopt the new methods Ernst & Young LLP Page 39

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41 Jan Skelton, Deloitte Tax ONGOING COMPLIANCE CHALLENGES UNDER SECT. 263A

42 Property Produced Under A Contract Sect A-2(a)(1)(ii)(B)(1) provides that, in general, property produced for the taxpayer under a contract with another party is treated as property produced by the taxpayer, to the extent the taxpayer makes payments or otherwise incurs costs with respect to the property. Sect A-3(a)(2)(iii) permits resellers with de minimis production activities to be treated as resellers. Production activities are de minimis if the gross receipts from the produced property are less than 10% of total gross receipts, and the labor costs associated with the property are less than 10% of total labor costs. In Suzy s Zoo v. Commissioner, 114 T.C. 1 (2000), aff d 88 AFTR2d par (Nov. 21, 2001), a designer of greeting cards printed by a third party was treated as the producer of greeting cards. The court rejected the argument that the de minimis rule applied. 42 Deloitte Development LLC. All rights reserved.

43 Property Produced Under A Contract: Producer Or Reseller? Application of property produced under a contract rule producer or reseller? Private label goods sold by a department store Likely to meet de minimis rule Products sold by specialty retailer Less than 10% of sales and labor? Implication of treatment as a producer rather than a reseller Unable to use simplified resale method Unable to use $10M small reseller exception Possble capitalization of more costs 43 Deloitte Development LLC. All rights reserved.

44 Property Produced Under A Contract: Self-Constructed Assets Property produced under a contract includes property constructed by another for the taxpayer for the taxpayer s self-use e.g., self-constructed assets. Indirect costs must be capitalized to self-constructed assets under Sect. 263A. These self-constructed assets could include office buildings, stores, customer service centers, etc. Note that when a taxpayer produces self-constructed assets (regardless of whether under a contract) and also produces or sells inventory, if the simplified service cost method (SSCM) is used to determine mixed service costs allocable to inventory, then mixed service costs must be allocated first to selfconstructed assets under another method of accounting prior to the application of the SSCM. 44 Deloitte Development LLC. All rights reserved.

45 Interplay With Sect. 199 A taxpayer seeking to claim a Sect. 199 deduction must treat itself as a producer under Sect. 263A. Under Sect. 263A, in the case of property produced under a contract, both the taxpayer having property produced for it under a contract and the contractor performing the work on the property may subject to Sect. 263A, if the contractor is regarded as the tax-owner of the property under Sect. 263A. However, under Sect. 199, only one party can be treated as the producer of the property. Thus, a taxpayer may be treated as a producer required to capitalize costs under Sect. 263A but not as a producer entitled to a Sect. 199 benefit. 45 Deloitte Development LLC. All rights reserved.

46 Producer, Service Provider Or Reseller? In Suzy s Zoo, the Court of Appeals held that the greeting card designer was the only owner of the greeting cards throughout the entire production process. Thus, the designer was required to capitalize costs under Sect. 263A. The implication is that the printer is not a tax owner of the property but rather a service provider not required to capitalize costs under Sect. 263A. The IRS disagrees with this principle. In a technical advice memorandum, the IRS National Office did agree that an auto mechanic repairing customer owner vehicles was not a producer. The IRS seems to believe that to the extent parts are provided in the repair process, the mechanic is a reseller. However, under Osteopathic Medical Oncology & Hematology, P.C. v. Commissioner, 113 T.C. 376 (1999), items that are an integral, indispensable, inseparable part of rendering services should not be regarded as inventory held for sale. 46 Deloitte Development LLC. All rights reserved.

47 Restaurants Restaurants have historically viewed themselves as members of the hospitality services industry e.g., as service providers. Over the last 15 years, the IRS Exam function has proposed audit adjustments to treat restaurants as producers under Sect. 263A. Audit defense techniques that should be considered include: Under the three-i test articulated in Osteopathic Medical, food used in food preparation services should not be treated as inventory and therefore should not be subject to Sect. 263A. Issues with property provided incident to services rule in Sect A-1(b)(11) If an adjustment is proposed: Ensure direct labor is not treated as an allocable indirect cost Pursue option of using a burden rate method rather than the SPM 47 Deloitte Development LLC. All rights reserved.

48 Dual Function Storage Facilities Resellers are generally required to capitalize storage costs. However, costs incurred in an on-site storage facility are not required to be capitalized. On-site generally means on the site of a retail sales facility. A storage facility that serves both an on-site and off-site storage facility is a dual-function storage facility. Costs allocable to the off-site function must be capitalized. Facts that could cause a facility to be a dual function storage facility: Leases Bulk purchases Shipments to other stores Internet orders 48 Deloitte Development LLC. All rights reserved.

49 Miscellaneous Issues Expansive definition of handing activities Application of 1/3-2/3 rule on a person-by-person basis Schedule M adjustments 49 Deloitte Development LLC. All rights reserved.

50 Method Change Issues Change in method of accounting Automatic method change vs. advance consent change Three-year revaluation method Prevelence of requiring concurrent unicap changes when other changes are made 50 Deloitte Development LLC. All rights reserved.