[Federal Register Volume 59, Number 150 (Friday, August 5, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-19079]


[[Page Unknown]]

[Federal Register: August 5, 1994]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8559]
RIN 1545-AQ88

 

Capitalization and Inclusion in Inventory of Certain Costs

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains final and temporary regulations under 
section 263A of the Internal Revenue Code of 1986 relating to 
accounting for costs incurred in producing property and acquiring 
property for resale. Section 263A was enacted as part of the Tax Reform 
Act of 1986. Changes to the applicable law were made by the Omnibus 
Budget Reconciliation Act of 1987, the Technical and Miscellaneous 
Revenue Act of 1988, and the Omnibus Budget Reconciliation Act of 1989. 
These final regulations primarily affect taxpayers subject to section 
263A that acquire property for resale.

EFFECTIVE DATE: August 5, 1994.

FOR FURTHER INFORMATION CONTACT: Rosemary DeLeone or Harry-Todd Astrov 
of the Office of the Assistant Chief Counsel, Income Tax and 
Accounting, (202) 622-4970 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    On March 30, 1987, and August 7, 1987, temporary regulations under 
section 263A were published in the Federal Register (TD 8131, 52 FR 
10052 and TD 8148, 52 FR 29375). A public hearing was held on December 
7, 1987. On August 9, 1993, final regulations under section 263A were 
published in the Federal Register (TD 8482, 58 FR 42198). In addition, 
a notice of proposed rulemaking was published on August 9, 1993, (58 FR 
42263) regarding certain provisions that were reserved in the final 
regulations. A public hearing was held on November 30, 1993, on these 
provisions. After consideration of the public comments regarding the 
proposed regulations, the regulations are adopted as revised by this 
Treasury decision.

Explanation of Statutory Provisions

    Section 263A (the uniform capitalization rules) was enacted as part 
of the Tax Reform Act of 1986, Pub. L. 99-514, 100 Stat. 2085, 1986-3 
C.B. (Vol. 1) (the 1986 Act). The statute was amended as part of the 
Omnibus Budget Reconciliation Act of 1987, Pub. L. 100-203, 101 Stat. 
1330, 1987-3 C.B. 1 (the 1987 Act), the Technical and Miscellaneous 
Revenue Act of 1988, Pub. L. 100-647, 102 Stat. 3342, 1988-3 C.B. 1 
(the 1988 Act), and the Omnibus Budget Reconciliation Act of 1989, Pub. 
L. 101-239, 103 Stat. 2106 (the 1989 Act), 1990-1 C.B. 210.
    Section 263A provides a uniform set of rules that govern the 
capitalization of direct and indirect costs associated with property 
produced and property acquired for resale. Specifically, section 263A 
requires taxpayers to capitalize the direct and indirect costs properly 
allocable to real property and tangible personal property that they 
produce. Section 263A also requires taxpayers to capitalize the direct 
and indirect costs (including purchasing, handling, and storage costs) 
properly allocable to real property and personal property acquired for 
resale.
    The final regulations under section 263A that were published on 
August 9, 1993, generally require handling costs to be capitalized. 
Handling costs include costs attributable to processing, assembling, 
repackaging, transporting, and other similar activities, provided these 
activities do not come within the meaning of the term ``produce'' as 
defined in Sec. 1.263A-2(a)(1). However, the final regulations under 
section 263A also provide that certain handling costs are not required 
to be capitalized. For instance, handling costs incurred at a retail 
sales facility with respect to property sold to retail customers at the 
facility are not required to be capitalized. In addition, handling 
costs incurred at a dual-function storage facility with respect to 
property sold to customers from the facility are not required to be 
capitalized to the extent that the costs are incurred with respect to 
property sold in on-site sales.
    The final regulations under section 263A that were published on 
August 9, 1993, reserve several provisions previously contained in the 
temporary regulations relating to certain other costs that were not 
considered handling costs. In particular, the regulations reserve 
provisions relating to distribution costs, custom-order delivery costs, 
and repackaging costs. After publishing a notice of proposed rulemaking 
and considering public comments, these final regulations provide rules 
concerning such costs. In addition, these final regulations provide 
rules that permit the District Director to require appropriate 
adjustments to the valuation of inventories and other property subject 
to section 263A if a transfer of property is made to another person for 
a principal purpose of avoiding the application of section 263A.

Public Comments

The Scope of Distribution Costs

    The proposed regulations provide that distribution costs are not 
required to be capitalized. The proposed regulations define 
distribution costs as any transportation costs incurred outside a 
storage facility in delivering goods to an unrelated customer. For this 
purpose, the proposed regulations state that any costs incurred on a 
loading dock are treated as incurred outside a storage facility.
    Several commentators argued that, in addition to transportation 
costs incurred outside a storage facility, distribution costs should 
also include all costs (i.e., labor, equipment, and occupancy costs) 
incurred after a sales order has been received, regardless of whether 
these costs are incurred inside or outside a storage facility. They 
stated that the costs of retrieving the goods and readying them for 
shipment are more in the nature of deductible selling and distribution 
costs and do not relate to the production, acquisition, or holding of 
property.
    The preamble to the proposed regulations cites the Blue Book to the 
1986 Act which states that deductible ``distribution expenses are 
intended to include only external distribution costs, that is, those 
costs incurred in transporting goods from the taxpayer's warehouse or 
retail outlet to the customer, or to the customer's agent, a common 
carrier, or some other intermediary. Distribution expenses do not 
include costs of moving inventory from a taxpayer's warehouse to its 
retail store or other internal transportation costs.'' Joint Committee 
on Taxation Staff, General Explanation of the Tax Reform Act of 1986, 
99th Cong., JCS-10-87, 510 n.61. Commentators contended that this 
reference was taken out of context and suggested that it should be used 
to define the nature of an activity (e.g., shipment to a customer vs. 
internal transfers) rather than the location of an activity (e.g., 
inside an off-site storage facility vs. the loading dock).
    These final regulations retain the definition of distribution costs 
contained in the proposed regulations. The Service and Treasury 
continue to believe that this definition of distribution costs provides 
for a better matching of income and related expenses because gross 
income is not typically recognized from the sale of an item when an 
order is placed, but rather when the item is shipped, delivered, or 
accepted, or when title to the item passes to the purchaser. Since 
costs incurred inside a storage facility are typically incurred prior 
to an item being shipped, delivered, or accepted, or when title passes, 
these costs should be capitalized until income is recognized.
    Furthermore, the Conference Report to the 1986 Act specifically 
states that ``processing, assembly, repackaging, and similar costs, 
including labor costs attributable to unloading goods (but not 
including labor costs attributable to loading of goods for final 
shipment to customers, or labor at a retail facility)'' should be 
capitalized. H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. II-306 
(1986), 1986-3 (Vol. 4) C.B. 306. Thus, because Congress intended that 
costs incurred prior to loading goods for shipment be capitalized, 
distribution activities should not be construed to begin any earlier 
than at the loading dock.

Pick and Pack Costs and Repackaging Costs

    Several commentators have expressed concern that the definition of 
distribution costs contained in the proposed regulations may result in 
some taxpayers abandoning the use of the simplified resale method. In 
response, these final regulations except ``pick and pack'' costs from 
the scope of capitalizable handling costs incurred inside a storage 
facility. These final regulations define pick and pack costs as those 
costs incurred inside a storage facility in preparing specific goods 
for imminent shipment to a particular customer after the customer has 
ordered those goods. Examples of pick and pack costs include costs 
incurred to move specific goods from a storage location in preparation 
for shipment to the customer, pack or repack those goods for shipment 
to the customer, and stage those goods for shipment to the customer.
    Pick and pack costs, however, do not include occupancy costs, such 
as rent, depreciation, insurance, taxes, utilities, and maintenance. 
The Service and Treasury believe that the exclusion of these costs from 
the scope of pick and pack costs is consistent with Congressional 
intent that all off-site storage and warehousing costs be capitalized. 
See H. R. Conf. Rep. No. 841, 99th Cong., 2d Sess. II-306 (1986), 1986-
3 (Vol. 4) C.B. 306. Furthermore, this position is supported by the 
Conference Report to the 1986 Act. In a footnote to the Conference 
Report the conferees state that ``[o]ffsite storage and warehousing 
costs generally include the cost of a facility whose primary function 
is the storage or warehousing of goods.'' H. R. Conf. Rep. No. 841, 
99th Cong., 2d Sess. II-306 (1986), 1986-3 (Vol. 4) C.B. 306. Thus, 
because the primary function of an off-site storage facility is the 
storage or warehousing of goods, all occupancy costs incurred at an 
off-site storage facility must be capitalized.
    Because the above rule for pick and pack costs essentially replaces 
the exception for repackaging costs contained in the proposed 
regulations, the separate exception for repackaging costs is 
unnecessary and has been eliminated.

Costs of Delivering Custom-Ordered Items

    The proposed regulations provide that, notwithstanding the general 
requirement that costs incurred in transporting goods from a taxpayer's 
storage facility to its retail sales facility are required to be 
capitalized, costs incurred outside a storage facility in delivering 
custom-ordered items to a retail sales facility are not required to be 
capitalized. For this purpose, the proposed regulations provide that 
any costs incurred on a loading dock are treated as incurred outside a 
storage facility. The preamble to the proposed regulations also states 
that the Service is considering eliminating this exception altogether.
    Commentators contended that the custom-order exception should not 
be eliminated because these delivery costs are more appropriately 
characterized as costs incurred to ship goods directly to a customer 
rather than as costs incurred to internally move inventory. In 
addition, commentators asserted that the custom-order exception should 
not be limited to costs incurred outside a storage facility in 
delivering custom-ordered items to a retail sales facility. These 
commentators believe that all costs incurred in delivering custom-
ordered items to a retail sales facility should be deductible, 
regardless of whether they are incurred inside or outside a storage 
facility.
    These final regulations retain the custom-order exception. The 
Service and Treasury believe that limiting this exception to costs 
incurred outside a storage facility in delivering custom-ordered items 
to a retail sales facility provides for a better matching of income and 
related expenses.

Costs of Transporting Goods to a Related Person

    The proposed regulations provide that distribution costs do not 
include costs incurred by a taxpayer in delivering goods to a related 
person. The proposed regulations further provide that when a taxpayer 
sells goods to a related person, the costs of transporting the goods 
are included in determining the basis of the goods that are sold, and 
hence in determining the resulting gain or loss from such sale, for all 
purposes of the Internal Revenue Code and the regulations thereunder. 
For purposes of this provision, the proposed regulation states that 
persons are related if they are described in section 267(b) or section 
707(b).
    One commentator argued that the requirement to capitalize costs 
incurred by a taxpayer in delivering goods to a related person is 
contrary to the purported purpose of section 263A and can result in the 
permanent disallowance of the capitalized costs. The commentator noted 
that if the capitalization of costs incurred in transporting property 
between related parties produces or increases a loss, the loss 
disallowance rules in sections 267(a)(1) and 707(b)(1) may in some 
instances permanently disallow the loss. Thus, the commentator argued 
that the requirement to capitalize costs incurred by a taxpayer in 
delivering goods to a related person is unfair because it results in 
harsher treatment than the treatment of internal transportation costs 
carried on within a single entity.
    These final regulations retain the rule contained in the proposed 
regulations. The Service and Treasury continue to believe that the cost 
of transporting goods between related parties is properly treated as a 
capitalizable handling cost for all purposes (i.e., not just for timing 
purposes, but also for character purposes). In addition, the very 
limited potential for loss disallowance under sections 267(a)(1) and 
707(b)(1) could result from any one of a number of properly 
capitalizable costs (e.g., storage costs, production costs, etc.) other 
than handling costs associated with transporting goods to a related 
party. Moreover, the fact that sections 267(a)(1) and 707(b)(1) will 
result in loss disallowance only in unusual circumstances does not 
justify the additional complexity that would result to all taxpayers 
from the series of rules that would be necessary to accommodate the 
treatment requested by the commentator.

Transfers for Tax Avoidance Purposes

    The proposed regulations provide that the District Director may 
require appropriate adjustments to valuations of inventory and other 
property subject to section 263A if the transfer of property is made to 
another person for a principal purpose of tax avoidance. The example 
provided in the proposed regulations states that the District Director 
may require a taxpayer using the simplified production method (as 
described in Sec. 1.263A-2(b)) to apply that method to transferred 
inventories immediately prior to a transfer under section 351 if a 
principal purpose of the transfer is tax avoidance. The Service and 
Treasury continue to believe that the Secretary has the authority to 
prescribe regulations to prevent taxpayers from using related parties, 
pass-thru entities, or intermediaries to avoid the application of 
section 263A. Therefore, the final regulations retain the anti-abuse 
rule contained in the proposed regulations with one clarifying 
modification that substitutes ``a principal purpose to avoid the 
application of section 263A'' for ``a principal purpose of tax 
avoidance.''

Effective Dates

    These final regulations are applicable to costs incurred in taxable 
years beginning after December 31, 1993. In the case of property that 
is inventory in the hands of the taxpayer, however, these regulations 
are effective for taxable years beginning after December 31, 1993.

Accounting Method Changes

    If a taxpayer must change its method of accounting as a result of 
these regulations, the taxpayer generally must file a Form 3115, 
Application for Change in Accounting Method, with the Commissioner in 
accordance with the requirements of Sec. 1.446-1(e)(3)(i) and Rev. 
Proc. 92-20, 1992-1 C.B. 685. If, however, as a result of these 
regulations a taxpayer changes its method of accounting in its first 
taxable year beginning on or after January 1, 1994, then the change 
must be made pursuant to Rev. Proc. 94-49, 1994-30 I.R.B., dated July 
25, 1994.

Special Analysis

    It has been determined that these regulations are not a significant 
regulatory action as defined in EO 12866. Therefore, a regulatory 
assessment is not required. It has also 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. Therefore, a Regulatory Impact Analysis is not required. 
Pursuant to section 7805(f) of the Internal Revenue Code, a copy of the 
notice of proposed rulemaking preceding these regulations was submitted 
to the Chief Counsel for Advocacy of the Small Business Administration 
for comment on its impact on small business.

Drafting Information

    The principal authors of these regulations are Rosemary DeLeone and 
Harry-Todd Astrov of the Office of Assistant Chief Counsel, Income Tax 
and Accounting, IRS. However, other personnel from the IRS and the 
Treasury Department assisted in developing these regulations on matters 
of both substance and style.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by 
removing the entry for ``Section 1.263A-1T'' and adding new entries in 
numerical order to read as follows:

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

    Section 1.263A-1 also issued under 26 U.S.C. 263A. * * *
    Section 1.263A-3 also issued under 26 U.S.C. 263A. * * *
    Section 1.263A-4T also issued under 26 U.S.C. 263A. * * *
    Section 1.263A-7T also issued under 26 U.S.C. 263A. * * *

    Par. 2. Section 1.263A-4T is added to read as follows:


Sec. 1.263A-4T   Rules relating to property produced in a farming 
business.

    (a) through (c) [Reserved]
    (d) This section is effective for costs incurred after December 31, 
1986, in taxable years ending after such date. In the case of property 
that is inventory in the hands of the taxpayer, this section is 
effective for taxable years beginning after December 31, 1986.


Sec. 1.263A-1T   [Amended]

    Par. 3. Paragraph (c) of Sec. 1.263A-1T is redesignated as 
paragraph (c) of 1.263A-4T.
    Par. 4. Section 1.263A-7T is added to read as follows:


Sec. 1.263A-7T   Rules relating to changes in methods of accounting.

    (a) through (e) [Reserved]
    (f) This section is effective for costs incurred after December 31, 
1986, in taxable years ending after such date. In the case of property 
that is inventory in the hands of the taxpayer, this section is 
effective for taxable years beginning after December 31, 1986.


Sec. 1.263A-1T   [Amended]

    Par. 5. Paragraph (e) of Sec. 1.263A-1T is redesignated as 
paragraph (e) of 1.263A-7T.
    Par. 6. Sec. 1.263A-7T(e) is amended as follows:
    1. The first and fourth sentences of paragraph (e)(1)(i) are 
amended by removing the phrase ``this section'' and replacing it with 
``section 263A and the regulations thereunder''.
    2. The third sentence of paragraph (e)(1)(i) is amended by removing 
the phrase ``this section'' and replacing it with ``the regulations 
thereunder''.
    3. Paragraph (e)(1)(ii) is amended by removing the phrase ``this 
section'' and replacing it with ``section 263A and the regulations 
thereunder'' every place that it appears.
    4. The first sentence of paragraph (e)(1)(iii)(B) is amended by 
removing the phrase ``this section'' the first time it appears and 
replacing it with ``section 263A and the regulations thereunder'' and 
by removing ``of this section''.
    5. The second sentence of paragraph (e)(1)(iii)(B) is amended by 
removing the phrase ``of this section''.
    6. The first sentence of paragraph (e)(1)(iv) is amended by 
removing the phrase ``this section'' the first, second, and third time 
it appears and replacing it with ``section 263A and the regulations 
thereunder''.
    7. The first sentence of paragraph (e)(2) is amended by removing 
the phrase ``this section'' and replacing it with ``section 263A and 
the regulations thereunder''.
    8. Paragraph (e)(3)(i) is amended by removing the phrase ``this 
section'' and replacing it with ``section 263A and the regulations 
thereunder''.
    9. The first sentence of paragraph (e)(4)(i) is amended by removing 
the phrase ``this section'' the first time it appears and replacing it 
with ``section 263A and the regulations thereunder''.
    10. The third sentence of the Example of paragraph (e)(4)(ii) is 
amended by removing the phrase ``this section'' and replacing it with 
``section 263A and the regulations thereunder''.
    11. The first sentences of Example (1) and Example (3) of paragraph 
(e)(5) are amended by removing the phrase ``this section'' and 
replacing it with ``section 263A and the regulations thereunder''.
    12. The first and last sentences of paragraph (e)(6)(i) are amended 
by removing the phrase ``this section'' and replacing it with ``section 
263A and the regulations thereunder''.
    13. The first and second sentences of paragraph (e)(6)(ii)(A) are 
amended by removing the phrase ``this section'' and replacing it with 
``section 263A and the regulations thereunder''.
    14. Paragraph (e)(6)(ii)(A)(1) is amended by removing the phrase 
``this section'' and replacing it with ``section 263A and the 
regulations thereunder''.
    15. In paragraph (e)(6)(ii)(C), the second sentence of Example (1), 
the third sentence of Example (3), and the first sentence of Example 
(5) are amended by removing the phrase ``this section'' and replacing 
it with ``section 263A and the regulations thereunder''.
    16. The third sentence of paragraph (e)(6)(iii)(A) is amended by 
removing the phrase ``this section'' and replacing it with ``section 
263A and the regulations thereunder''.
    17. The second sentence of paragraph (e)(6)(iii)(B)(1) is amended 
by removing the phrase ``this section'' and replacing it with ``section 
263A and the regulations thereunder''.
    18. The fourth sentence of the Example of paragraph 
(e)(6)(iii)(B)(2) is amended by removing the phrase ``this section'' 
and replacing it with ``section 263A and the regulations thereunder''.
    19. The second sentence of paragraph (e)(6)(iii)(C)(1) is amended 
by removing the phrase ``this section'' and replacing it with ``section 
263A and the regulations thereunder''.
    20. The eighth sentence of the Example of paragraph 
(e)(6)(iii)(C)(2) is amended by removing the phrase ``this section'' 
and replacing it with ``section 263A and the regulations thereunder''.
    21. The third and fifth sentences of the Example of paragraph 
(e)(6)(iv)(C) are amended by removing the phrase ``this section'' and 
replacing it with ``section 263A and the regulations thereunder''.
    22. The second sentence of paragraph (e)(7)(iii)(B) is amended by 
removing the phrase ``this section'' and replacing it with ``section 
263A and the regulations thereunder''.
    23. The fourth sentence of the Example of paragraph (e)(7)(v) is 
amended by removing the phrase ``this section'' and replacing it with 
``section 263A and the regulations thereunder''.
    24. Paragraph (e)(9)(i) is amended by removing the phrase ``this 
section'' and replacing it with ``section 263A and the regulations 
thereunder'' every place that it appears.
    25. The third and sixth sentences of Example 1, the third sentence 
of Example 2, the fifth sentence of Example 3, the seventh sentence of 
Example 4, and the third sentence of Example 5 of paragraph (e)(9)(ii) 
are amended by removing the phrase ``this section'' and replacing it 
with ``section 263A and the regulations thereunder''.
    26. The first sentence of paragraph (e)(10)(i) is amended by 
removing ``this section'' and replacing it with ``section 263A and the 
regulations thereunder.''
    27. The second sentence of paragraph (e)(10)(i) is amended by 
removing the phrase ``this section'' the first time it appears and 
replacing it with ``the regulations thereunder'' and removing the 
phrase ``this section'' the second time it appears and replacing it 
with ``section 263A and the regulations thereunder''.
    28. Paragraph (e)(10)(ii)(A) is amended by removing the phrase 
``this section'' and replacing it with ``the regulations thereunder'' 
every place that it appears.
    29. The third sentence of paragraph (e)(10)(iii) is amended by 
removing the phrase ``this section'' and replacing it with ``section 
263A and the regulations thereunder''.
    30. The first sentence of paragraph (e)(11)(i) is amended by 
removing the phrase ``this section'' and replacing it with ``section 
263A and the regulations thereunder''.
    31. The first sentence of paragraph (e)(11)(ii) is amended by 
removing the phrase ``this section'' and replacing it with ``section 
263A and the regulations thereunder''.
    32. The first and second sentences of paragraph (e)(11)(iii) are 
amended by removing the phrase ``this section'' and replacing it with 
``section 263A and the regulations thereunder''.
    33. Paragraph (e)(11)(iv) is amended by removing the phrase ``this 
section'' and replacing it with ``section 263A and the regulations 
thereunder''.
    34. Paragraph (e)(11)(v) is amended by removing the phrase ``this 
section'' and replacing it with ``section 263A and the regulations 
thereunder'' every place that it appears.


Sec. 1.263A-1T   [Removed]

    Par. 7. Section 1.263A-1T is removed.
    Par. 8. Section 1.263A-1 is amended as follows:
    1. The last sentence of paragraph (a)(2)(i) is amended by removing 
``1.263A-1T(e)'' and replacing it with ``1.263A-7T(e)''.
    2. Paragraph (a)(3)(v) is amended by removing ``1.263A-1T(c)'' and 
replacing it with ``1.263A-4T(c)''.
    3. The second sentence of paragraph (b)(3) is amended by removing 
``1.263A-1T(c)'' and replacing it with ``1.263A-4T(c)''.
    4. The second sentence of paragraph (b)(4) is amended by removing 
``1.263A-1T(c)'' and replacing it with ``1.263A-4T(c)''.
    5. Paragraph (b)(10) is amended by removing the second sentence and 
by adding paragraphs (b)(10) (i) and (ii).
    6. The text of paragraph (j)(4) is added.
    7. The added text reads as follows:


Sec. 1.263A-1   Uniform capitalization of costs.

* * * * *
    (b) * * *
    (10) * * *
    (i) For purposes of this section, substantial construction is 
deemed to have occurred if the lesser of--
    (A) 10 percent of the total estimated costs of construction; or
    (B) The greater of $10 million or 2 percent of the total estimated 
costs of construction, was incurred before March 1, 1986.
    (ii) For purposes of the provision in paragraph (b)(10)(i) of this 
section, the total estimated costs of construction shall be determined 
by reference to a reasonable estimate, on or before March 1, 1986, of 
such amount. Assume, for example, that on March 1, 1986, the estimated 
costs of constructing a facility were $150 million. Assume that before 
March 1, 1986, $12 million of construction costs had been incurred. 
Based on the above facts, substantial construction would be deemed to 
have occurred before March 1, 1986, because $12 million (the costs of 
construction incurred before such date) is greater than $10 million 
(the lesser of $15 million; or the greater of $10 million or $3 
million). For purposes of this provision, construction costs are 
defined as those costs incurred after construction has commenced at the 
site of the property being constructed (unless the property will not be 
located on land and, therefore, the initial construction of the 
property must begin at a location other than the intended site). For 
example, in the case of a building, construction commences when work 
begins on the building, such as the excavation of the site, the pouring 
of pads for the building, or the driving of foundation pilings into the 
ground. Preliminary activities such as project engineering and 
architectural design do not constitute the commencement of 
construction, nor are such costs considered construction costs, for 
purposes of this paragraph (b)(10).
* * * * *
    (j) * * *
    (4) * * * The District Director may require appropriate adjustments 
to valuations of inventory and other property subject to section 263A 
if a transfer of property is made to another person for a principal 
purpose of avoiding the application of section 263A. Thus, for example, 
the District Director may require a taxpayer using the simplified 
production method of Sec. 1.263A-2(b) to apply that method to 
transferred inventories immediately prior to a transfer under section 
351 if a principal purpose of the transfer is to avoid the application 
of section 263A.
    Par. 9. Section 1.263A-3(c)(4)(vi) is amended as follows:
    1. The heading is revised.
    2. The text of paragraphs (A) and (B) is added.
    3. The heading for paragraph (C) is revised and the text is added.
    4. The revised and added provisions read as follows:


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

* * * * *
    (c) * * *
    (4) * * *
    (vi) Costs not required to be capitalized as handling costs--(A) 
Distribution costs--(1) In general. Distribution costs are not required 
to be capitalized. Distribution costs are any transportation costs 
incurred outside a storage facility in delivering goods to a customer. 
For this purpose, any costs incurred on a loading dock are treated as 
incurred outside a storage facility.
    (2) Costs incurred in transporting goods to a related person. 
Distribution costs do not include costs incurred by a taxpayer in 
delivering goods to a related person. Thus, for example, when a 
taxpayer sells goods to a related person, the costs of transporting the 
goods are included in determining the basis of the goods that are sold, 
and hence in determining the resulting gain or loss from the sale, for 
all purposes of the Internal Revenue Code and the regulations 
thereunder. See, e.g., sections 267, 707, and 1502. For purposes of 
this provision, persons are related if they are described in section 
267(b) or section 707(b).
    (B) Delivery of custom-ordered items. Generally, costs incurred in 
transporting goods from a taxpayer's storage facility to its retail 
sales facility must be capitalized. However, costs incurred outside a 
storage facility in delivering custom-ordered items to a retail sales 
facility are not required to be capitalized. For this purpose, any 
costs incurred on a loading dock are treated as incurred outside a 
storage facility. Delivery of custom-ordered items occurs when a 
taxpayer can demonstrate that a delivery to the taxpayer's retail sales 
facility is made to fill an identifiable order of a particular customer 
(placed by the customer before the delivery of the goods occurs) for 
the particular goods in question. Factors that may demonstrate the 
existence of a specific, identifiable delivery include the following--
    (1) The customer has paid for the item in advance of the delivery;
    (2) The customer has submitted a written order for the item;
    (3) The item is not normally available at the retail sales facility 
for on-site customer purchases; and
    (4) The item will be returned to the storage facility (and not held 
for sale at the retail sales facility) if the customer cancels an 
order.
    (C) Pick and pack costs--(1) In general. Generally, handling costs 
incurred inside a storage or warehousing facility must be capitalized. 
However, costs attributable to pick and pack activities inside a 
storage or warehousing facility are not required to be capitalized. 
Pick and pack activities are activities undertaken in preparation for 
imminent shipment to a particular customer after the customer has 
ordered the specific goods in question. Examples of pick and pack 
activities include:
    (i) Moving specific goods from a storage location in preparation 
for shipment to the customer;
    (ii) Packing or repacking those goods for shipment to the customer; 
and
    (iii) Staging those goods for shipment to the customer.
    (2) Activities that are not pick and pack activities. Pick and pack 
activities do not include:
    (i) Unloading goods that are received for storage;
    (ii) Checking the quantity and quality of goods received;
    (iii) Comparing the quantity of goods received to the amounts 
ordered and preparing the receiving documents;
    (iv) Moving the goods to their storage location, e.g., bins, racks, 
containers, etc.; and
    (v) Storing the goods.
    (3) Costs not attributable to pick and pack activities. Occupancy 
costs, such as rent, depreciation, insurance, security, taxes, 
utilities, and maintenance costs properly allocable to the storage or 
warehousing facility, are not costs attributable to pick and pack 
activities.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
    Approved: June 28, 1994.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 94-19079 Filed 8-2-94; 12:41 pm]
BILLING CODE 4830-01-U