[Federal Register Volume 59, Number 249 (Thursday, December 29, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-31431]


[[Page Unknown]]

[Federal Register: December 29, 1994]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[T.D. 8584]
RIN 1545-AK03

 

Capitalization of Interest

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the 
requirement to capitalize interest with respect to the production of 
property. The regulations provide guidance necessary for taxpayers to 
comply with the requirement to capitalize interest with respect to 
certain produce property.

EFFECTIVE DATE: January 1, 1995.

FOR FURTHER INFORMATION CONTACT:
Jan L. Skelton, (202) 622-4970 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in these final regulations 
have been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act (44 U.S.C. 3504(h)) 
under control number 1545-1265. The estimated average annual burden per 
recordkeeper is 14 minutes. The estimated average annual reporting 
burden per respondent is 2 hours.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Internal 
Revenue Service, Attn: IRS Reports Clearance Officer PC:FP, Washington 
DC 20224, and to the Office of Management and Budget, Attention: Desk 
Officer for the Department of the Treasury, Office of Information and 
Regulatory Affairs, Washington DC 20503.

Background

    On Friday, August 16, 1991, the Federal Register published proposed 
amendments (56 FR 40815) to the Income Tax Regulations (26 CFR part 1) 
under section 263A(f) of the Internal Revenue Code (Code). Written 
comments responding to the notice were received and a public hearing 
was held on November 20, 1991. After careful consideration of all the 
comments, the proposed amendments are adopted, except as revised and 
renumbered by this document.

In General

    The uniform capitalization rules of section 263A generally require 
the capitalization of certain costs relating to the acquisition of 
property for resale or the production of property. Interest is a cost 
subject to section 263A. Section 263A(f) provides special rules for 
capitalizing interest.
    In general, section 263A(f) limits the capitalization of interest 
to interest that is paid or incurred during the production period of 
certain property (referred to as designated property). Designated 
property includes all real property and certain tangible personal 
property.
    The amount of interest required to be capitalized is determined 
using the avoided cost method. Under the avoided cost method, interest 
on any indebtedness directly attributable to production expenditures 
for designated property (traced debt) is capitalized first. If 
production expenditures for designated property exceed the amount of 
traced debt, interest on any other debt is capitalized to the extent 
such interest could have been reduced if production expenditures had 
not been incurred. The application of the avoided cost method does not 
depend on whether the taxpayer actually would have used amounts 
expended for production to repay or reduce debt. Instead, the avoided 
cost method is based on the assumption that if production expenditures 
had not been incurred, debt of the taxpayer would have been repaid or 
reduced without regard to the taxpayer's subjective intentions or to 
restrictions against repayment or use of the debt proceeds.
    For example, if Corporation X has incurred $1.5 million of 
production expenditures for a unit of real property it is constructing, 
and has an outstanding $1 million loan (from an unrelated party) for 
the construction of the real property, Corporation X must capitalize 
interest on the loan as provided in section 263A(f). In addition, 
because Corporation X has production expenditures ($1.5 million) that 
exceed traced debt ($1 million), Corporation X must capitalize interest 
on any other debt (subject to certain limitations) as provided in 
section 263A(f). In general, to determine the amount of interest it 
must capitalize on its other debt, Corporation X multiplies its excess 
production expenditures ($.5 million) by a weighted average interest 
rate for its other debt.

Public Comments

Simplification

    The proposed regulations include several provisions designed to 
reduce administrative complexity without undermining the principles of 
section 263A(f). These provisions include (1) a de minimis rule 
exempting certain insignificant production activities from the 
requirement to capitalize interest; (2) an exception from the 
requirement to capitalize interest for inventory property that has a 
class life of 20 years or more but does not satisfy the other 
classification thresholds for tangible personal property; (3) an 
election not to trace debt to designated property; (4) an election to 
calculate interest under the avoided cost method on a taxable year 
basis in lieu of a monthly or more frequent basis; and (5) a simplified 
method to calculate the amount of interest required to be capitalized 
with respect to certain inventory property.
    Commentators made several suggestions for further simplifying the 
proposed rules. As discussed in more detail below, the final 
regulations add a number of these simplifying suggestions. For example, 
the final regulations permit certain small taxpayers to use a specified 
external rate as a substitute for the weighted average interest rate. 
In addition, the final rules make the 3-month, $10,000 de minimis rule 
of the proposed regulations more flexible by increasing the dollar 
threshold for production expenditures to $1 million divided by the 
number of days in the production period. Further, the final regulations 
shorten the time required to qualify for the suspension rule from 12 
months to 120 consecutive days and apply the suspension rule 
retroactively.

Designated Property

In General
    Designated property includes all real property produced by the 
taxpayer. Tangible personal property produced by the taxpayer is also 
designated property, but only if it has a class life of 20 years or 
more, an estimated production period of more than 1 year and total 
production costs of more than $1 million, or an estimated production 
period of more than 2 years.
De Minimis Exception
    The proposed regulations provide a de minimis exception from 
interest capitalization for property that would otherwise be designated 
property. This exception applies if the property has a production 
period that does not exceed 3 months and a total cost of production 
that does not exceed $10,000.
    Commentators recommended a number of changes to this de minimis 
rule. Several commentators argued that the proposed de minimis rule 
should be liberalized by either applying the production period and cost 
thresholds in the disjunctive or increasing the thresholds. One 
commentator recommended that, in addition to a de minimis rule for 
property, the final regulations should provide a ``small taxpayer'' 
exception.
    The final regulations revise the 3-month, $10,000 de minimis rule. 
The revised rule liberalizes the de minimis rule and provides more 
flexibility in its application by adopting a dollar-day rule. As 
revised the de minimis rule excepts from interest capitalization 
property with a production period of not more than 90 days and a total 
cost of production that does not exceed $1,000,000 divided by the 
number of days in the production period. The final regulations, 
however, do not adopt a small taxpayer exception.
    Commentators also recommended that interest that would be 
capitalized if property were designated property be excluded from 
production costs in determining whether the $10,000 threshold of the 
proposed de minimis rule is met. The final regulations adopt this 
recommendation for purposes of determining production expenditures 
under the revised de minimis rule.
Definition of Real Property
    The proposed regulations provide that real property includes land, 
unsevered natural products of land, buildings, and inherently permanent 
structures. An inherently permanent structure is property that is 
affixed to real property and that will ordinarily remain affixed for an 
indefinite period of time.
    Certain commentators believed that the proposed definition of real 
property is too broad. They argued that the section 263A(f) regulations 
should define real property to exclude property classified as section 
1245 property, as well as property classified or treated as personal 
property for investment tax credit purposes (former section 48).
    Neither section 263A(f) nor its legislative history expressly 
defines ``real property.'' Nevertheless, the IRS and Treasury do not 
believe it is necessary or appropriate to define ``real property'' as 
narrowly as some commentators have suggested.
    Section 1245 provides for the recapture of the benefit of 
accelerated depreciation on, or amortization with respect to, certain 
property. Congress clearly intended to classify certain real property 
as property subject to the section 1245 rules. See section 
1245(a)(3)(B) and (C). Nothing in either section 263A(f) or its 
legislative history (or in section 189, the predecessor of section 
263A(f), and its legislative history) suggests Congress intended to 
exclude real property subject to section 1245 from the definition of 
real property for purposes of interest capitalization. See S. Rep. No. 
169, 98th Cong., 2d Sess. I-280 n. 19 (1984).
    Congress intended that the benefit of the investment tax credit 
apply expansively under former section 48. See H. Rep. No. 1447, 87th 
Cong., 2d Sess. (1962) 1962-3 C.B. 405, 415. Consistent with this 
intent, tangible personal property was not to be defined narrowly and 
was not to follow state law. Id. Nothing in the legislative history of 
section 263A(f) suggests, however, that Congress intended that such a 
broad definition of personal property be adopted for interest 
capitalization purposes.
    Some commentators interpreted certain language in proposed 
Sec. 1.263A(f)-1 (relating to the classification of property for 
purposes of former section 48 and Sec. 1.48-1(c) and Sec. 1.48-1(d)) to 
provide that property that would otherwise be an inherently permanent 
structure under section 263A(f) (i.e., because it is affixed to real 
property and will ordinarily remain affixed for an indefinite period of 
time) is not an inherently permanent structure under section 263A(f) if 
such property would constitute property in the nature of machinery 
under the principles of former section 48 and Sec. 1.48-1(c).
    As indicated above, however, the IRS and Treasury do not believe 
that the classification or treatment of property as personal property 
for purposes of former section 48 should be determinative of the 
classification of property as personal property for purposes of section 
263A(f). Accordingly, the final regulations provide that a structure 
may be an inherently permanent structure, and not property in the 
nature of machinery or essentially an item of machinery, even if the 
structure is necessary to operate or use, supports, or is otherwise 
associated with machinery.
Classification Thresholds for Personal Property
    Under the proposed regulations, designated property includes 
tangible personal property that is (i) property with a class life of 20 
years or more, but only if produced for self-use, (ii) property with an 
estimated production period exceeding 2 years (2-year property), or 
(iii) property with an estimated production period exceeding 1 year and 
a cost exceeding $1 million (1-year property). Commentators made 
recommendations regarding the $1 million cost threshold for 1-year 
property and the production period thresholds for 1-year and 2-year 
property produced under a contract.
    One commentator recommended the final regulations clarify whether 
interest that would be required to be capitalized if property were 
designated property is taken into account in determining whether the 
production costs for property exceed the $1 million production costs 
threshold. The final regulations clarify that such interest is not 
taken into account in determining whether property is designated 
property.
Classification Thresholds for Personal Property Produced Under a 
Contract
    In the case of tangible personal property produced under a 
contract, the proposed regulations require the contractor and the 
customer each to determine whether the 1-year and 2-year production 
period thresholds are satisfied. For this purpose, the proposed 
regulations require the customer to treat the production period as 
beginning on the earlier of the date the contract is executed or the 
date the customer's accumulated production expenditures are at least 5 
percent of the customer's total estimated production expenditures 
(contract date rule). One commentator recommended that a customer be 
allowed to elect to use the contract date rule, and in the absence of 
an election, treat the production period as beginning when the 
customer's accumulated production expenditures are at least 5 percent 
of the total estimated production expenditures.
    The final regulations retain the contract date rule. However, to 
address commentators' concerns, the final regulations provide that a 
customer may elect to determine the 1- and 2-year production period 
thresholds by treating the customer's production period as beginning on 
the date that aggregate accumulated production expenditures for both 
the contractor and the customer are at least 5 percent of the 
customer's estimated production expenditures for the property. The IRS 
and Treasury believe that a 5-percent rule based only on production 
expenditures incurred by a customer could be abused (e.g., a customer 
could avoid designated property classification and, thus, interest 
capitalization by simply withholding payments to the contractor).
Definition of a Contract
     Section 263A(g)(2) provides that the taxpayer shall be treated as 
producing any property produced for the taxpayer under a contract with 
the taxpayer. The final regulations under section 263A (relating to the 
capitalization of costs other than interest) published in the Federal 
Register on August 9, 1993, reserved the definition of a contract for 
this purpose.
    The preamble to those regulations stated that the definition of a 
contract was being studied under the section 263A(f) regulations. 
Commentators believed that the definition of a contract provided in the 
proposed regulations under section 263A(f) should be modified, for 
example, to exclude routine purchase orders.
    For purposes of determining whether property is produced under a 
contract, the final regulations define a contract as any agreement 
providing for the production of property if the agreement is entered 
into before the production of the property to be delivered under the 
contract is completed. Whether an agreement exists depends on all the 
facts and circumstances. Facts and circumstances to be taken into 
account include making a prepayment, or entering into an arrangement to 
make a prepayment, for property prior to the date of completion of the 
production of property or incurring significant expenditures for 
property of specialized design or specialized application.
    In response to commentators' concerns, the amendments to the final 
regulations provide that a routine purchase order for the production of 
fungible property is not a contract for purposes of section 263A(g)(2). 
Under this rule, an agreement will not be treated as a routine purchase 
order for the production of fungible property if the seller is required 
to make more than de minimis modifications to the property to tailor it 
to the customer's specific needs, or if at the time the agreement is 
entered into, the customer knows or has reason to know that the seller 
cannot satisfy the agreement within 30 days out of existing stocks and 
normal production of finished goods.

The Avoided Cost Method

In General
    The proposed regulations require taxpayers to use the avoided cost 
method described in proposed Sec. 1.263A(f)-(2) to calculate the amount 
of interest required to be capitalized under section 263A(f). A number 
of commentators argued that, for purposes of capitalizing interest 
under section 263A(f), taxpayers should be permitted to elect to use 
Statement of Financial Accounting Standards No. 34 (SFAS 34), which 
establishes standards for capitalizing interest for financial statement 
purposes.
    Congress indicated that it intended interest to be capitalized 
under the avoided cost method, using rules similar to those applicable 
under former section 189. See S. Rep. No. 313, 99th Cong., 2d Sess. 144 
(1986). Former section 189 applied rules similar to those contained in 
Financial Accounting Standards Board (FASB) Statement No. 34. H.R. 
Conf. Rep. No. 760, 97th Cong., 2d Sess. 484-85 (1982). The proposed 
section 263A(f) regulations adopt an approach similar to the rules in 
SFAS 34 in that they treat interest that would have been avoided if 
production expenditures had been used to repay indebtedness of the 
taxpayer as interest subject to capitalization.
    Although the proposed regulations use an approach similar to SFAS 
34, the IRS and Treasury are not persuaded that the regulations should 
be changed to permit the use of the financial accounting rules of SFAS 
34 instead of the avoided cost method in the proposed regulations. The 
IRS and Treasury believe that the results obtained by applying SFAS 34 
could diverge significantly from the results obtained by applying tax 
principles. For example, differences in the amount of interest 
capitalized could result because: the bases of assets for book and tax 
purposes differ; SFAS 34 allows more discretion and subjectivity (e.g., 
in identifying borrowings used to determine interest capitalization) 
that does the statute; and materiality standards used for financial 
accounting rules may not be acceptable for tax purposes. Accordingly, 
the final regulations do not permit the use of SFAS 34 as an 
alternative to the avoided cost method set forth in the regulations.
Accounts Payable and Simplification Rule for Tracing
    Under the proposed regulations, the calculation of the amount of 
interest required to be capitalized is made by reference to eligible 
debt. Eligible debt generally includes all debt of the taxpayer on 
which interest is deductible in computing taxable income. However, 
noninterest bearing debt is excluded from the definition of eligible 
debt unless the debt is traced debt (or, if the taxpayer makes an 
election not to trace debt, is debt that would have been treated as 
traced debt in the absence of such an election).
    Commentators indicated that noninterest bearing debt such as 
accounts payable should be treated as eligible debt whether or not the 
debt is traced to the accumulated production expenditures of designated 
property.
    The IRS and Treasury continue to believe that treating all 
noninterest bearing debt as eligible debt is inconsistent with 
Congressional intent. Such treatment is not similar to the FASB 34 rule 
and would distort the interest capitalization rate. The final 
regulations, therefore, maintain the treatment prescribed in the 
proposed regulations.
    Some commentators believed that it is administratively 
impracticable or virtually impossible for certain taxpayers to 
determine the noninterest bearing debt traced to the accumulated 
production expenditures of designated property. These commentators 
recommended that, if the regulations do not treat all accounts payable 
as eligible debt, the regulations should provide a simplification 
measure under which a taxpayer may ``deem'' a certain portion of 
noninterest bearing debt as constituting traced debt.
    One commentator suggested a safe harbor under which the amount of 
noninterest bearing debt deemed to be traced debt would be that portion 
of accounts payable equal to the ratio of the production expenditures 
for designated property over the production expenditures for all 
property. IRS and Treasury believe that this recommendation would not 
sufficiently approximate the portion of noninterest bearing debt that 
is traced debt for all or certain segments of taxpayers. Moreover, the 
IRS and Treasury were unable to establish a workable safe harbor. 
Finally, except for immaterial amounts, taxpayers must perform the same 
sort of tracing to adjust production expenditures for noninterest 
bearing accounts payable when they prepare financial statements. Under 
SFAS 34, the expenditures that attract interest capitalization include 
only expenditures requiring the payment of cash, the transfer of other 
assets, or the incurring of a liability on which interest is charged. 
Accordingly, the final regulations do not adopt a safe harbor under 
which a certain portion of noninterest bearing debt would be deemed 
traced debt.
Interest Capitalized on Traced Debt
    Under the avoided cost method in the proposed regulations, the 
interest capitalized on debt traced to the accumulated production 
expenditures for a unit of designated property includes the interest on 
the traced debt for the entire measurement period for any measurement 
period in which production occurs (traced debt amount).
    Commentators objected to this rule because the production period of 
a unit may not begin on the first day of the first measurement period 
of the production period and may not end on the last day of the last 
measurement period of the production period. In these situations, the 
commentators argued that only interest incurred on traced debt for the 
actual number of days encompassing the production period of a unit 
should constitute the traced debt amount.
    The IRS and Treasury believe that the proposed traced debt amount 
rule is an appropriate simplification measure. Moreover, a taxpayer 
desiring a more precise traced debt amount can effect greater precision 
by choosing more frequent measurement dates. Under the proposed rule, 
taxpayers can choose their measurement periods, the choice is not a 
method of accounting, and taxpayers may change measurement periods each 
taxable year. Accordingly, the final regulations adopt the proposed 
traced debt amount rule without change.
External Rate--Substitute for Weighted Average Interest Rate
    The avoided cost method involves the capitalization of two amounts 
of interest with respect to a unit of property: (1) an amount of 
interest with respect to traced debt and (2) an amount of interest with 
respect to nontraced debt. The amount of interest required to be 
capitalized with respect to nontraced debt is determined by multiplying 
the accumulated production expenditures that exceed traced debt for a 
unit (excess expenditures) by the weighted average interest rate 
determined on all eligible debt of a taxpayer other than traced debt 
(nontraced debt).
    To simplify the interest capitalization computation with respect to 
nontraced debt, commentators suggested that the final regulations 
permit taxpayers to elect to use an external rate as a substitute for 
the weighted average interest rate. Most commentators suggested the 
election of a rate based on the applicable federal rate (AFR). Certain 
commentators believed that small taxpayers, at a minimum, should be 
allowed this simplifying election.
    The IRS and Treasury believe that an election to use an external 
rate as a substitute for the weighted average interest rate on 
nontraced debt would generally be inappropriate because of the 
difficulty in establishing a suitable external rate for all taxpayers. 
Accordingly, the final regulations do not adopt the recommendation to 
permit all taxpayers to elect to use an external rate as a substitute 
for the weighted average interest rate.
    The final regulations do, however, permit certain small taxpayers 
to elect to use the highest AFR under section 1274(d) in effect during 
the computation period plus 3 percentage points (AFR plus 3) as a 
substitute for the weighted average interest rate. A taxpayer may elect 
to use the AFR plus 3 for a taxable year if the average annual gross 
receipts of the taxpayer (or any predecessor) for the preceding 3 
taxable years do not exceed $10,000,000 (the $10,000,000 gross receipts 
test), and the taxpayer has met the $10,000,000 gross receipts test for 
all prior taxable years beginning after December 31, 1994. The rules of 
Sec. 1.263A-3(b) apply in determining whether a taxpayer satisfies the 
$10,000,000 gross receipts test. A taxpayer making the AFR plus 3 
election may not trace debt.

Notional Principal Contracts

    The treatment of notional principle contracts and other derivatives 
under section 263A(f) is reserved in the final regulations.

Definition of Unit of Property

    The proposed regulations provide that a unit includes any 
components owned by the taxpayer or a related party that are 
functionally interdependent. Components of property are functionally 
interdependent when the placing in service of one component is 
dependent on the placing in service of one or more other components.
    Certain commentators recommended that the final regulations adopt 
the definition of a unit provided under Sec. 1.167(a)-11(d)(2)(vi), 
which defines a unit of property for purposes of applying the elective 
alternative depreciation (ADR) repair allowance provisions. Section 
1.167(a)-11(d)(2)(vi) defines a unit to include each operating unit 
that performs a discrete function and that a taxpayer customarily 
acquires for original installation and retires as a unit. Commentators 
argued that taxpayers are already familiar with this definition of a 
unit.
    The IRS and Treasury believe that section 263A(f) and its 
legislative history indicate that property includes the functionally 
interdependent components of property. Congress repealed former section 
189 (relating to the capitalization of interest and taxes during the 
construction period of real property) and enacted the more expansive, 
uniform capitalization rules under section 263A(f). Under former 
section 189, an entire building (including the land component) was 
property to which interest was capitalized. See H.R. Conf. Rep. No. 
760, 97th Cong., 2d Sess. 48 (1982). The IRS and Treasury believe that 
Congress did not intend that property be defined more narrowly under 
section 263A(f) than under former section 189. Accordingly, under 
section 263A(f), property also includes an entire building (including 
the land component), as the aggregation of functionally interdependent 
components of property. Section 263A(f) defines property uniformly, and 
therefore, property in all circumstances includes the functionally 
interdependent components of property.
    Treating the functionally interdependent components of property as 
a single property for interest capitalization is consistent with the 
concept of a single property that applies under section 167 in 
determining the date on which components of a single property are 
placed in service. As the commentators recognized, this concept of a 
single property may differ from the concept of a single or separate 
property that taxpayers use for other purposes (e.g., for computing 
amounts of depreciation deductions or separately tracking the bases of 
assets).
    The Sec. 1.167(a)-11(d)(2)(vi) definition of a unit may not 
encompass the functionally interdependent components of property. This 
definition of a unit applied for purposes of applying the alternative 
depreciation (ADR) repair allowance provisions, which were elective. 
The provisions provided a simplification procedure for treating a 
taxpayer's expenditures as either capitalized expenditures or 
deductible expenses. Taxpayers that elected the provisions, and used 
this Sec. 1.167(a)-11(d)(2)(vi) definition of a unit, we required to 
use the same standard that other taxpayers used in determining the date 
on which property was placed in service (i.e., the standard consistent 
with the concept of a single property as an aggregation of functionally 
interdependent components). Accordingly, the final regulations do not 
adopt commentators' recommendation to modify the definition of a unit 
of property.

Common Feature Rules

Land Attributable to Benefitted Property
    Under the proposed regulations, an allocable share of a common 
feature that benefits real property and the real property being 
benefitted are a single unit of real property (common feature rule). 
The production period for the entire unit begins when production begins 
on either the benefitted real property or a common feature allocable to 
the unit. Thus, commencing production on only a common feature results 
in interest being capitalized not only on the costs of the common 
feature but also on the costs of land underlying the benefitted 
property.
    Commentators argued that the proposed common feature rule produces 
harsh consequences. For example, when construction commences on a 
single common feature that benefits each house in a housing 
development, interest capitalization commences on all land in the 
housing development even if no direct production activity has been 
undertaken on any house. Commentators also indicated that the proposed 
interest suspension rule provides insufficient relief in these 
circumstances. Under the proposed regulations, interest capitalization 
may be suspended prospectively for a unit only when production 
activities have ceased for the unit for at least a 12-month period. 
Thus, in the case of the housing development described above, the 
proposed regulations would require interest on land costs attributable 
to the houses to be capitalized from the commencement of construction 
of the common feature until the 13th month after its completion. 
Interest capitalization would be required with respect to those costs 
for that period even if no direct production activity will be 
undertaken on the houses for several years.
    The final regulations continue to provide that the allocable share 
of a common feature and the benefitted property are a single unit of 
real property, but provide two new rules in response to the 
commentators' concerns. Under the first new rule, the land costs of the 
benefitted property are not treated as included in the accumulated 
production expenditures for the unit (i.e., are not treated as included 
in the costs that attract interest capitalization) until a direct 
production activity commences on the benefitted property. Thus, for 
example, if no direct production activities have been undertaken on 
planned houses, such as clearing and grading activities on the land 
underlying the houses, the cost of the land underlying the houses is 
not treated as included in the accumulated production expenditures for 
the unit. This treatment is permitted until direct production 
activities begin on the houses, even though the production periods for 
the house units have begun because production has begun on common 
features benefitting the houses.
    The second new rule provides that if after clearing and grading has 
been undertaken with respect to the land attributable to the benefitted 
property (the land underlying the houses in the above example), there 
is no direct production activity taken with respect to the benefitted 
property for a period of at least 120 consecutive days, the accumulated 
production expenditures attributable to the benefitted property are 
treated as not included in the accumulated production expenditures of 
the unit from the first measurement period after the beginning on the 
120-day period until the measurement period in which direct production 
activity resumes with respect to the benefitted property.
Benefitted Property Completed
    The proposed regulations indicate that, when benefitted property is 
sold or placed in service prior to the completion of a common feature 
allocable to a unit, the costs of the benefitted property and allocable 
common features no longer attract interest capitalization. See 
Sec. 1.263A-10(b)(6), Example 5.
    Commentators suggested that the final regulations provide a rule 
under which the costs of a benefitted property would not be included in 
accumulated production expenditures when the benefitted property is 
completed prior to the completion of a common feature included in the 
unit, irrespective of whether such benefitted property is sold or 
placed in service.
    The IRS and Treasury believe the exception provided in the proposed 
regulations should not be extended to cases where a benefitted property 
is not sold or placed in service prior to the completion of the common 
feature. Accordingly, the final regulations do not adopt the 
commentators' recommendation.
    Rev. Proc. 92-29, 1992-1 C.B. 748, permits a developer to include 
in the basis of properties sold their allocable share of the estimated 
cost of common improvements without regard to whether the costs are 
incurred under section 461(h) of the Code, relating to economic 
performance. As of the end of any taxable year, however, the total 
amount of common improvement costs included in the basis of the 
properties sold may not exceed the amount of common improvement costs 
that have been incurred under section 461(h) (``the alternative cost 
limitation''). The final regulations clarify that Rev. Proc. 92-29 does 
not affect the determination of accumulated production expenditures of 
unsold units even if the costs of common improvements for those unsold 
units have been used to determine the alternative cost limitation for 
purposes of including common improvement costs in the basis of sold 
units.

Utilities--Construction Work in Process

    Under the proposed regulations, the accumulated production 
expenditures for a unit of property (i.e, the costs that attract 
interest capitalization) generally include the amount of the direct and 
indirect costs that are required to be capitalized with respect to the 
unit.
    Certain commentators indicated that if construction work in process 
(CWIP) is included in rate base for ratemaking purposes (of utilities, 
for example), the CWIP should be excluded from the accumulated 
production expenditures. These commentators pointed out that in 
enacting section 263A(f), Congress intended to match the interest 
incurred in producing property with the related income from property. 
These commentators argued that by including CWIP in rate base for 
ratemaking purposes, income is currently taken into account, and that 
to match interest with its related income, the interest attributable to 
CWIP should be currently deductible. They believed that to achieve this 
match, CWIP should be excluded from accumulated production 
expenditures.
    Under the avoided cost method of section 263A(f), CWIP expenditures 
are incurred with respect to property produced, and no statutory 
exception excludes them from the production expenditures for property. 
The legislative history of section 263A(f) indicates that the avoided 
cost method is intended to apply to a taxpayer, such as a regulated 
utility company, irrespective of whether the method is required, 
authorized, or considered appropriate under financial or regulatory 
accounting principles. See H.R. Conf. Rep. No. 841, 99th Cong., 2d 
Sess. II-309 (1986). CWIP is therefore intended to be included in the 
production expenditures for property produced, and interest capitalized 
with respect to CWIP is intended to become a cost of the property 
produced, which is recovered as the property is used in the taxpayer's 
trade or business. Moreover, the suggestion that the commentators urge 
the IRS and Treasury to adopt in the final regulations is inconsistent 
with the rules that apply to determine the date on which CWIP is placed 
in service for depreciation purposes and is inconsistent with the rules 
that apply under broader section 263A provisions to capitalize other 
direct and indirect costs to CWIP during periods for which the 
commentators argue the CWIP is generating income.
    Further, the commentators' suggestion would not present a 
consistent resolution to the matching concerns that the commentators 
argue exist with respect to the treatment of CWIP within regulated 
utilities industries. Interest incurred prior to the beginning of the 
production period on CWIP that is not included in rate base, for 
example, presents matching concerns that would not be resolved by the 
commentators' suggestion. For this and the other reasons summarized 
above, the commentators' suggestion has not been adopted in the final 
regulations.
    As an alternative suggestion, commentators urged the IRS and 
Treasury to adopt a book conformity rule for the treatment of interest 
on CWIP. This suggestion was not adopted, however, for principally the 
same reasons that the use of the FAS 34 computation as a substitute for 
section 263A(f) avoided cost computations was not adopted. 
Additionally, the difference between the regulatory accounting for CWIP 
and the required statutory treatment of CWIP under section 263A(f) is 
but one example of the many inconsistencies between regulatory and tax 
accounting (some of which were illustrated above). Therefore, the IRS 
and Treasury believe it would be inappropriate to adopt a book 
conformity rule for interest capitalization alone given the existence 
of these other inconsistencies.

Improvements to Real Property

Property Taken Out of Service
    The proposed regulations provide special rules for determining the 
accumulated production expenditures for an improvement to existing real 
property. The accumulated production expenditures for an improvement 
include all direct and indirect costs required to be capitalized with 
respect to the improvement, plus an allocable portion of the cost of 
associated land. Additionally, the adjusted bases of any existing 
structure or common features that directly benefit or are incurred by 
reason of the improvement are included in the accumulated production 
expenditures if they either are not already placed in service or must 
be taken out of service in order to complete the improvement.
    Commentators indicated that sometimes property must be temporarily 
disconnected or otherwise taken out of service for health, safety, or 
regulatory reasons in order to make certain improvements (e.g., a power 
generating facility must be taken out of service in order to make 
capital improvements). Commentators suggested that the regulations 
provide that property is taken out of service only if the property is 
taken out of service for depreciation purposes.
    The final regulations do not adopt the suggestion concerning when 
property should be considered taken out of service. However, the final 
regulations provide a de minimis rule for property taken out of 
service. Under the de minimis rule, the aggregate costs of all property 
or common features taken out of service to complete an improvement 
(associated property costs) are excluded from the accumulated 
production expenditures for the improvement unit during its production 
period if, on the date the production period of the unit begins, the 
taxpayer reasonably expects that on no date during the production 
period of the unit will the accumulated production expenditures for the 
unit, determined without regard to associated property costs, exceed 5 
percent of associated property costs.
Inclusion of Land
    The proposed regulations provide that an improvement to existing 
real property includes the allocable portion of land associated with 
the improvement. As such, the basis of land may be included in the 
accumulated production expenditures for more than one unit of 
designated property. For example, a portion of the basis of land 
included in the accumulated production expenditures for a building unit 
must also be included in the accumulated production expenditures for a 
separate tenant improvement unit.
    Commentators objected to this rule. They suggested that, once land 
was included in the accumulated production expenditures for a unit of 
property, it should not be included in the accumulated production 
expenditures for any other unit of property.
    Section 263A(f)(4)(C) provides that the production expenditures for 
property include all capitalized costs of property, whether or not 
those costs are incurred during the production period of property. Land 
expenditures are part of the capitalized costs of property, and land 
costs should be included in the accumulated production expenditures for 
property during its production period, even if they are incurred before 
the production period. Accordingly, the final regulations do not adopt 
the commentators' recommendation.

End of the Production Period--Customizing Activities

    The proposed regulations provide that the production period 
generally ends for a unit of property that will be held for sale on the 
date the unit is ready to be held for sale and all production 
activities reasonably expected to be undertaken with respect to the 
unit are completed. The proposed regulations provide that the 
production period generally ends for a unit of property produced for 
self-use on the date the unit is ready to be placed in service and all 
production activities reasonably expected to be undertaken with respect 
to the unit are completed.
    Commentators believe it is unfair for the production period to 
continue for a residential or commercial unit that is complete except 
for activities relating to ``de minimis'' production expenditures for 
customized features chosen by a buyer or lessee. These features, which 
include carpeting, cabinets, appliances, wall coverings, and flooring, 
are often not added to a unit until an identified buyer or lessee 
selects the features, or the unit is sold. These commentators 
recommended that the production period should end for a unit when only 
``de minimis'' customizing activities remain to be performed.
    The final regulations do not adopt this recommendation, however, 
because the IRS and Treasury continue to believe that customizing 
activities are production activities and that the production period 
does not end until these activities are completed. Nevertheless, a 
shortened, retroactive suspension period rule adopted in the final 
regulations (and explained below) will provide relief in situations 
that involve long periods of delay in the performance of customizing 
activities.

Suspension Period

    The proposed regulations provide that, when production activities 
related to the production of a unit of designated property cease for a 
period of 12 consecutive months, the capitalization of interest is not 
required (i.e., is suspended) for the period beginning with the 13th 
month of cessation. The suspension period ends when production 
activities resume. For administrative convenience, the proposed 
regulations use an objective time test, and therefore, the reasons for 
suspending production are not considered.
    Commentators believed that the rule in the proposed regulations 
unduly delays the suspension of interest capitalization. They argued 
that a taxpayer should not have to wait 12 months before suspending 
interest capitalization if production activities cease for reasons such 
as strikes, fires, or natural disasters. Some commentators believed 
that the determination of whether activities have ceased should be a 
facts and circumstances test and that interest capitalization should be 
suspended in the month following the cessation of production 
activities. Others argued that the cessation period should be only 3 or 
4 months. Still others argued that, if the 12-month cessation period is 
retained, the suspension of interest capitalization should apply 
retroactively as of the first month of cessation.
    In response to these comments, the final regulations shorten the 
cessation period from 12 consecutive months to 120 consecutive days 
and, once the cessation period is satisfied, permit taxpayers to 
retroactively suspend interest capitalization as of the first 
measurement period following the measurement period in which production 
activities ceased. Alternatively, if the cessation period spans more 
than one taxable year, and a taxpayer does not want to file an amended 
return for the prior year, the taxpayer may suspend the capitalization 
of interest with respect to its units of designated property beginning 
with the first measurement period of the taxable year in which the 120-
day period is satisfied.
    In connection with the shorter 120-day cessation period, however, 
the final regulations introduce several new criteria for determining 
whether production activities are considered to have ceased. Production 
activities are not considered to have ceased under the final 
regulations if they cease because of any delays inherent in the asset 
production process.

Oil and Gas Provisions

Section 614 Costs in Accumulated Production Expenditures
    Under the proposed regulations, the costs with respect to a section 
614 property (section 614 costs) are included in the accumulated 
production expenditures for the first well in a multi-phase 
development. Each subsequent well includes a pro rata share of these 
undepleted costs based on total wells that the taxpayer could feasibly 
drill on the section 614 property. However, the taxpayer may partition 
the section 614 costs among the number of wells to be drilled on the 
section 614 property if the taxpayer can devise a ``definite plan'' 
upfront that identifies the number and location of wells to be drilled.
    Commentators indicated that the ``definite plan'' requirement is 
impracticable. According to them, the number and location of wells to 
be drilled on a property may not be known on the date that a first 
drilling activity is undertaken on the section 614 property. 
Commentators, therefore, suggested that the final regulations allow 
taxpayers to partition the section 614 costs among the number of wells 
``feasibly expected'' to be drilled on the section 614 property. 
Alternatively, commentators suggested that the final regulations 
require taxpayers to include the section 614 costs only in the 
accumulated production expenditures for a first well drilled on the 
section 614 property.
    The final regulations retain the definite plan rule. In light of 
the unique nature of a mineral interest and the circumstances 
surrounding the development of such an interest, however, the final 
regulations revise the rule for taxpayers unable to establish a 
definite plan. Under the revised rule, the section 614 costs are 
generally only included once in the accumulated production expenditures 
for a first productive well unit on the section 614 property. (However, 
the final regulations provide that the undepleted portion of section 
614 costs allocated to the first productive well unit must be included 
in the accumulated production expenditures for an improvement to the 
unit.) The final regulations provide that a first productive well unit 
generally includes all wells that are drilled on a section 614 property 
prior to the date the first productive well on the property is placed 
in service and all production activities reasonably expected to be 
undertaken are completed. Accordingly, the section 614 costs are 
included in a unit (to attract interest capitalization) from the date 
the first physical site activity is undertaken with respect to the 
section 614 property until the date the first productive well on the 
section 614 property is placed in service and all production activities 
reasonably expected to be undertaken are completed. Generally, each 
well on a section 614 property that is drilled subsequent to such date 
comprises a separate unit of property. The IRS and Treasury believe 
this rule is more objective and practical than a rule that would 
require the section 614 costs to be partitioned among the number of 
wells ``feasibly expected'' to be drilled on a section 614 property.
    The final regulations provide a rule for common feature costs 
similar to the rule provided for section 614 property costs. Under the 
final regulations, the costs of the common features are generally 
included only in the accumulated production expenditures for the first 
productive well unit.
Beginning of Production Period
    The proposed regulations provide that the production period begins 
for an oil or gas well on the first date physical site preparation 
activities are undertaken with respect to the property.
    Certain commentators believed that the production period should 
begin for an onshore oil or gas well unit on the ``spud date,'' rather 
than on the first date of physical site preparation activity. 
Commentators indicated that taxpayers often do not separately track the 
first date of physical site activity on a property, but do maintain 
records with respect to the spud date for purposes of applying other 
provisions of the Code, such as section 291(b).
    The IRS and Treasury do not believe that the spud date is an 
appropriate date to adopt as the beginning of the production period for 
an onshore oil or gas well unit. The spud date may occur long after the 
first date that a physical site preparation activity is undertaken on a 
section 614 property. Using the spud date could, therefore, be too 
great a deviation from the general rule that treats site preparation as 
the beginning of the production period of other real property. 
Accordingly, the final regulations do not adopt the commentators' 
recommendation regarding the spud date.
Surface Equipment and End of Production Period
    The proposed regulations provide that the production period 
generally ends for an oil or gas well on the date that surface 
production equipment is installed and the well is placed in service.
    Commentators argued that the production period for a well unit 
should not continue beyond the date a ``Christmas tree'' is installed 
on the well and that the accumulated production expenditures for the 
well should not include the costs of surface production equipment.
    The final regulations provide that the production period generally 
ends for a productive well unit on the date that the productive well 
included in the unit is placed in service and all production activities 
reasonably expected to be undertaken are completed. These rules are 
consistent with the general rules that apply in the case of other types 
of produced property.
Casing Point
    The proposed regulations provide that the production period 
generally ends for a nonproductive well on the date that the 
nonproductive well is plugged and abandoned.
    Commentators believed that the production period for a 
nonproductive well unit should end at the casing point, which they 
indicate is the date that a decision is made not to complete the well 
for production.
    The final regulations do not address the date on which the 
production period ends for a nonproductive well. The IRS and Treasury 
believe, however, that the general standards that apply in the case of 
other types of abandoned property should be used to determine the date 
on which the production period ends for a nonproductive well.
Allocation of Capitalized Interest to Depreciable or Depletable Unit 
Components
    The proposed regulations provide that the interest required to be 
capitalized with respect to a unit is added to the basis of designated 
property, rather than to the bases of any assets used to produce the 
designated property. Additionally, interest required to be capitalized 
with respect to the production of land is added to the basis of any 
related depreciable improvement.
    Commentators believed that the final regulations should provide 
that interest required to be capitalized with respect to an oil or gas 
well unit is first capitalized into the basis of the unit's depreciable 
property components, if any, prior to the bases of the unit's 
depletable property components. The commentators believed that this 
rule is substantially similar to the rule in the proposed regulations 
with respect to the allocation of capitalized interest to components of 
a land improvement unit.
    The IRS and Treasury believe that interest capitalized with respect 
to components of a unit of property that are not subject to an 
allowance for depreciation or depletion is appropriately added to the 
basis of the components of a unit of property that are subject to an 
allowance for depreciation or depletion. Thus, the proposed regulations 
provided that interest capitalized with respect to land, the cost of 
which is not depreciable or depletable, is added to the basis of 
related depreciable improvements, if any. However, interest capitalized 
with respect to the depletable property components of a well unit is 
subject to an allowance for depletion. Accordingly, the final 
regulations do not adopt the commentators' suggestions.
Independent Producer Onshore Well Exemption
    Certain commentators suggested that independent producer onshore 
wells should be exempted from interest capitalization based on their 
belief that the compliance costs for these wells outweigh the tax 
revenues to be gained.
    Under section 263A(c)(3), Congress exempted from the uniform 
capitalization rules certain costs incurred with respect to oil and gas 
activities, but did not exempt oil and gas activities themselves. Thus, 
the IRS and Treasury do not believe that a specific exemption for all 
independent onshore wells is appropriate. Accordingly, the final 
regulations do not provide a specific exemption for independent onshore 
wells.

Examples

    The final regulations provide examples, but delete the 
comprehensive real estate example. The IRS anticipates providing 
illustrations of interest capitalization in other guidance.

Related Person Rules

In General
    Section 263A(i) provides that the Secretary shall prescribe such 
regulations as may be necessary or appropriate to carry out the 
purposes of the uniform capitalization rules, including regulations to 
prevent the use of related persons, pass-through entities, or 
intermediaries to avoid these rules.
    Notice 88-99, issued August 17, 1998, provides the principal source 
of guidance concerning the application of related person rules under 
section 263A(f). Notice 88-99 generally provides that if a taxpayer is 
producing designated property and has accumulated production 
expenditures that exceed the total amount of its eligible debt, one or 
more related persons (generally members of the same parent-subsidiary 
controlled group as defined in section 1563(a)(1), whether or not 
filing consolidated returns) must capitalize interest with respect to 
the excess expenditures. Under Notice 88-99, the related persons, in 
effect, capitalize interest with respect to the excess expenditures as 
if the related persons had incurred those expenditures directly. The 
notice provides similar rules in the case of flow through entities 
(i.e., partnerships or S corporations).
    The proposed regulations also provide certain related person rules 
and direct taxpayers to follow applicable administrative pronouncements 
in applying the rules. More comprehensive related person rules will be 
proposed at a future date under a separate regulations project. Until 
more specific rules are provided under related person regulations, 
however, Notice 88-99 generally indicates the position of the IRS with 
respect to the application of related persons rules under section 
263A(f). To the extent that Notice 88-99 rules are modified by specific 
provisions in, or principles of, these final regulations, the rules and 
principles of the final regulations are controlling.
Consolidated Return Interest Rule
    Consistent with the purposes of section 263A(f), the proposed 
regulations provide that to the extent of a consolidated group's 
outside interest deduction, the consolidated group must currently 
report, rather than defer, the interest income on intragroup debt on 
which it capitalizes interest (consolidated section 263A(f) interest 
rule). Without this rule, a consolidated group could effectively avoid 
capitalizing interest under section 263A(f) if the group were to 
capitalize interest intragroup debt, but at the same time defer 
reporting the associated interest income and deduct outside interest 
equal to or less than the interest capitalized.
    Certain taxpayers believed that the consolidated section 263A(f) 
interest rule does not apply unless and until final regulations are 
issued under section 263A or section 1502. The IRS and Treasury 
believe, however, that a consolidated group that effectively deducts 
interest by capitalizing interest on intragroup debt under section 
263A(f) and deferring the associated interest income on the debt adopts 
an unreasonable interpretation of the statute and legislative history 
of section 263A(f) to the extent the associated interest income on the 
intragroup debt is less than or equal to the group's outside interest 
expense deductions.
Comments on Related Person Rules
    Commentators submitted comments on certain related persons issues. 
In particular, commentators believed that, under Notice 88-99 and the 
proposed rules, capitalizing interest on the intragroup debt of an 
affiliated group that is not a consolidated group may create an 
overcapitalization of interest. According to the commentators, 
overcapitalization may occur, for example, if two or more members 
capitalize interest with respect to the same debt (e.g., back-to-back 
loans). Additionally, one commentator believed that interest on debt 
owed to a producing member by a nonproducing member should not be 
subject to capitalization.
    In response to commentator concerns, the IRS and Treasury are 
studying whether the amount of interest capitalized by the related 
person members of an affiliated group should be limited to the interest 
incurred by all affiliated group members on outside debt, less any 
interest capitalized by the producing member on outside and intragroup 
debt. It is generally the intent of Rev. Proc. 88-99 and the final 
regulations to prevent taxpayers from avoiding the purposes of interest 
capitalization through the use of related persons. The IRS and Treasury 
welcome additional comments on this and other related person issues 
that should be addressed in future related person regulations.

Accounting Method Changes

    The final section 263A(f) regulations are generally effective for 
taxable years beginning on or after January 1, 1995. Taxpayers that 
have previously adopted methods of accounting under section 263A(f) may 
be required to change their methods of accounting under section 263A(f) 
to comply with the final regulations. Within 30 days, the IRS will 
issue a revenue procedure prescribing the procedures, terms, and 
conditions for effecting method changes necessary due to the 
promulgation of these regulations.
    The revenue procedure will facilitate election of early application 
of the regulations to the first taxable year beginning on or after 
January 1, 1994 so that taxpayers may combine, within the same taxable 
year, changes under the final section 263A(f) regulations and changes 
under the final general section 263A regulations.

Clarification of Mixed Service Costs De Minimis Rules

    The final regulations clarify the application of the 90 percent de 
minimis rule for mixed service department costs contained in the final 
main section 263A regulations. Under that rule, an electing taxpayer is 
not required to allocate any portion of a mixed service department's 
costs to property produced or acquired for resale if 90 percent or more 
of the department's costs are deductible service costs. The final 
regulations clarify that if this election is made, the taxpayer must 
also allocate all of a mixed service department's costs to property 
produced or acquired for resale if 90 percent or more of the 
department's costs are capitalizable service costs.
Special Analyses
    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in EO 12866. Therefore, a 
regulatory assessment is not required. It also has been determined that 
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) 
and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to 
these regulations, and, therefore, a Regulatory Flexibility Analysis is 
not required. Pursuant to section 7805(f) of the Internal Revenue Code, 
the notice of proposed rulemaking preceding these regulations was 
submitted to the Small Business Administration for comment on its 
impact on small business.

Drafting Information

    The principal author of these final regulations is Mary E. Goode of 
the Office of Assistant Chief Counsel, Internal Revenue Service. 
However, personnel from other offices of the Internal Revenue Service 
and Treasury Department participated in their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 602 are amended as follows:
    Paragraph 1. The authority citation for part 1 is amended by adding 
the following citation:

    Authority: 26 U.S.C. 7805 * * * Sections 1.263A-8 through 
1.263A-15 also issued under 26 U.S.C. 263A(i).

    Par. 2. Section 1.263A-0 is amended by revising the introductory 
text, removing the word ``Reserved'' after Sec. 1.263A-
2(a)(1)(ii)(B)(2), removing the word ``Reserved'' after Secs. 1.263A-
3(c)(4)(vi) (A) through (C) to reflect issuance of T.D. 8559 on August 
5, 1994, and adding the following headings for Secs. 1.263A-8 through 
1.263A-15 to read as follows:


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

    This section lists the paragraphs in Secs. 1.263A-1 through 1.263A-
3 and Secs.  1.263A-8 through 1.263A-15.
* * * * *


Sec. 1.263A-8   Requirement to capitalize interest.

    (a) In general.
    (1) General rule.
    (2) Treatment of interest required to be capitalized.
    (3) Methods of accounting under section 263A(f).
    (4) Special definitions.
    (i) Related person.
    (ii) Placed in service.
    (b) Designated property.
    (1) In general.
    (2) Special rules.
    (i) Application of thresholds.
    (ii) Relevant activities and costs.
    (iii) Production period and cost of production.
    (3) Excluded property.
    (4) De minimis rule.
    (i) In general.
    (ii) Determination of total production expenditures.
    (c) Definition of real property.
    (1) In general.
    (2) Unsevered natural products of land.
    (3) Inherently permanent structures.
    (4) Machinery.
    (i) Treatment.
    (ii) Certain factors not determinative.
    (d) Production.
    (1) Definition of produce.
    (2) Property produced under a contract.
    (i) Customer.
    (ii) Contractor.
    (iii) Definition of a contract.
    (iv) Determination of whether thresholds are satisfied.
    (A) Customer.
    (B) Contractor.
    (v) Exclusion for property subject to long-term contract rules.
    (3) Improvements to existing property.
    (i) In general.
    (ii) Real property.
    (iii) Tangible personal property.


Sec. 1.263A-9   The avoided cost method.

    (a) In general.
    (1) Description.
    (2) Overview.
    (i) In general.
    (ii) Rules that apply in determining amounts.
    (3) Definitions of interest and incurred.
    (4) Definition of eligible debt.
    (b) Traced debt amount.
    (1) General rule.
    (2) Identification and definition of traced debt.
    (3) Example.
    (c) Excess expenditure amount.
    (1) General rule.
    (2) Interest required to be capitalized.
    (3) Example.
    (4) Treatment of interest subject to a deferral provision.
    (5) Definitions.
    (i) Nontraced debt.
    (A) Defined.
    (B) Example.
    (ii) Average excess expenditures.
    (A) General rule.
    (B) Example.
    (iii) Weighted average interest rate.
    (A) Determination of rate.
    (B) Interest incurred on nontraced debt.
    (C) Average nontraced debt.
    (D) Special rules if taxpayer has no nontraced debt or rate is 
contingent.
    (6) Examples.
    (7) Special rules where the excess expenditure amount exceeds 
incurred interest.
    (i) Allocation of total incurred interest to units.
    (ii) Application of related person rules to average excess 
expenditures.
    (iii) Special rule for corporations.
    (d) Election not to trace debt.
    (1) General rule.
    (2) Example.
    (e) Election to use external rate.
    (1) In general.
    (2) Eligible taxpayer.
    (f) Selection of computation period and measurement dates and 
application of averaging conventions.
    (1) Computation period.
    (i) In general.
    (ii) Method of accounting.
    (iii) Production period beginning or ending during the computation 
period.
    (2) Measurement dates.
    (i) In general.
    (ii) Measurement period.
    (iii) Measurement dates on which accumulated production 
expenditures must be taken into account.
    (iv) More frequent measurement dates.
    (3) Examples.
    (g) Special rules.
    (1) Ordering rules.
    (i) Provisions preempted by section 263A(f).
    (ii) Deferral provisions applied before this section.
    (2) Application of section 263A(f) to deferred interest.
    (i) In general.
    (ii) Capitalization of deferral amount.
    (iii) Deferred capitalization.
    (iv) Substitute capitalization.
    (A) General rule.
    (B) Capitalization of amount carried forward.
    (C) Method of accounting.
    (v) Examples.
    (3) Simplified inventory method.
    (i) In general.
    (ii) Segmentation of inventory.
    (A) General rule.
    (B) Example.
    (iii) Aggregate interest capitalization amount.
    (A) Computation period and weighted average interest rate.
    (B) Computation of the tentative aggregate interest capitalization 
amount.
    (C) Coordination with other interest capitalization computations.
    (1) In general.
    (2) Deferred interest.
    (3) Other coordinating provisions.
    (D) Treatment of increases or decreases in the aggregate interest 
capitalization amount.
    (E) Example.
    (iv) Method of accounting.
    (4) Financial accounting method disregarded.
    (5) Treatment of intercompany transactions.
    (i) General rule.
    (ii) Special rule for consolidated group with limited outside 
borrowing.
    (iii) Example.
    (6) Notional principal contracts and other derivatives.
    (7) 15-day repayment rule.


Sec. 1.263A-10  Unit of property.

    (a) In general.
    (b) Units of real property.
    (1) In general.
    (2) Functional interdependence.
    (3) Common features.
    (4) Allocation of costs to unit.
    (5) Treatment of costs when a common feature is included in a unit 
of real property.
    (i) General rule.
    (ii) Production activity not undertaken on benefitted property.
    (A) Direct production activity not undertaken.
    (1) In general.
    (2) Land attributable to a benefitted property.
    (B) Suspension of direct production activity after clearing and 
grading undertaken.
    (1) General rule.
    (2) Accumulated production expenditures.
    (iii) Common feature placed in service before the end of production 
of a benefitted property.
    (iv) Benefitted property sold before production completed on common 
feature.
    (v) Benefitted property placed in service before production 
completed on common feature.
    (6) Examples.
    (c) Units of tangible personal property.
    (d) Treatment of installations.


Sec. 1.263A-11  Accumulated production expenditures.

    (a) General rule.
    (b) When costs are first taken into account.
    (1) In general.
    (2) Dedication rule for materials and supplies.
    (c) Property produced under a contract.
    (1) Customer.
    (2) Contractor.
    (d) Property used to produce designated property.
    (1) In general.
    (2) Example.
    (3) Excluded equipment and facilities.
    (e) Improvements.
    (1) General rule.
    (2) De minimis rule.
    (f) Mid-production purchases.
    (g) Related person costs.
    (h) Installation.


Sec. 1.263A-12  Production period.

    (a) In general.
    (b) Related person activities.
    (c) Beginning of production period.
    (1) In general.
    (2) Real property.
    (3) Tangible personal property.
    (d) End of production period.
    (1) In general.
    (2) Special rules.
    (3) Sequential production or delivery.
    (4) Examples.
    (e) Physical production activities.
    (1) In general.
    (2) Illustrations.
    (f) Activities not considered physical production.
    (1) Planning and design.
    (2) Incidental repairs.
    (g) Suspension of production period.
    (1) In general.
    (2) Special rule.
    (3) Method of accounting.
    (4) Example.


Sec. 1.263A-13  Oil and gas activities.

    (a) In general.
    (b) Generally applicable rules.
    (1) Beginning of production period.
    (i) Onshore activities.
    (ii) Offshore activities.
    (2) End of production period.
    (3) Accumulated production expenditures.
    (i) Costs included.
    (ii) Improvement unit.
    (c) Special rules when definite plan not established.
    (1) In general.
    (2) Oil and gas units.
    (i) First productive well unit.
    (ii) Subsequent units.
    (3) Beginning of production period.
    (i) First productive well unit.
    (ii) Subsequent wells.
    (4) End of production period.
    (5) Accumulated production expenditures.
    (i) First productive well unit.
    (ii) Subsequent well unit.
    (6) Allocation of interest capitalized with respect to first 
productive well unit.
    (7) Examples.


Sec. 1.263A-14  Rules for related persons.


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

    (a) Effective dates.
    (b) Transitional rule for accumulated production expenditures.
    (1) In general.
    (2) Property used to produce designated property.
    (c) Anti-abuse rule.
    Par. 3. Section 1.263A-1 is amended by revising the third sentence 
of paragraph (g)(4)(ii) to read as follows:


Sec. 1.263A-1  Uniform capitalization of costs.

* * * * *
    (g) * * *
    (4) * * *
    (ii) * * * Under this election, however, if 90 percent or more of a 
mixed service department's costs are capitalizable service costs, a 
taxpayer must allocate 100 percent of the department's costs to the 
production or resale activity benefitted. * * *
* * * * *
    Par. 4. Section 1.263A-2 is amended by revising paragraph 
(a)(1)(ii)(B)(2) to read as follows:


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

    (a) * * *
    (1) * * *
    (ii) * * *
    (B) * * *
    (2) Definition of a contract--(i) General rule. Except as provided 
under paragraph (a)(1)(ii)(B)(2)(ii) of this section, a contract is any 
agreement providing for the production of property if the agreement is 
entered into before the production of the property to be delivered 
under the contract is completed. Whether an agreement exists depends on 
all the facts and circumstances. Facts and circumstances indicating an 
agreement include, for example, the making of a prepayment, or an 
arrangement to make a prepayment, for property prior to the date of the 
completion of production of the property, or the incurring of 
significant expenditures for property of specialized design or 
specialized application that is not intended for self-use.
    (ii) Routine purchase order exception. A routine purchase order for 
fungible property is not treated as a contract for purposes of this 
section. An agreement will not be treated as a routine purchase order 
for fungible property, however, if the contractor is required to make 
more than de minimis modifications to the property to tailor it to the 
customer's specific needs, or if at the time the agreement is entered 
into, the customer knows or has reason to know that the contractor 
cannot satisfy the agreement within 30 days out of existing stocks and 
normal production of finished goods.
* * * * *
    Par. 5. Section 1.263A-7 is added and reserved and Sections 1.263A-
8 through 1.263A-15 are added reading as follows:


Sec. 1.263A-8  Requirement to capitalize interest.

    (a) In general--(1) General rule. Capitalization of interest under 
the avoided cost method described in Sec. 1.263A-9 is required with 
respect to the production of designated property described in paragraph 
(b) of this section.
    (2) Treatment of interest required to be capitalized. In general, 
interest that is capitalized under this section is treated as a cost of 
the designated property and is recovered in accordance with 
Sec. 1.263A-1(c)(4). Interest capitalized by reason of assets used to 
produce designated property (within the meaning of Sec. 1.263A-11(d)) 
is added to the basis of the designated property rather than the bases 
of the assets used to produce the designated property. Interest 
capitalized with respect to designated property that includes both 
components subject to an allowance for depreciation or depletion and 
components not subject to an allowance for depreciation or depletion is 
ratably allocated among, and is treated as a cost of, components that 
are subject to an allowance for depreciation or depletion.
    (3) Methods of accounting under section 263A(f). Except as 
otherwise provided, methods of accounting and other computations under 
Secs. 1.263A-8 through 1.263A-15 are applied on a taxpayer, as opposed 
to a separate and distinct trade or business, basis.
    (4) Special definitions--(i) Related person. Except as otherwise 
provided, for purposes of Secs. 1.263A-8 through 1.263A-15, a person is 
related to a taxpayer if their relationship is described in section 
267(b) or 707(b).
    (ii) Placed in service. For purposes of Secs. 1.263A-8 through 
1.263A-15, placed in service has the same meaning as set forth in 
Sec. 1.46-3(d).
    (b) Designated property--(1) In general. Except as provided in 
paragraphs (b)(3) and (b)(4) of this section, designated property means 
any property that is produced and that is either:
    (i) Real property; or
    (ii) Tangible personal property (as defined in Sec. 1.263A-2(a)(2)) 
which meets any of the following criteria:
    (A) Property with a class life of 20 years or more under section 
168 (long-lived property), but only if the property is not property 
described in section 1221(l) in the hands of the taxpayer or a related 
person,
    (B) Property with an estimated production period (as defined in 
Sec. 1.263A-12) exceeding 2 years (2-year property), or
    (C) Property with an estimated production period exceeding 1 year 
and an estimated cost of production exceeding $1,000,000 (1-year 
property).
    (2) Special rules--(i) Application of thresholds. The thresholds 
described in paragraphs (b)(l)(ii)(A), (B), and (C) of this section are 
applied separately for each unit of property (as defined in 
Sec. 1.263A-10).
    (ii) Relevant activities and costs. For purposes of determining 
whether property is designated property, all activities and costs are 
taken into account if they are performed or incurred by, or for, the 
taxpayer or any related persons and they directly benefit or are 
incurred by reason of the production of the property.
    (iii) Production period and cost of production. For purposes of 
applying the thresholds under paragraphs (b)(l)(ii) (B) and (C) of this 
section to a unit of property, the taxpayer is required, at the 
beginning of the production period, to reasonably estimate the 
production period and the total cost of production for the unit of 
property. The taxpayer must maintain contemporaneous written records 
supporting the estimates and classification. If the estimates are 
reasonable based on the facts in existence at the beginning of the 
production period, the taxpayer's classification of the property is not 
modified in subsequent periods, even if the actual length of the 
production period or the actual cost of production differs from the 
estimates. To be considered reasonable, estimates of the production 
period and the total cost of production must include anticipated 
expense and time for delay, rework, change orders, and technological, 
design or other problems. To the extent that several distinct 
activities related to the production of the property are expected to 
occur simultaneously, the period during which these distinct activities 
occur is not counted more than once. The bases of assets used to 
produce a unit of property (within the meaning of Sec. 1.263A-11(d)) 
and any interest that would be required to be capitalized if a unit of 
property were designated property are disregarded in making estimates 
of the total cost of production for purposes of this paragraph 
(b)(2)(iii).
    (3) Excluded property. Designated property does not include:
    (i) Timber and evergreen trees that are more than 6 years old when 
severed from the roots, or
    (ii) Property produced by the taxpayer for use by the taxpayer 
other than in a trade or business or an activity conducted for profit.
    (4) De minimis rule--(i) In general. Designated property does not 
include property for which--
    (A) The production period does not exceed 90 days; and
    (B) The total production expenditures do not exceed $1,000,000 
divided by the number of days in the production period.
    (ii) Determination of total production expenditures. For purposes 
of determining whether the condition of paragraph (b)(4)(i)(B) of this 
section is met with respect to property, the cost of land, the adjusted 
basis of property used to produce property, and interest that would be 
capitalized with respect to property if it were designated property are 
excluded from total production expenditures.
    (c) Definition of real property--(1) In general. Real property 
includes land, unsevered natural products of land, buildings, and 
inherently permanent structures. Any interest in real property of a 
type described in this paragraph (c), including fee ownership, co-
ownership, a leasehold, an option, or a similar interest is real 
property under this section. Real property includes the structural 
components of both buildings and inherently permanent structures, such 
as walls, partitions, doors, wiring, plumbing, central air conditioning 
and heating systems, pipes and ducts, elevators and escalators, and 
other similar property. Tenant improvements to a building that are 
inherently permanent or otherwise classified as real property within 
the meaning of this paragraph (c)(1) are real property under this 
section. However, property produced for sale that is not real property 
in the hands of the taxpayer or a related person, but that may be 
incorporated into real property by an unrelated buyer, is not treated 
as real property by the producing taxpayer (e.g., bricks, nails, paint, 
and windowpanes.)
    (2) Unsevered natural products of land. Unsevered natural products 
of land include growing crops and plants, mines, wells, and other 
natural deposits. Growing crops and plants, however, are real property 
only if the preproductive period of the crop or plant exceeds 2 years.
    (3) Inherently permanent structures. Inherently permanent 
structures include property that is affixed to real property and that 
will ordinarily remain affixed for an indefinite period of time, such 
as swimming pools, roads, bridges, tunnels, paved parking areas and 
other pavements, special foundations, wharves and docks, fences, 
inherently permanent advertising displays, inherently permanent outdoor 
lighting facilities, railroad tracks and signals, telephone poles, 
power generation and transmission facilities, permanently installed 
telecommunications cables, broadcasting towers, oil and gas pipelines, 
derricks and storage equipment, grain storage bins and silos. For 
purposes of this section, affixation to real property may be 
accomplished by weight alone. Property may constitute an inherently 
permanent structure even though it is not classified as a building for 
purposes of former section 48(a)(1)(B) and Sec. 1.48-1. Any property 
not othewise described in this paragraph (c)(3) that constitutes other 
tangible property under the principles of former section 48(a)(1)(B) 
and Sec. 1.48-1(d) is treated for the purposes of this section as an 
inherently permanent structure.
    (4) Machinery--(i) Treatment. A structure that is property in the 
nature of machinery or is essentially an item of machinery or equipment 
is not an inherently permanent structure and is not real property. In 
the case, however, of a building or inherently permanent structure that 
includes property in the nature of machinery as a structural component, 
the property in the nature of machinery is real property.
    (ii) Certain factors not determinative. A structure may be an 
inherently permanent structure, and not property in the nature of 
machinery or essentially an item of machinery, even if the structure is 
necessary to operate or use, supports, or is otherwise associated with, 
machinery.
    (d) Production--(1) Definition of produce. Produce is defined as 
provided in section 263A(g) and Sec. 1.263A-2(a)(1)(i).
    (2) Property produced under a contract--(i) Customer. A taxpayer is 
treated as producing any property that is produced for the taxpayer 
(the customer) by another party (the contractor) under a contract with 
the taxpayer or an intermediary. Property produced under a contract is 
designated property to the customer if it is real property or tangible 
personal property that satisfies the classification thresholds 
described in paragraph (b)(1)(ii) of this section. If property produced 
under a contract will become part of a unit of designated property 
produced by the customer in the customer's hands, the property produced 
under the contract is designated property to the customer.
    (ii) Contractor. Property produced under a contract is designated 
property to the contractor if it is real property, 2-year property, or 
1-year property and the property produced under the contract is not 
excluded by reason of paragraph (d)(2)(v) of this section.
    (iii) Definition of a contract. For purposes of this paragraph 
(d)(2), contract has the same meaning as under Sec. 1.263A-
2(a)(1)(ii)(B)(2).
    (iv) Determination of whether thresholds are satisfied. In the case 
of tangible personal property produced under a contract, the customer 
and the contractor each determine under this paragraph (d)(2), whether 
the property satisfies the classification thresholds described in 
paragraph (b)(1)(ii) of this section. Thus, tangible personal property 
may be designated property with respect to either, or both, the 
customer and the contractor. The provisions of paragraph (b)(2)(iii) of 
this section are modified as set forth in this paragraph (d)(2)(iv) for 
purposes of determining whether tangible personal property produced 
under a contract is 2-year property or 1-year property.
    (A) Customer. In determining a customer's estimated cost of 
production, the customer takes into account costs and payments that are 
reasonably expected to be incurred by the customer, but does not take 
into account costs incurred (or to be incurred) by an unrelated 
contractor. In determining the customer's estimated length of the 
production period, the production period is treated as beginning on the 
earlier of the date the contract is executed or the date that the 
customer's accumulated production expenditures for the unit are at 
least 5 percent of the customer's total estimated production 
expenditures for the unit. The customer, however, may elect to treat 
the production period as beginning on the date the sum of the 
accumulated production expenditures of the contractor (or contractors 
if more than one contractor is producing components for the unit of 
property) and of the customer are at least 5 percent of the customer's 
estimated production expenditures for the unit.
    (B) Contractor. In determining a contractor's estimated cost of 
production, the contractor takes into account only the costs that are 
reasonably expected to be incurred by the contractor, without any 
reduction for payments from the customer. In determining the 
contractor's estimated length of the production period, the production 
period is treated as beginning on the date the contractor's accumulated 
production expenditures (without any reduction for payments from the 
customer) are at least 5 percent of the contractor's total estimated 
accumulated production expenditures.
    (v) Exclusion for property subject to long-term contract rules. 
Property described in paragraph (b) of this section is designated 
property with respect to a contractor only if--
    (A) The contract is not a long-term contract (within the meaning of 
section 460(f)); or
    (B) The contract is a home construction contract (within the 
meaning of section 460(e)(6)(A) with respect to which the requirements 
of section 460(d)(1)(B) (i) and (ii) are not met.
    (3) Improvements to existing property--(i) In general. Any 
improvement to property described in Sec. 1.263(a)-1(b) constitutes the 
production of property. Generally, any improvement to designated 
property constitutes the production of designated property. An 
improvement is not treated as the production of designated property, 
however, if the de minimis exception described in paragraph (b)(4) of 
this section applies to the improvement. In addition, paragraph 
(d)(3)(iii) of this section provides an exception for certain 
improvements to tangible personal property. Incidental maintenance and 
repairs are not treated as improvements under this paragraph (d)(3). 
See Sec. 1.162-4.
    (ii) Real property. The rehabilitation or preservation of a 
standing building, the clearing of raw land prior to sale, and the 
drilling of an oil well are activities constituting improvements to 
real property and, therefore, the production of designated property. 
Similarly, the demolition of a standing building generally constitutes 
an activity that is an improvement to real property and, therefore, the 
production of designated property. See the exceptions, however, in 
paragraphs (b)(3) and (b)(4) of this section.
    (iii) Tangible personal property. If the taxpayer has treated a 
unit of tangible personal property as designated property under this 
section, an improvement to such property constitutes the production of 
designated property regardless of the remaining useful life of the 
improved property (or the improvement) and, except as provided in 
paragraph (b)(4) of this section, regardless of the estimated length of 
the production period or the estimated cost of the improvement. If the 
taxpayer has not treated a unit of tangible personal property as 
designated property under this section, an improvement to such property 
constitutes the production of designated property only if the 
improvement independently meets the classification thresholds described 
in paragraph (b)(1)(ii) of this section.


Sec. 1.263A-9  The avoided cost method.

    (a) In general--(1) Description. The avoided cost method described 
in this section must be used to calculate the amount of interest 
required to be capitalized under section 263A(f). Generally, any 
interest that the taxpayer theoretically would have avoided if 
accumulated production expenditures (as defined in Sec. 1.263A-11) had 
been used to repay or reduce the taxpayer's outstanding debt must be 
capitalized under the avoided cost method. The application of the 
avoided cost method does not depend on whether the taxpayer actually 
would have used the amounts expended for production to repay or reduce 
debt. Instead, the avoided cost method is based on the assumption that 
debt of the taxpayer would have been repaid or reduced without regard 
to the taxpayer's subjective intentions or to restrictions (including 
legal, regulatory, contractual, or other restrictions) against 
repayment or use of the debt proceeds.
    (2) Overview--(i) In general. For each unit of designated property 
(within the meaning of Sec. 1.263A-8(b)), the avoided cost method 
requires the capitalization of--
    (A) The traced debt amount under paragraph (b) of this section, and
    (B) The excess expenditure amount under paragraph (c) of this 
section.
    (ii) Rules that apply in determining amounts. The traced debt and 
excess expenditure amounts are determined for each taxable year or 
shorter computation period that includes the production period (as 
defined in Sec. 1.263A-12) of a unit of designated property. Paragraph 
(d) of this section provides an election not to trace debt to specific 
units of designated property. Paragraph (f) of this section provides 
rules for selecting the computation period, for calculating averages, 
and for determining measurement dates within the computation period. 
Special rules are in paragraph (g) of this section.
    (3) Definitions of interest and incurred. Except as provided in the 
case of certain expenses that are treated as a substitute for interest 
under paragraphs (c)(2)(iii) and (g)(2)(iv) of this section, interest 
refers to all amounts that are characterized as interest expense under 
any provision of the Code, including, for example, sections 482, 483, 
1272, 1274, and 7872. Incurred refers to the amount of interest that is 
properly accruable during the period of time in question determined by 
taking into account the loan agreement and any applicable provisions of 
the Internal Revenue laws and regulations such as section 163, 
Sec. 1.446-2, and sections 1271 through 1275.
    (4) Definition of eligible debt. Except as provided in this 
paragraph (a)(4), eligible debt includes all outstanding debt (as 
evidenced by a contract, bond, debenture, note, certificate, or other 
evidence of indebtedness). Eligible debt does not include--
    (i) Debt (or the portion thereof) bearing interest that is 
disallowed under a provision described in Sec. 1.163-8T(m)(7)(ii);
    (ii) Debt, such as accounts payable and other accrued items, that 
bears no interest, except to the extent that such debt is traced debt 
(as defined in paragraph (b)(2) of this section);
    (iii) Debt that is borrowed directly or indirectly from a person 
related to the taxpayer and that bears a rate of interest that is less 
than the applicable Federal rate in effect under section 1274(d) on the 
date of issuance;
    (iv) Debt (or the portion thereof) bearing personal interest within 
the meaning of section 163(h)(2);
    (v) Debt (or the portion thereof) bearing qualified residence 
interest within the meaning of section 163(h)(3);
    (vi) Debt incurred by an organization that is exempt from Federal 
income tax under section 501(a), except to the extent interest on such 
debt is directly attributable to an unrelated trade or business of the 
organization within the meaning of section 512;
    (vii) Reserves, deferred tax liabilities, and similar items that 
are not treated as debt for Federal income tax purposes, regardless of 
the extent to which the taxpayer's applicable financial accounting or 
other regulatory reporting principles require or support treating these 
items as debt; and
    (viii) Federal, State, and local income tax liabilities, deferred 
tax liabilities under section 453A, and hypothetical tax liabilities 
under the look-back method of section 460(b) or similar provisions.
    (b) Traced debt amount--(1) General rule. Interest must be 
capitalized with respect to a unit of designated property in an amount 
(the traced debt amount) equal to the total interest incurred on the 
traced debt during each measurement period (as defined in paragraph 
(f)(2)(ii) of this section) that ends on a measurement date described 
in paragraph (f)(2)(iii) of this section. See the example in paragraph 
(b)(3) of this section. If any interest incurred on the traced debt is 
not taken into account for the taxable year that includes the 
measurement period because of a deferral provision, see paragraph 
(g)(2) of this section for the time and manner for capitalizing and 
recovering that amount. This paragraph (b)(1) does not apply if the 
taxpayer elects under paragraph (d) of this section not to trace debt.
    (2) Identification and definition of traced debt. On each 
measurement date described in paragraph (f)(2)(iii) of this section, 
the taxpayer must identify debt that is traced debt with respect to a 
unit of designated property. On each such date, traced debt with 
respect to a unit of designated property is the outstanding eligible 
debt (as defined in paragraph (a)(4) of this section) that is 
allocated, on that date, to accumulated production expenditures with 
respect to the unit of designated property under the rules of 
Sec. 1.163-8T Traced debt also includes unpaid interest that has been 
capitalized with respect to such unit under paragraph (b)(1) of this 
section and that is included in accumulated production expenditures on 
the measurement date.
    (3) Example. The provisions of paragraphs (b)(1) and (b)(2) of this 
section are illustrated by the following example.

    Example. Corporation X, a calendar year taxpayer, is engaged in 
the production of a single unit of designated property during 1995 
(unit A). Corporation X adopts a taxable year computation period and 
quarterly measurement dates. Production of unit A starts on January 
14, 1995, and ends on June 16, 1995. On March 31, 1995 and on June 
30, 1995, Corporation X has outstanding a $1,000,000 loan that is 
allocated under the rules of Sec. 1.163-8T to production 
expenditures with respect to unit A. During the period January 1, 
1995, through June 30, 1995, Corporation X incurs $50,000 of 
interest related to the loan. Under paragraph (b)(1) of this 
section, the $50,000 of interest Corporation X incurs on the loan 
during the period January 1, 1995, through June 30, 1995, must be 
capitalized with respect to
unit A.

    (c) Excess expenditure amount--(1) General Rule. If there are 
accumulated production expenditures in excess of traced debt with 
respect to a unit of designated property on any measurement date 
described in paragraph (f)(2)(iii) of this section, the taxpayer must, 
for the computation period that includes the measurement date, 
capitalize with respect to this unit the excess expenditure amount 
calculated under this paragraph (c)(1). However, if the sum of the 
excess expenditure amounts for all units of designated property of a 
taxpayer exceeds the total interest described in paragraph (c)(2) of 
this section, only a prorata amount (as determined under paragraph 
(c)(7) of this section) of such interest must be capitalized with 
respect to each unit. For each unit of designated property, the excess 
expenditure amount for a computation period equals the production of--
    (i) The average excess expenditures (as determined under paragraph 
(c)(5)(ii) of this section) for the unit of designated property for 
that period, and
    (ii) The weighted average interest rate (as determined under 
paragraph (c)(5)(iii) of this section) for that period.
    (2) Interest required to be capitalized. With respect to an excess 
expenditure amount, interest incurred during the computation period is 
capitalized from the following sources and in the following sequence 
but not in excess of the excess expenditure amount for all units of 
designated property:
    (i) Interest incurred on nontraced debt (as defined in paragraph 
(c)(5)(i) of this section);
    (ii) Interest incurred on borrowings described in paragraph 
(a)(4)(iii) of this section (relating to certain borrowings from 
related persons); and
    (iii) In the case of a partnership, guaranteed payments for the use 
of capital (within the meaning of section 707(c)) that would be 
deductible by the partnership if section 263A(f) did not apply.
    (3) Example. The provisions of paragraph (c)(1) and (2) of this 
section are illustrated by the following example.

    Example. (i) P, a partnership owned equally by Corporation A and 
Individual B, is engaged in the construction of an office building 
during 1995. Average excess expenditures for the office building for 
1995 are $2,000,000. When P was formed, A and B agreed that A would 
be entitled to an annual guaranteed payment of $70,000 in exchange 
for A's capital contribution. The only borrowing of P, A, and B for 
1995 is a loan to P from an unrelated lender of $1,000,000 (loan #). 
The loan is nontraced debt and bears interest at an annual rate of 
10 percent. Thus, P's weighted average interest rate (determined 
under paragraph (c)(5)(iii) of this section) is 10 percent and 
interest incurred during 1995 is $100,000.
    (ii) In accordance with paragraph (c)(1) of this section, the 
excess expenditure amount is $200,000 ($2,000,000  x  10%). The 
interest capitalized under paragraph (c)(2) of this section is 
$170,000 ($100,000 of interest plus $70,000 of guaranteed payments).

    (4) Treatment of interest subject to a deferral provision. If any 
interest described in paragraph (c)(2) of this section is not taken 
into account for the taxable year that includes the computation period 
because of a deferral provision described in paragraph (g)(1)(ii) of 
this section, paragraph (c)(2) of this section is first applied without 
regard to the amount of the deferred interest. After applying paragraph 
(c)(2) without regard to the deferred interest, if the amount of 
interest capitalized with respect to all units of designated property 
for the computation period is less than the amount that would have been 
capitalized if a deferral provision did not apply, see paragraph (g)(2) 
of this section for the time and manner for capitalizing and recovering 
the difference (the shortfall amount).
    (5) Definitions--(i) Nontraced debt--(A) Defined. Nontraced debt 
means all eligible debt on a measurement date other than any debt that 
is treated as traced debt with respect to any unit of designated 
property on that measurement date. For example, nontraced debt includes 
eligible debt that is allocated to expenditures that are not 
capitalized under section 263A(a) (e.g., expenditures deductible under 
section 174(a) or 263(c)). Similarly, even if eligible debt is 
allocated to a production expenditure for a unit of designated 
property, the debt is included in nontraced debt on measurement dates 
before the first or after the last measurement date for that unit of 
designated property. Thus, nontraced debt may include debt that was 
previously treated as traced debt or that will be treated as traced 
debt on a future measurement date.
    (B) Example. The provisions of paragraph (c)(5)(i)(A) of this 
section are illustrated by the following example.

    Example. In 1995, Corporation X begins, but does not complete, 
the construction of two office buildings that are separate units of 
designated property as defined in Sec. 1.263A-10 (Property D and 
Property E). At the beginning of 1995, X borrows $2,500,00 (the 
$2,500,000 loan), which will be used exclusively to finance 
production expenditures for Property D. Although interest is paid 
currently, the entire principal amount of the loan remains 
outstanding at the end of 1995. Corporation X also has outstanding 
during all of 1995 a long-term loan with a principal amount of 
$2,000,000 (the $2,000,000 loan). The proceeds of the $2,000,000 
loan were used exclusively to finance the production of Property C, 
a unit of designated property that was completed in 1994. Under the 
rules of paragraph (b)(2) of this section, the portion of the 
$2,500,000 loan allocated to accumulated production expenditures for 
property D at each measurement date during 1995 is treated as traced 
debt for that measurement date. The excess, if any, of $2,500,000 
over the amount treated as traced debt at each measurement date 
during 1995 is treated as nontraced debt for that measurement date, 
even though it is expected that the entire $2,500,000 will be 
treated as traced debt with respect to Property D on subsequent 
measurement dates as more of the proceeds of the loan are used to 
finance additional production expenditures. In addition, the entire 
principal amount of the $2,000,000 loan is treated as nontraced debt 
for 1995, even though it was treated as traced debt with respect to 
Property C in a previous period.

    (ii) Average excess expenditures--(A) General rule. The average 
excess expenditures for a unit of designated property for a computation 
period are computed by--
    (1) Determining the amount (if any) by which accumulated production 
expenditures exceed traced debt at each measurement date during the 
computation period; and
    (2) Dividing the sum of these amounts by the number of measurement 
dates during the computation period.
    (B) Example. The provisions of paragraph (c)(5)(ii)(A) of this 
section are illustrated by the following example.

    Example. Corporation X, a calendar year taxpayer, is engaged in 
the production of a single unit of designated property during 1995 
(unit A). Corporation X adopts the taxable year as the computation 
period and quarterly measurement dates. The production period for 
unit A begins on January 14, 1995, and ends on June 16, 1995. On 
March 31, 1995, and on June 30, 1995, Corporation X has outstanding 
$1,000,000 of traced debt with respect to unit A. Accumulated 
production expenditures for unit A on March 31, 1995, are $1,400,000 
and on June 30, 1995, are $1,600,000. Accumulated production 
expenditures in excess of traced debt for unit A on March 31, 1995, 
are $400,000 and on June 30, 1995, are $600,000. Average excess 
expenditures for unit A during 1995 are therefore $250,000 
([$400,000 + $600,000 + $0 +$0]  4).

    (iii) Weighted average interest rate--(A) Determination of rate. 
The weighted average interest rate for a computation period is 
determined by dividing interest incurred on nontraced debt during the 
period by average nontraced debt for the period.
    (B) Interest incurred on nontraced debt. Interest incurred on 
nontraced debt during the computation period is equal to the total 
amount of interest incurred during the computation period on all 
eligible debt minus the amount of interest incurred during the 
computation period on traced debt. Thus, all interest incurred on 
nontraced debt during the computation period is included in the 
numerator of the weighted average interest rate, even if the underlying 
nontraced debt is repaid before the end of a measurement period and 
excluded from nontraced debt outstanding for measurement dates after 
repayment, in determining the denominator of the weighted average 
interest rate. However, see paragraph (g)(7) of this section for an 
election to treat eligible debt that is repaid within the 15-day period 
immediately preceding a quarterly measurement date as outstanding on 
that measurement date. See paragraph (a)(3) of this section for the 
definitions of interest and incurred.
    (C) Average nontraced debt. The average nontraced debt for a 
computation period is computed by--
    (1) Determining the amount of nontraced debt outstanding on each 
measurement date during the computation period; and
    (2) Dividing the sum of these amounts by the number of measurement 
dates during the computation period.
    (D) Special rules if taxpayer has no nontraced debt or rate is 
contingent--If the taxpayer does not have nontraced debt outstanding 
during the computation period, the weighted average interest rate for 
purposes of applying paragraphs (c)(1) and (c)(2) of this section is 
the highest applicable Federal rate in effect under section 1274(d) 
during the computation period. If interest is incurred at a rate that 
is contingent at the time the return for the year that includes the 
computation period is filed, the amount of interest is determined using 
the higher of the fixed rate of interest (if any) on the underlying 
debt or the applicable Federal rate in effect under section 1274(d) on 
the date of issuance.
    (6) Examples. The following examples illustrate the principles of 
this paragraph (c):

    Example 1. (i) W, a calendar year taxpayer, is engaged in the 
production of a unit of designated property during 1995. For 
purposes of applying the avoided cost method of this section, W uses 
the taxable year as the computation period. During 1995, W's only 
debt is a $1,000,000 loan bearing interest at a rate of 7 percent 
from Y, a person that is related to W. Assuming the applicable 
Federal rate in effect under section 1274(d) on the date of issuance 
of the loan is 10 percent, the loan is not eligible debt under 
paragraph (a)(4) of this section. However, even though W has no 
eligible debt, W incurs $70,000 ($1,000,000 x 7%) of interest during 
the computation period. This interest is described in paragraph 
(c)(2) of this section and must be capitalized under paragraph 
(c)(1) of this section to the extent it does not exceed W's excess 
expenditure amount for the unit of property.
    (ii) W determines, under paragraph (c)(5)(ii) of this section, 
that average excess expenditures for the unit of property are 
$600,000. Assuming the highest applicable Federal rate in effect 
under section 1274(d) during the computation period is 10 percent, W 
uses 10 percent as the weighted average interest rate for purposes 
of determining the excess expenditure amount. See paragraph 
(c)(5)(iii)(D) of this section. In accordance with paragraph (c)(1) 
of this section, the excess expenditure amount is therefore $60,000. 
Because this amount does not exceed the total amount of interest 
described in paragraph (c)(2) of this section ($70,000), W is 
required to capitalize $60,000 of interest with respect to the unit 
of designated property for the 1995 computation period.
    Example 2. (i) Corporation X, a calendar year taxpayer, is 
engaged in the production of a single unit of designated property 
during 1955 (unit A). Corporation X adopts the taxable year as the 
computation period and quarterly measurement dates. Production of 
unit A begins in 1994 and ends on June 30, 1995. On March 31, 1995, 
and on June 30, 1995, Corporation X has outstanding $1,000,000 of 
eligible debt (loan #1) that is allocated under the rules of 
Sec. 1.163-8T to production expenditures for unit A. During each of 
the first two quarters of 1995, $30,000 of interest is incurred on 
loan #1. The loan is repaid on July 1, 1995. Throughout 1995, 
Corporation X also has outstanding $2,000,000 of eligible debt (loan 
#2) which is not allocated under the rules of Sec. 1.163-8T to the 
production of unit A. During 1995, $200,000 of interest is incurred 
on this nontraced debt. Accumulated production expenditures on March 
31, 1995, are $1,400,000 and on June 30, 1995, are $1,600,000. 
Accumulated production expenditures in excess of traced debt on 
March 31, 1995, are $400,000 and on June 30, 1995, are $600,000.
    (ii) Under paragraph (b)(1) of this section, the amount of 
interest capitalized with respect to traced debt is $60,000 ($30,000 
for the measurement period ending March 31, 1995, and $30,000 for 
the measurement period ending June 30, 1995). Under paragraph 
(c)(5)(ii) of this section, average excess expenditures for unit A 
are $250,000 ([$1,400,000-$1,000,000) + ($1,600,000-$1,000,000) + $0 
+ $0]4). Under paragraph (c)(5)(iii)(C) of this section, 
average nontraced debt is $2,000,000 ([$2,000,000 + $2,000,000 + 
$2,000,000 + $2,000,000]4). Under paragraph (c)(5)(iii)(B) 
of this section, interest incurred on nontraced debt is $200,000 
($260,000 of interest incurred on all eligible debt less $60,000 of 
interest incurred on traced debt). Under paragraph (c)(5)(iii)(A) of 
this section, the weighted average interest rate is 10 percent 
($200,000$2,000,000). Under paragraph (c)(1) of this 
section, Corporation X capitalizes the excess expenditure amount of 
$25,000 ($250,000 x 10%), because it does not exceed the total 
amount of interest subject to capitalization under paragraph (c)(2) 
of this section ($200,000). Thus, the total interest capitalized 
with respect to unit A during 1995 is $85,000 ($60,000+$25,000).

    (7) Special rules where the excess expenditure amount exceeds 
incurred interest.--(i) Allocation of total incurred interest to units. 
For a computation period in which the sum of the excess expenditure 
amounts under paragraph (c)(1) of this section for all units of 
designated property exceeds the total amount of interest (including 
deferred interest) available for capitalization, as determined under 
paragraph (c)(2) of this section, the amount of interest that is 
allocated to a unit of designated property is equal to the product of--
    (A) The total amount of interest (including deferred interest) 
available for capitalization, as determined under paragraph (c)(2) of 
this section; and
    (B) A fraction, the numerator of which is the average excess 
expenditures for the unit of designated property and the denominator of 
which is the sum of the average excess expenditures for all units of 
designated property.
    (ii) Application of related person rules to average excess 
expenditures. Certain excess expenditures must be taken into account by 
the persons (if any) required to capitalize interest with respect to 
production expenditures of the taxpayer under applicable related person 
rules. For each computation period, the amount of average excess 
expenditures that must be taken into account by such persons for each 
unit of the taxpayer's property is computed by--
    (A) Determining, for the computation period, the amount (if any) by 
which the excess expenditures amount for the unit exceeds the amount of 
interest allocated to the unit under paragraph (c)(7)(i) of this 
section; and
    (B) Dividing the excess by the weighted average interest rate for 
the period.
    (iii) Special rule for corporations. If a corporation is related to 
another person for the purposes of the applicable related party rules, 
the District Director upon examination may require that the corporation 
apply this paragraph (c)(7) and other provisions of the regulations by 
excluding deferred interest from the total interest available for 
capitalization.
    (d) Election not to trace debt.--(1) General rule. Taxpayers may 
elect not to trace debt. If the election is made, the average excess 
expenditures and weighted average interest rate under paragraph (c)(5) 
of this section are determined by treating all eligible debt as 
nontraced debt. For this purpose, debt specified in paragraph 
(a)(4)(ii) of this section (e.g., accounts payable) may be included in 
eligible debt, provided it would be treated as traced debt but for an 
election under this paragraph (d). The election not to trace debt is a 
method of accounting that applies to the determination of capitalized 
interest for all designated property of the taxpayer. The making or 
revocation of the election is a change in method of accounting 
requiring the consent of the Commissioner under section 446(e) and 
Sec. 1.446-1(e).
    (2) Example. The provisions of paragraph (d)(1) of this section are 
illustrated by the following example.

    Example. (i) Corporation X, a calendar year taxpayer, is engaged 
in the production of a single unit of designated property during 
1995 (unit A). Corporation X adopts the taxable year as the 
computation period and quarterly measurement dates. At each 
measurement date (March 31, June 30, September 30, and December 31) 
Corporation X has the following outstanding indebtedness:

Noninterest-bearing accounts payable traced to unit A........   $100,000
Noninterest-bearing accounts payable that are not traced to             
 unit A......................................................   $300,000
Interest-bearing loans that are eligible debt within the                
 meaning of paragraph (a)(4) of this section.................   $900,000
                                                                        

    (ii) Corporation X elects under this paragraph (d) not to trace 
debt. Eligible debt at each measurement date for purposes of 
calculating the weighted average interest rate under paragraph 
(c)(5)(iii) of this section is $1,000,000 ($100,000 + $900,000).

    (e) Election to use external rate--(1) In general. An eligible 
taxpayer may elect to use the highest applicable Federal rate (AFR) 
under section 1274(d) in effect during the computation period plus 3 
percentage points (AFR plus 3) as a substitute for the weighted average 
interest rate determined under paragraph (c)(5)(iii) of this section. A 
taxpayer that makes this election may not trade debt. The use of the 
AFR plus 3 as provided under this paragraph (e)(1) constitutes a method 
of accounting. A taxpayer makes the election to use the AFR plus 3 
method by using the AFR plus 3 as the taxpayer's weighted average 
interest rate, and any change to the AFR plus 3 method by a taxpayer 
that has never previously used the method does not require the consent 
of the Commissioner. Any other change to or from the use of the AFR 
plus 3 method under this paragraph (e)(1) (other than by reason of a 
taxpayer ceasing to be an eligible taxpayer) is a change in method of 
accounting requiring the consent of the Commissioner under section 
446(e) and Sec. 1.446-1(e). All changes to or from the AFR plus 3 
method are effected on a cut-off basis.
    (2) Eligible taxpayer. A taxpayer is an eligible taxpayer for a 
taxable year for purposes of this paragraph (e) if the average annual 
gross receipts of the taxpayer for the three previous taxable years do 
not exceed $10,000,000 (the $10,000,000 gross receipts test for all 
prior taxable years beginning after December 31, 1994. For purposes of 
this paragraph (e)(2), the principles of section 263A(b)(2)(B) and (C) 
and Sec. 1.263A-3(b) apply in determining whether a taxpayer is an 
eligible taxpayer for a taxable year.
    (f) Selection of computation period and measurement dates and 
application of averaging conventions.--(1) Computation period--(i) In 
general. A taxpayer may (but is not required to) make the avoided cost 
calculation on the basis of a full taxable year. If the taxpayer uses 
the taxable year as the computation period, a single avoided cost 
calculation is made for each unit of designated property for the entire 
taxable year. If the taxpayer uses a computation period that is shorter 
than the full taxable year, an avoided cost calculation is made for 
each unit of designated property for each shorter computation period 
within the taxable year. If the taxpayer uses a shorter computation 
period, the computation period may not include portions of more than 
one taxable year and, except as provided in the case of short taxable 
years, each computation period within a taxable year must be the same 
length. In the case of a short taxable year, a taxpayer may treat a 
period shorter than the taxpayer's regular computation period as the 
first or last computation period, or as the only computation period for 
the year if the year is shorter than the taxpayer's regular computation 
period. A taxpayer must use the same computation periods for all 
designated property produced during a single taxable year.
    (ii) Method of accounting. The choice of a computation period is a 
method of accounting. Any change in the computation period is a change 
in method of accounting requiring the consent of the Commissioner under 
section 446(e) and Sec. 1.446-1(e).
    (iii) Production period beginning or ending during the computation 
period. The avoided cost method applies to the production of a unit of 
designated property on the basis of a full computation period, 
regardless of whether the production period for the unit of designated 
property begins or ends during the computation period.
    (2) Measurement dates--(i) In general. If a taxpayer uses the 
taxable year as the computation period, measurement dates must occur at 
quarterly or more frequent regular intervals. If the taxpayer uses 
computation periods that are shorter than the taxable year, measurement 
dates must occur at least twice during each computation period and at 
least four times during the taxable year (or consecutive 12-month 
period in the case of a short taxable year). The taxpayer must use the 
same measurement dates for all designated property produced during a 
computation period. Except in the case of a computation period that 
differs from the taxpayer's regular computation period by reason of a 
short taxable year (see paragraph (f)(1)(i) of this section), 
measurement dates must occur at equal intervals during each computation 
period that falls within a single taxable year. For any computation 
period that differs from the taxpayer's regular computation period by 
reason of a short taxable year, the measurement dates used by the 
taxpayer during that period must be consistent with the principles and 
purposes of section 263A(f). A taxpayer is permitted to modify the 
frequency of measurement dates from year to year.
    (ii) Measurement period. For purposes of this section, measurement 
period means the period that begins on the first day following the 
preceding measurement date and that ends on the measurement date.
    (iii) Measurement dates on which accumulated production 
expenditures must be taken into account. The first measurement date on 
which accumulated production expenditures must be taken into account 
with respect to a unit of designated property is the first measurement 
date following the beginning of the production period for the unit of 
designated property. The final measurement date on which accumulated 
production expenditures with respect to a unit of designated property 
must be taken into account is the first measurement date following the 
end of the production period for the unit of designated property. 
Accumulated production expenditures with respect to a unit of 
designated property must also be taken into account on all intervening 
measurement dates. See Sec. 1.263A-12 to determine when the production 
period begins and ends.
    (iv) More frequent measurement dates. When in the opinion of the 
District Director more frequent measurement dates are necessary to 
determine capitalized interest consistent with the principles and 
purposes of section 263A(f) for a particular computation period, the 
District Director may require the use of more frequent measurement 
dates. If a significant segment of the taxpayer's production activities 
(the first segment) requires more frequent measurement dates than 
another significant segment of the taxpayer's production activities, 
the taxpayer may request a ruling from the Internal Revenue Service 
permitting, for a taxable year and all subsequent taxable years, a 
segregation of the two segments and, notwithstanding paragraph 
(f)(2)(i) of this section, the use of the more frequent measurement 
dates for only the first segment. The request for a ruling must be made 
in accordance with any applicable rules relating to submissions of 
ruling requests. The request must be filed on or before the due date 
(including extensions) of the original Federal income tax return for 
the first taxable year to which it will apply.
    (3) Examples. The following examples illustrate the principles of 
this paragraph (f):

    Example 1. Corporation X, a calendar year taxpayer, is engaged 
in the production of designated property during 1995. Corporation X 
adopts the taxable year as the computation period and quarterly 
measurement dates. Corporation X must identify traced debt, 
accumulated production expenditures, and nontraced debt at each 
quarterly measurement date (March 31, June 30, September 30, and 
December 31). Under paragraph (c)(5)(ii) of this section, 
Corporation X must calculate average excess expenditures for each 
unit of designated property by determining the amount by which 
accumulated production expenditures exceed traced debt for each unit 
at the end of each quarter and dividing the sum of these amounts by 
four. Under paragraph (c)(5)(iii) (C) of this section, Corporation X 
must calculate average nontraced debt by determining the amount of 
nontraced debt outstanding at the end of each quarter and dividing 
the sum of these amounts by four.
    Example 2. Corporation X, a calendar year taxpayer, is engaged 
in the production of designated property during 1995. Corporation X 
adopts a 6-month computation period with two measurement dates 
within each computation period. Corporation X must identify traced 
debt, accumulated production expenditures, and nontraced debt at 
each measurement date (March 31 and June 30 for the first 
computation period and September 30 and December 31 for the second 
computation period). Under paragraph (c)(5)(ii) of this section, 
Corporation X must, for each computation period, calculate average 
excess expenditures for each unit of designated property by 
determining the amount by which accumulated production expenditures 
exceed traced debt for each unit at each measurement date during the 
period and dividing the sum of these amounts by two. Under paragraph 
(c)(5)(iii)(C) of this section, Corporation X must calculate average 
nontraced debt for each computation period by determining the amount 
of nontraced debt outstanding at each measurement date during the 
period and dividing the sum of these amounts by two.
    Example 3. (i) Corporation X, a calendar year taxpayer, is 
engaged in the production of two units of designated property during 
1995. Production of Unit A starts in 1994 and ends on June 20, 1995. 
Production of Unit B starts on April 15, 1995, but does not end 
until 1996. Corporation X adopts the taxable year as its computation 
period and does not elect under paragraph (d) of this section not to 
trace debt. Corporation X uses quarterly measurement dates and pays 
all interest on eligible debt in the quarter in which the interest 
is incurred. During 1995, Corporation X has two items of eligible 
debt. The debt and the manner in which it is used are as follows:

------------------------------------------------------------------------
                              Annual                                    
    No.        Principal       rate        Period       Use of proceeds 
                            (percent)    outstanding                    
------------------------------------------------------------------------
1.........      $1,000,000          9       1/01-9/01  Unit A.          
2.........       2,000,000         11      6/01-12/31  Nontrace.        
------------------------------------------------------------------------

    (ii) Based on the annual 9 percent rate of interest, Corporation 
X incurs $7,500 of interest during each month that Loan #1 is 
outstanding.
    (iii) Accumulated production expenditures at the end of each 
quarter during 1995 are as follows:

------------------------------------------------------------------------
            Measurement date                  Unit A          Unit B    
------------------------------------------------------------------------
March 31................................      $1,200,000              $0
June 30.................................       1,800,000         500,000
Sept. 30................................               0       1,000,000
Dec. 31.................................               0       1,600,000
------------------------------------------------------------------------

    (iv) Corporation X must first determine the amount of interest 
incurred on traced debt and capitalize the interest incurred on this 
debt (the traced debt amount). Loan #1 is allocated to Unit A on the 
March 31 and June 30 measurement dates. Accordingly, Loan #1 is 
treated as traced debt with respect to unit A for the measurement 
periods beginning January 1 and ending June 30. The interest 
incurred on Loan #1 during the period that Loan #1 is treated as 
traced debt must be capitalized with respect to Unit A. Thus, 
$45,000 ($7,500 per month for 6 months) is capitalized with respect 
to Unit A.
    (v) Second, Corporation X must determine average excess 
expenditures for Unit A and Unit B. For Unit A, this amount is 
$250,000 ([$200,000 + $800,000 + $0 +$0]  4). For Unit B, 
this amount is $775,000 ([$0 + $500,000 + $1,000,000 + $1,600,000 
 4).
    (vi) Third, Corporation X must determine the weighted average 
interest rate and apply that rate to the average excess expenditures 
for Units A and B. The rate is equal to the total amount of interest 
incurred on nontraced debt (i.e., interest incurred on all eligible 
debt reduced by interest incurred on traced debt) divided by the 
average nontraced debt. The interest incurred on nontraced debt 
equals $143,333 ([$1,000,000  x  9%  x  \8/12\] + [$2,000,000  x  
11%  x  \7/12\] - $45,000). The average nontraced debt equals 
$1,500,000 ([$0 + $2,000,000 + $2,000,000 + $2,000,000]  4). 
The weighted average interest rate of 9.56 percent ($143,333 ' 
$1,500,000), is then applied to average excess expenditures for 
Units A and B. Accordingly, Corporation X capitalizes an additional 
$23,900 ($250,000  x  9.56%) with respect to Unit A and $74,090 
($775,000  x  9.56%) with respect to Unit B (the excess expenditure 
amounts).

    (g) Special rules--(1) Ordering rules--(i) Provisions preempted by 
section 263A(f). Interest must be capitalized under section 263A(f) 
before the application of section 163(d) (regarding the investment 
interest limitation), section 163(j) (regarding the limitation on 
interest paid to a tax-exempt related person), section 266 (regarding 
the election to capitalize carrying charges), section 469 (regarding 
the limitation on passive losses), and section 861 (regarding the 
allocation of interest to United States sources). Any interest that is 
capitalized under section 263A(f) is not taken into account as interest 
under those sections. However, in applying section 263A(f) with respect 
to the excess expenditure amount, the taxpayer must capitalize all 
interest that is neither investment interest under section 163(d), 
exempt related person interest under section 163(j), nor passive 
interest under section 469 before capitalizing any interest that is 
either investment interest, exempt related person interest, or passive 
interest. Any interest that is not required to be capitalized after the 
application of section 263A(f) is then taken into account as interest 
subject to sections 163(d), 163(j), 266, 469, and 861. If, after the 
application of section 263A(f), interest is deferred under sections 
163(d), 163(j), 266, or 469, that interest is not subject to 
capitalization under section 263A(f) in any subsequent taxable year.
    (ii) Deferral provisions applied before this section. Interest 
(including contingent interest) that is subject to a deferral provision 
described in this paragraph (g)(1)(ii) is subject to capitalization 
under section 263A(f) only in the taxable year in which it would be 
deducted if section 263A(f) did not apply. Deferral provisions include 
sections 163(e)(3), 267, 446, and 461, and all other deferral or 
limitation provisions that are not described in paragraph (g)(1)(i) of 
this section. In contrast to the provisions of paragraph (g)(1)(i) of 
this section, deferral provisions are applied before the application of 
section 263A(f).
    (2) Application of section 263A(f) to deferred interest--(i) In 
general. This paragraph (g)(2) describes the time and manner of 
capitalizing and recovering the deferral amount. The deferral amount 
for any computation period equals the sum of--
    (A) The amount of interest that is incurred on traced debt that is 
deferred during the computation period and is not deductible for the 
taxable year that includes the computation period because of a deferral 
provision described in paragraph (g)(1)(ii) of this section, and
    (B) The shortfall amount described in paragraph (c)(4) of this 
section.
    (ii) Capitalization of deferral amount. The rules described in 
paragraph (g)(2)(iii) of this section apply to the deferral amount 
unless the taxpayer elects under paragraph (g)(2)(iv) of this section 
to capitalize substitute costs.
    (iii) Deferred capitalization. If the taxpayer does not elect under 
paragraph (g)(2)(iv) of this section to capitalize substitute costs, 
deferred interest to which the deferral amount is attributable 
(determined under any reasonable method) is capitalized in the year or 
years in which the deferred interest would have been deductible but for 
the application of section 263A(f) (the capitalization year). For this 
purpose, any interest that is deferred from a prior computation period 
is taken into account in subsequent capitalization years in the same 
order in which the interest was deferred. If a unit of designated 
property to which previously deferred interest relates is sold before 
the capitalization year, the deferred interest applicable to that unit 
of property is taken into account in the capitalization year and 
treated as if recovered from the sale of the property. If the taxpayer 
continues to hold, throughout the capitalization year, a unit of 
depreciable property to which previously deferred interest relates, the 
adjusted basis and applicable recovery percentages for the unit of 
property are redetermined for the capitalization year and subsequent 
years so that the increase in basis is accounted for over the remaining 
recovery periods beginning with the capitalization year. See Example 2 
of paragraph (g)(2)(v) of this section.
    (iv) Substitute capitalization--(A) General rule. In lieu of 
deferred capitalization under paragraph (g)(2)(iii) of this section, 
the taxpayer may elect the substitute capitalization method described 
in this paragraph (g)(2)(iv). Under this method, the taxpayer 
capitalizes for the computation period in which interest is incurred 
and deferred (the deferral period) costs that would be deducted but for 
this paragraph (g)(2)(iv) (substitute costs). The taxpayer must 
capitalize an amount of substitute costs equal to the deferral amount 
for each unit of designated property, or if less, a prorata amount 
(determined in accordance with the principles of paragraph (c)(7)(i) of 
this section) of the total substitute costs that would be deducted but 
for this paragraph (g)(2)(iv) during the deferral period. If the entire 
deferral amount is capitalized pursuant to this paragraph (g)(2)(iv) in 
the deferral period, any interest incurred and deferred in the deferral 
period is neither capitalized nor deducted during the deferral period 
and, unless subsequently capitalized as a substitute cost under this 
paragraph (g)(2)(iv), is deductible in the appropriate subsequent 
period without regard to section 263A(f).
    (B) Capitalization of amount carried forward. If the taxpayer has 
an insufficient amount of substitute costs in the deferral period, the 
amount by which substitute costs are insufficient with respect to each 
unit of designated property is a deferral amount carryforward to 
succeeding computation periods beginning with the next computation 
period. In any carryforward year, the taxpayer must capitalize an 
amount of substitute costs equal to the deferral amount carryforward 
or, if less, a prorata amount (determined in accordance with the 
principles of paragraph (c)(7)(i) of this section) of the total 
substitute costs that would be deducted during the carryforward year or 
years (the carryforward capitalization year) but for this paragraph 
(g)(2)(iv) (after applying the substitute cost method of this paragraph 
(g)(2)(iv) to the production of designated property in the carryforward 
period). If a unit of designated property to which the deferral amount 
carryforward relates is sold prior to the carryforward capitalization 
year, substitute costs applicable to that unit of property are taken 
into account in the carryforward capitalization year and treated as if 
recovered from the sale of the property. If the taxpayer continues to 
hold, throughout the capitalization year, a unit of depreciable 
property to which a deferral amount carryforward relates, the adjusted 
basis and applicable recovery percentages for the unit of property are 
redetermined for the carryforward capitalization year and subsequent 
years so that the increase in basis is accounted for over the remaining 
recovery periods beginning with the carryforward capitalization year. 
See Example 2 of paragraph (g)(2)(v) of this section.
    (c) Method of accounting. The substitute capitalization method 
under this paragraph (g)(2)(iv) is a method of accounting that applies 
to all designated property of the taxpayer. A change to or from the 
substitute capitalization method is a change in method of accounting 
requiring the consent of the Commissioner under section 446(e) and 
Sec. 1.446-1(e).
    (v) Examples. The following examples illustrate the application of 
the avoided cost method when interest is subject to a deferral 
provisions:

    Example 1. (i) Corporation X is a calendar year taxpayer and 
uses the taxable year as it computation period. During 1995, X is 
engaged in the construction of a warehouse which X will use in its 
storage business. The warehouse is completed and placed in service 
in December 1995. X's average excess expenditures for 1995 equal 
$1,000,000. Throughout 1995, X's only outstanding debt is nontraced 
debt of $900,000 and $1,200,000, bearing interest at 15 percent and 
9 percent, respectively, per year. Of the $243,000 interest incurred 
during the year ([$900,000 x 15%] + [$1,200,000 x 9%] = 
[$135,000 x $108,000]), $75,000 is deferred under section 267(a)(2).
    (ii) X must first determine the amount of interest required to 
be capitalized under paragraph (c)(1) of this section for 1995 (the 
deferral period) without applying section 267(a)(2). The weighted 
average interest rate is 11.6 percent ([$135,000 x $108,000] 
$2,100,000), and the excess expenditure amount under paragraph 
(c)(1) of this section is $116,000 ($1,000,000 x 11.6%). Under 
paragraph (c)(4) of this section, X must then determine the amount 
of interest that would be capitalized by applying paragraph (c)(2) 
of this section without regard to the amount of deferred interest. 
Disregarding deferred interest, the amount of interest available for 
capitalization is $168,000 ([$900,000 x 15%] + [$1,200,000 x 9%]- 
$75,000). Thus, the full excess expenditure amount ($116,000) is 
capitalized from interest that is not deferred under section 
267(a)(2) and there is no shortfall amount.
    Example 2. (i) The facts are the same as in Example 1, except 
that $140,000 of interest is deferred under section 267 (a)(2) in 
1995. The taxpayer does not elect to use the substitute 
capitalization method. This interest is also deferred in 1996 but 
would be deducted in 1997 if section 263A(f) did not apply. As in 
Example 1, the excess expenditure amount is $116,000. However, the 
amount of interest available for capitalization after excluding the 
amount of deferred interest is $103,000 ([$900,000 x 15%] + 
[$1,200,000 x 9%]- $140,000). Thus, only $103,000 of interest is 
capitalized with respect to the warehouse in 1995. Since $116,000 of 
interest would be capitalized if section 267(a)(2) did not apply, 
the deferral amount determined under paragraphs (c)(2) and (g)(2)(i) 
of this section is $13,000 ($116,000 -$103,000), and $13,000 of 
deferred interest must be capitalized in the year in which it would 
be deducted if section 263A(f) did not apply.
    (ii) The $140,000 of interest deferred under section 267(a)(2) 
in 1995 would be deducted in 1997 if section 263A(f) did not apply. 
X is therefore required to capitalize an additional $13,000 of 
interest with respect to the warehouse in 1997 and must redetermine 
its basis and recovery percentage.

    (3) Simplified inventory method--(i) In general. This paragraph 
(g)(3) provides a simplified method of capitalizing interest expense 
with respect to designated property that is inventory. Under this 
method, the taxpayer determines beginning and ending inventory and cost 
of goods sold applying all other capitalization provisions, including, 
for example, the simplified production method of Sec. 1.263A-2(b), but 
without regard to the capitalization of interest with respect to 
inventory. The taxpayer must establish a separate capital asset, 
however, in an amount equal to the aggregate interest capitalization 
amount (as defined in paragraph (g)(3)(iii)(C) of this section). Under 
the simplified inventory method, increases in the aggregate interest 
capitalization amount from one year to the next generally are treated 
as reductions in interest expense, and decreases in the aggregate 
interest capitalization amount from one year to the next are treated as 
increases to cost of goods sold.
    (ii) Segmentation of inventory--(A) General rule. Under the 
simplified inventory method, the taxpayer first separates its total 
ending inventory value into segments that are equal to the total ending 
inventory value divided by the inverse inventory turnover rate. Each 
inventory segment is then assigned an age starting with one year and 
increasing by one year for each additional segment. The inverse 
inventory turnover rate is determined by finding the average of 
beginning and ending inventory, dividing the average by the cost of 
goods sold for the year, and rounding the result to the nearest whole 
number. Beginning and ending inventory amounts are determined using 
total current cost of inventory for the year (rather than carrying 
value). Cost of goods sold, however, may be determined using either 
total current cost or the taxpayer's inventory method. In addition, for 
purposes of this paragraph (g)(3)(ii), current costs for a year (and, 
if applicable, the cost of goods sold for the year under the taxpayer's 
inventory method) are determined without regard to the capitalization 
of interest with respect to inventory.
    (B) Example. The provisions of paragraph (g)(3)(ii)(A) of this 
section are illustrated by the following example.

    Example. X, a taxpayer using the FIFO inventory method, 
determines that total cost of goods sold for 1995 equals $900, and 
the cost of both beginning and ending inventory equals $3,000. Thus, 
X's inverse inventory turnover rate equals 3 (3.33 rounded to the 
nearest whole number). Total ending inventory of $3,000 is divided 
into three segments of $1,000 each. One segment is treated as 3-
year-old inventory, one segment is treated as 2-year-old inventory, 
and one segment is treated as 1-year-old inventory.

    (iii) Aggregate interest capitalization amount--(A) Computation 
period and weighted average interest rate. If a taxpayer elects the 
simplified inventory method, the taxpayer must use the taxable year as 
its computation period and use the weighted average interest rate 
determined under this paragraph (g)(3)(iii)(A) in determining the 
aggregate interest capitalization amount defined in paragraph 
(g)(3)(iii)(C) of this section and in determining the amount of 
interest capitalized with respect to any designated property that is 
not inventory. Under the simplified inventory method, the taxpayer 
determines the weighted average interest rate in accordance with 
paragraph (c)(5)(iii) of this section, treating all eligible debt 
(other than debt traced to noninventory property in the case of a 
taxpayer tracing debt) as nontraced debt (i.e., without tracing debt to 
inventory). A taxpayer that has elected under paragraph (e) of this 
section to use an external rate as a substitute for the weighted 
average interest rate determined under paragraph (c)(5)(iii) of this 
section uses the rate described in paragraph (e)(1) as the weighted 
average interest rate.
    (B) Computation of the tentative aggregate interest capitalization 
amount. The weighted average interest rate is compounded annually by 
the number of years assigned to a particular inventory segment to 
produce an interest factor (applicable interest factor) for that 
segment. The amounts determined by multiplying the value of each 
inventory segment by its applicable interest factor are then combined 
to produce a tentative aggregate interest capitalization amount.
    (C) Coordination with other interest capitalization computations--
(1) In general. If the tentative aggregate interest capitalization 
amount for a year exceeds the aggregate interest capitalization amount 
(defined in paragraph (g)(3)(iii)(D) of this section) as of the close 
of the preceding year, then, for purposes of applying the rules of 
paragraph (c)(7) of this section, the excess is treated as an excess 
expenditure amount and the inventory to which the simplified inventory 
method of this paragraph (g)(3) applies is treated as a single unit of 
designated property. If, after these modifications, no paragraph (c)(7) 
interest allocation is necessary (i.e., the excess expenditure amounts 
for all units of designated property do not exceed the total amount of 
interest (including deferred interest) available for capitalization), 
the aggregate interest capitalization amount generally equals the 
tentative aggregate interest capitalization amount. If, on the other 
hand, a paragraph (c)(7) allocation is necessary, the tentative 
aggregate interest capitalization amount is generally adjusted to 
reflect the results of that allocation (i.e., the increase in the 
aggregate interest capitalization amount is limited to the amount of 
interest allocated to inventory, reduced, however, by any substitute 
costs that are capitalized with respect to inventory under applicable 
related party rules).
    (2) Deferred interest. In determining the aggregate interest 
capitalization amount, the tentative aggregate interest capitalization 
amount is adjusted (after the application of paragraph (c)(7) of this 
section) as appropriate to reflect the deferred interest rules of 
paragraph (g)(2) of this section. The tentative aggregate interest 
capitalization amount would be reduced, for example, by the amount of a 
taxpayer's deferred interest for a taxable year unless the taxpayer has 
elected the substitute capitalization method under paragraph 
(g)(2)(iv).
    (3) Other coordinating provisions. The Commissioner may prescribe, 
by revenue ruling or revenue procedure, additional provisions to 
coordinate the election and use of the simplified inventory method with 
other interest capitalization requirements and methods. See 
Sec. 601.601(d)(2)(ii)(b) of this chapter.
    (D) Treatment of increases or decreases in the aggregate interest 
capitalization amount. Except as otherwise provided in this paragraph 
(g)(3)(iii)(D), increases in the aggregate interest capitalization 
amount from one year to the next are treated as reductions in interest 
expense, and decreases in the aggregate interest capitalization amount 
from one year to the next are treated as increases to cost of goods 
sold. To the extent a taxpayer capitalizes substitute costs under 
either applicable related party rules or the deferred interest rules in 
paragraph (g)(2) of this section, increases in the aggregate interest 
capitalization amount are treated as reductions in applicable 
substitute costs, rather than interest expense.
    (E) Example. The provisions of this paragraph (g)(3)(iii) are 
illustrated by the following example.

    Example. The facts are the same as in the example in paragraph 
(g)(3)(ii)(B) of this section, and, in addition, X determines that 
its weighted average interest rate for 1995 is 10 percent. 
Additionally, assume that X has no deferred interest in 1995 or 1996 
and no deferral amount carryforward to either 1995 or 1996. (See 
paragraph (g)(2) of this section.) Also assume that no allocation is 
necessary under paragraph (c)(7) of this section in either 1995 or 
1996. Under the rules of paragraph (g)(3)(ii) of this section, S 
divides ending inventory into segments of $1,000 each. One segment 
is 1-year old inventory, one segment is 2-year old inventory, and 
one segment is 3-year inventory. Under paragraph (g)(3)(iii)(B) of 
this section, X must compute the applicable interest factor for each 
segment. The applicable interest factor for the 1-year old inventory 
is not compounded. The applicable interest factor for the 2-year old 
inventory is compounded for 1 year. The applicable interest factor 
for the 3-year old inventory is compounded for 2 years. The interest 
factor applied to the 1-year old inventory segment is .1. The 
interest factor applied to the 2-year old inventory segment is .21 
[(1.1 x 1.1)-1]. The interest factor applied to the 3-year old 
inventory is .331 [(1.1 x 1.1 x 1.1)-1]. Thus, the tentative 
aggregate interest capitalization amount for 1995 is $641 (1,000  x  
[.1 + .21 + .331]). Because X has no deferred interest in 1995, no 
deferral amount carryforward to 1995, and no required allocation 
under paragraph (c)(7) of this section in 1995, X's aggregate 
interest capitalization amount equals its $641 tentative aggregate 
interest capitalization amount. If, in 1996, X computes an aggregate 
interest capitalization amount of $750, the $109 increase in the 
amount from 1995 to 1996 would be treated as a reduction in interest 
expense for 1996.

    (iv) Method of accounting. The simplified inventory method is a 
method of accounting that must be elected for and applied to all 
inventory within a single trade or business of the taxpayer (within 
the meaning of section 446(d) and Sec. 1.446-1(d)). This method may 
be elected only if the inventory in that trade or business consists 
only of designated property and only if the taxpayer's inverse 
inventory turnover rate for that trade or business (as defined in 
paragraph (g)(3)(ii)(A) of this section) is greater than or equal to 
one. A change from or to the simplified inventory method is a change 
in method of accounting requiring the consent of the Commissioner 
under section 446(e) and Sec. 1.446-(1)(e).
    (4) Financial accounting method disregarded. The avoided cost 
method is applied under this section without regard to any financial or 
regulatory accounting principles for the capitalization of interest. 
For example, this section determines the amount of interest that must 
be capitalized without regard to Financial Accounting Standards Board 
(FASB) Statement Nos. 34, 71, and 90, issued by the Financial 
Accounting Standards Board, Norwalk, CT 06856-5116. Similarly, 
taxpayers are not permitted to net interest income and interest expense 
in determining the amount of interest that must be capitalized under 
this section with respect to certain restricted tax-exempt borrowings 
even though netting is permitted under FASB Statement No. 62.
    (5) Treatment of intercompany transactions--(i) General rule. If 
interest capitalized under section 263A(f) by a member of a 
consolidated group (within the meaning of Sec. 1.1502-1(h)) with 
respect to a unit of designated property is attributable to a loan from 
another member of the group (the lending member), the intercompany 
transaction provisions of the consolidated return regulations do not 
apply to the lending member's interest income with respect to that 
loan, except as provided in paragraph (g)(5)(ii) of this section. For 
this purpose, the capitalized interest expense that is attributable to 
a loan from another member is determined under any method that 
reasonably reflects the principles of the avoided cost method, 
including the traced and nontraced concepts. For purposes of this 
paragraph (g)(5)(i) and paragraph (g)(5)(ii) of this section, in order 
for a method to be considered reasonable it must be consistently 
applied.
    (ii) Special rule for consolidated group with limited outside 
borrowing. If, for any year, the aggregate amount of interest income 
described in paragraph (g)(5)(i) of this section for all members of the 
group with respect to all units of designated property exceeds the 
total amount of interest that is deductible for that year by all 
members of the group with respect to debt of a member owed to 
nonmembers (group deductible interest) after applying section 263A(f), 
the intercompany transaction provisions of the consolidated return 
regulations are applied to the excess, and the amount of interest 
income that must be taken into account by the group under paragraph 
(g)(5)(i) of this section is limited to the amount of the group 
deductible interest. The amount to which the intercompany transaction 
provisions of the consolidated return regulations apply by reason of 
this paragraph (g)(5)(ii) is allocated among the lending members under 
any method that reasonably reflects each member's share of interest 
income described in paragraph (g)(5)(i) of this section. If a lending 
member has interest income that is attributable to more than one unit 
of designated property, the amount to which the intercompany 
transaction provisions of the consolidated return regulations apply by 
reason of this paragraph (g)(5)(ii) with respect to the member is 
allocated among the units in accordance with the principles of 
paragraph (c)(7)(i) of this section.
    (iii) Example. The provisions of paragraph (g)(5)(ii) of this 
section are illustrated by the following example.

    Example. (i) P and S1 are the members of a consolidated group. 
In 1995, S1 begins and completes the construction of a shopping 
center and is required to capitalize interest with respect to the 
construction. S1's average excess expenditures for 1995 are 
$5,000,000. Throughout 1995, S1's only borrowings include a 
$6,000,000 loan from P bearing interest at an annual rate of 10 
percent ($600,000 per year). Under the avoided cost method, S1 is 
required to capitalize interest in the amount of $500,000 
([$600,000$6,000,000] x 5,000,000).
    (ii) P's only borrowing from unrelated lenders is a $2,000,000 
loan bearing interest at an annual rate of 10 percent ($200,000 per 
year). Under the principles of paragraph (g)(5)(ii) of this section, 
because the aggregate amount of interest described in paragraph 
(g)(5)(i) of this section ($500,000) exceeds the aggregate amount of 
currently deductible interest of the group ($200,000), the 
intercompany transaction provisions of the consolidated return 
regulations apply to the excess of $300,000 and the amount of P's 
interest income that is subject to current inclusion by reason of 
paragraph (g)(5)(i) of this section is limited to $200,000.

    (6) Notional principal contracts and other derivatives.
    [Reserved]
    (7) 15-day repayment rule. A taxpayer may elect to treat any 
eligible debt that is repaid within the 15-day period immediately 
preceding a quarterly measurement date as outstanding as of that 
measurement date for purposes of determining traced debt, average 
nontraced debt, and the weighted average interest rate. This election 
may be made or discontinued for any computation period and is not a 
method of accounting.


Sec. 1.263-10  Unit of property.

    (a) In general. The unit of property as defined in this section is 
used as the basis to determine accumulated production expenditures 
under Sec. 1.263A-11 and the beginning and end of the production period 
under Sec. 1.263A-12. Whether property is 1-year or 2-year property 
under Sec. 1.263A-8(b)(1)(ii) is also determined separately with 
respect to each unit of property as defined in this section.
    (b) Units of real property--(1) In general. A unit of real property 
includes any components of real property owned by the taxpayer or a 
related person that are functionally interdependent and an allocable 
share of any common feature owned by the taxpayer or a related person 
that is real property even though the common feature does not meet the 
functional interdependence test. When the production period begins with 
respect to any functionally interdependent component or any common 
feature of the unit of real property, the production period has begun 
for the entire unit of real property. See, however, paragraph (b)(5) of 
this section for rules under which the costs of a common feature or 
benefitted property are excluded from accumulated production 
expenditures for one or more measurement dates. The portion of land 
included in a unit of real property includes land on which real 
property (including a common feature) included in the unit is situated, 
land subject to setback restrictions with respect to such property, and 
any other contiguous portion of the tract of land other than land that 
the taxpayer holds for a purpose unrelated to the unit being produced 
(e.g., investment purposes, personal use purposes, or specified future 
development as a separate unit of real property).
    (2) Functional interdependence. Components of real property 
produced by, or for, the taxpayer, for use by the taxpayer or a related 
person are functionally interdependent if the placing in service of one 
component is dependent on the placing in service of the other component 
by the taxpayer or a related person. In the case of property produced 
for sale, components of real property are functionally interdependent 
if they are customarily sold as a single unit. For example, the real 
property components of a single-family house (e.g., the land, 
foundation, and walls) are functionally interdependent. In contrast, 
components of real property that are expected to be separately placed 
in service or held for resale are not functionally interdependent. 
Thus, dwelling units within a multi-unit building that are separately 
placed in service or sold (within the meaning of Sec. 1.263A-12(d)(1)) 
are treated as functionally independent of any other units, even though 
the units are located in the same building.
    (3) Common features. For purposes of this section, a common feature 
generally includes any real property (as defined in Sec. 1.263A-8(c)) 
that benefits real property produced by, or for, the taxpayer or a 
related person, and that is not separately held for the production of 
income. A common feature need not be physically contiguous to the real 
property that it benefits. Examples of common features include streets, 
sidewalks, playgrounds, clubhouses, tennis courts, sewer lines, and 
cables that are not held for the production of income separately from 
the units of real property that they benefit.
    (4) Allocation of costs to unit. Except as provided in paragraph 
(b)(5) of this section, the accumulated production expenditures for a 
unit of real property include, in all cases, the costs that directly 
benefit, or are incurred by reason of the production of, the unit of 
real property. Accumulated production expenditures also include the 
adjusted basis of property used to produce the unit of real property. 
The accumulated costs of a common feature or land that benefits more 
than one unit of real property, or that benefits designated property 
and property other than designated property, is apportioned among the 
units of designated property, or among the designated property and 
property other than designated property, in determining accumulated 
production expenditures. The apportionment of the accumulated costs of 
the common feature (allocable share) or land (attributable land costs) 
generally may be made using any method that is applied on a consistent 
basis and that reasonably reflects the benefits provided. For example, 
an apportionment based on relative costs to be incurred, relative space 
to be occupied, or relative fair market values may be reasonable.
    (5) Treatment of costs when a common feature is included in a unit 
of real property--(i) General rule. Except as provided in this 
paragraph (b)(5), the accumulated production expenditures of a unit of 
real property include the costs of functionally interdependent 
components (benefitted property) and an allocable share of the cost of 
common features throughout the entire production period of the unit. 
See Sec. 1.263A-12, relating to the production period of a unit of 
property.
    (ii) Production activity not undertaken on benefitted property--(A) 
Direct production activity not undertaken--(1) In general. The costs of 
land attributable to a benefitted property may be treated as not 
included in accumulated production expenditures for a unit of real 
property for measurement dates prior to the first date a production 
activity (direct production activity), including the clearing and 
grading of land, has been undertaken with respect to the land 
attributable to the benefitted property. Thus, the costs of land 
attributable to a benefitted property (as opposed to land attributable 
to the common features) with respect to which no direct production 
activities have been undertaken may be treated as not included in the 
accumulated production expenditures of a unit of real property even 
though a production activity has begun on a common feature allocable to 
the unit.
    (2) Land attributable to a benefitted property. For purposes of 
this paragraph (b)(5)(ii), land attributable to a benefitted property 
includes all land in the unit of real property that includes the 
benefitted property other than land for a common feature. (Thus, land 
attributable to a benefitted property does not include land 
attributable to a common feature.)
    (B) Suspension of direct production activity after clearing and 
grading undertaken--(1) General rule. This paragraph (b)(5)(ii)(B) may 
be used to determine the accumulated production expenditures for a unit 
of real property, if the only production activity with respect to a 
benefitted property has been clearing and grading and no further direct 
production activity is undertaken with respect to the benefitted 
property for at least 120 consecutive days (i.e., direct production 
activity has ceased). Under this paragraph (b)(5)(ii)(B), the 
accumulated production expenditures attributable to a benefitted 
property qualifying under this paragraph (b)(5)(ii)(B) may be excluded 
from the accumulated production expenditures of the unit of real 
property even though production continues on a common feature allocable 
to the unit. For purposes of this paragraph (b)(5)(ii)(B), production 
activity is considered to occur during any time which would not qualify 
as a cessation of production activities under the suspension period 
rules of Sec. 1.263A-12(g).
    (2) Accumulated production expenditures. If this paragraph 
(b)(5)(ii)(B) applies, accumulated production expenditures attributable 
to the benefitted property of the unit of real property may be treated 
as not included in the accumulated production expenditures for the unit 
starting with the first measurement period beginning after the first 
day of the 120 consecutive day period, but must be included in the 
accumulated production expenditures for the unit beginning in the 
measurement period in which direct production activity has resumed on 
the benefitted property. Accumulated production expenditures with 
respect to common features allocable to the unit of real property may 
not be excluded under this paragraph (b)(5)(ii)(B).
    (iii) Common feature placed in service before the end of production 
of a benefitted property. To the extent that a common feature with 
respect to which all production activities to be undertaken by, or for, 
a taxpayer or a related person are completed is placed in service 
before the end of the production period of a unit that includes an 
allocable share of the costs of the common feature, the costs of the 
common feature are not treated as included in accumulated production 
expenditures of the unit for measurement periods beginning after the 
date the common feature is placed in service.
    (iv) Benefitted property sold before production completed on common 
feature. If a unit of real property is sold before common features 
included in the unit are completed, the production period of the unit 
ends on the date of sale. Thus, common feature costs actually incurred 
and properly allocable to the unit as of the date of sale are excluded 
from accumulated production expenditures for measurement period 
beginning after the date of sale. Common feature costs properly 
allocable to the unit and actually incurred after the sale are not 
taken into account in determining accumulated production expenditures.
    (v) Benefitted property placed in service before production 
completed on common feature. Where production activities remain to be 
undertaken on a common feature allocable to a unit of real property 
that includes benefitted property, the costs of the benefitted property 
are not treated as included in the accumulated production expenditures 
for the unit for measurement periods beginning after the date the 
benefitted property is placed in service and all production activities 
reasonably expected to be undertaken by, or for, the taxpayer or a 
related person with respect to the benefitted property are completed.
    (6) Examples. The principles of paragraph (b) of this section are 
illustrated by the following examples:

    Example 1. B, an individual, is in the trade or business of 
constructing custom-built houses for sale. B owns a 10-acre tract 
upon which B intends to build four houses on 2-acre lots. In 
addition, on the remaining 2 acres B plans to construct a perimeter 
road that benefits the four houses and is not held for the 
production of income separately from the sale of the houses. In 
1995, B begins constructing the perimeter road and clears the land 
for one house. Under the principles of paragraph (b)(1) of this 
section, each planned house (including attributable land) is part of 
a separate unit of real property (house unit). Under the principles 
of paragraph (b)(3) of this section, the perimeter road (including 
attributable land) constitutes a common feature with respect to each 
planned house (i.e., benefitted property). In accordance with 
paragraph (b)(1), the production period for all four house units 
begins when production commences on the perimeter road in 1995. In 
addition, under the principles of paragraph (b)(4) of this section, 
the accumulated production expenditures for the four house units 
include the allocable costs of the road. In addition, for the house 
with respect to which B has cleared the land, the accumulated 
production expenditures for the house unit include the land costs 
attributable to the house. See paragraph (b)(5)(i) of this section. 
However, the accumulated production expenditures for each of the 
three house units that include a house for which B has not yet 
undertaken a direct production activity do not include the land 
costs attributable to the house. See paragraph (b)(5)(ii) of this 
section.
    Example 2. Assume the same facts as Example 1, except that B 
undertakes no further direct production activity with respect to the 
house for which the land was cleared for a period of at least 120 
days but continues constructing the perimeter road during this 
period. In accordance with paragraph (b)(5)(ii)(B) of this section, 
B may exclude the accumulated production expenditures attributable 
to the benefitted property from the accumulated production 
expenditures of the house unit starting with the first measurement 
period that begins after the first day of the 120 consecutive day 
period. B must include the accumulated production expenditures 
attributable to the benefitted property in the accumulated 
production expenditures for the house unit beginning with the 
measurement period in which direct production resumes on the 
benefitted property. The house unit will continue to include the 
accumulated production expenditures attributable to the perimeter 
road during the period in which direct production activity was 
suspended on the benefitted property.
    Example 3. (i) D, a corporation, is in the trade or business of 
developing commercial real property. D owns a 20-acre tract upon 
which D intends to build a shopping center with 150 stores. D 
intends to lease the stores. D will also provide on the 20 acres a 
1500-car parking lot, which is not held by D for the production of 
income separately from the stores in the shopping center. 
Additionally, D will not produce any other common features as part 
of the project. D intends to complete the shopping center in phases 
and expects that each store will be placed in service independently 
of any other store.
    (ii) Under paragraphs (b)(1) and (b)(2) of this section, each 
store (including attributable land) is part of a separate unit of 
real property (store unit). The 1500-car parking lot is a common 
feature benefitting each store, and D must include an allocable 
share of the parking lost in each store unit. See paragraph (b)(1) 
and (b)(3). In accordance with paragraph (b)(5)(i), D includes in 
the accumulated production expenditures for each store unit during 
each store unit's production period: the costs capitalized with 
respect to the store (including attributable land costs in 
accordance with paragraph (b)(5) of this section) and an allocable 
share of the parking lot costs (including attributable land costs in 
accordance with paragraph (b)(5) of this section. Under paragraph 
(b)(4), the portion of the parking lot costs that is included in the 
accumulated production expenditures of a store unit is determined 
using a reasonable method of allocation.
    Example 4. X, a real estate developer, begins a project to 
construct a condominium building and a convenience store for the 
benefit of the condominium. X intends to separately lease the 
convenience store. Because the convenience store is held for the 
production of income separately from the condominium units that it 
benefits, the convenience store is not a common feature with respect 
to the condominium building. Instead, the convenience store is a 
separate unit of property with a separate production period and for 
which a separate determination of accumulated production 
expenditures must be made.
    Example 5. (i) In 1995, X, a real estate developer, begins a 
project consisting of a condominium building and a common swimming 
pool that is not held for the production of income separately from 
the condominium sales. The condominium building consists of 10 
stories, and each story is occupied by a single condominium. 
Production of the swimming pool begins in January. No direct 
production activity is undertaken on any condominium until 
September, when direct production activity commences on each 
condominium. On December 31, 1995, 1 condominium that was completed 
in December has been sold, 3 condominiums that were completed in 
December have not been sold, and 6 condominiums are only partially 
complete; additionally, the swimming pool is completed. X is a 
calendar year taxpayer that uses a full taxable year as the 
computation period, and quarterly measurement dates.
    (ii) Under paragraphs (b)(1) and (b)(2) of this section, each 
condominium (including attributable land) is part of a separate unit 
of real property. Under the principles of paragraph (b)(3) of this 
section, the swimming pool is a common feature with respect to each 
condominium and under paragraph (b)(4) of this section the cost of 
the swimming pool is allocated equally among the condominiums.
    (iii) Under paragraph (b)(1) of this section, the production 
period of each of the 10 condominium units begins in January when 
production of the swimming pool begins. On X's March 31, 1995, and 
June 30, 1995, measurement dates, the accumulated production 
expenditures for each condominium unit include the allocable costs 
of the swimming pool, but not the land costs attributable to the 
condominium because no direct production activity has been 
undertaken on the condominium. See paragraph (b)(5)(ii)(A) of this 
section. On X's September 30, 1995, and December 31, 1995, 
measurement dates, the accumulated production expenditures for each 
unit include the allocable costs of the swimming pool, and the costs 
of the condominium (including attributable land costs) because a 
direct production activity has commenced on the condominium. See 
paragraph (b)(5)(i) of this section.
    (iv) The production period for the condominium unit that 
includes the condominium that is sold as of the end of 1995 ends on 
the date the condominium is sold. See paragraph (b)(5)(iv) of this 
section. The production period of each unit that is ready to be held 
for sale ends when all production activities have been completed on 
the unit, in this case on December 31, 1995, the date that the 
swimming pool included in the unit is completed. See Sec. 1.263A-
12(d). Accordingly, interest capitalization ceases for each such 
unit that is sold or ready to be held for sale as of the end of 1995 
(including each unit's allocable share of the completed swimming 
pool).
    (v) The production periods for the condominium units that 
include the condominiums that are only partially complete at the end 
of 1995 continue after 1995. The accumulated production expenditures 
for each partially completed condominium unit continue to include 
the costs of the condominium (including attributable land costs) in 
addition to the costs of an allocable share of the completed 
swimming pool (including attributable land costs).
    Example 6. Assume the same facts as in Example 5, except that 
the swimming pool is only partially complete as of the end of 1995. 
Under these facts, X capitalizes no interest during 1996 for the 1 
unit that includes the condominium sold during 1995 (including the 
costs of the allocable share of swimming pool). See paragraph 
(b)(5)(iv) of this section. However, with respect to the 6 
condominiums that are partially complete and the 3 condominiums that 
are completed but unsold, interest capitalization continues after 
the end of 1995. The accumulated production expenditures for each of 
these 9 units include the costs of an allocable share of the 
swimming pool. See paragraph (b)(5)(i) of this section. In 
determining the costs of an allocable share of the swimming pool 
included in the accumulated production expenditures for each of the 
9 units, X includes all costs of the swimming pool properly 
allocable to each unit, including those cost incurred as of the date 
of the sale of unit 1 that may have been used under applicable 
administrative procedures (e.g., Rev. Proc. 92-29, 1992-1 C.B. 748) 
in determining the basis of unit 1 solely for purposes of computing 
gain or loss on the sale of unit 1. See Sec. 601.601(d)(2)(ii)(b) of 
this chapter.
    Example 7. (i) Assume the same facts as in Example 5, except 
that X intends to lease rather than sell the condominiums and the 
completed swimming pool is placed in service for depreciation 
purposes on December 31, 1995. Additionally, assume that all 10 
condominiums are partially completed at the end of 1995.
    (ii) Under these facts, because the swimming pool is a common 
feature that is placed in service separately from the condominiums 
that it benefits, under paragraph (b)(5)(iii) of this section, the 
accumulated production expenditures of each of the condominium units 
do not include the costs of the allocable share of the swimming pool 
after 1995.

    (c) Units of tangible personal property. Components of tangible 
personal property are a single unit of property if the components are 
functionally interdependent. Components of tangible personal property 
that are produced by, or for, the taxpayer, for use by the taxpayer or 
a related person, are functionally interdependent if the placing in 
service of one component is dependent on the placing in service of the 
other component by the taxpayer or a related person. In the case of 
tangible personal property produced for sale, components of tangible 
personal property are functionally interdependent if they are 
customarily sold as a single unit. For example, if an aircraft 
manufacturer customarily sells completely assembled aircraft, the unit 
of property includes all components of a completely assembled aircraft. 
If the manufacturer also customarily sells aircraft engines separately, 
any engines that are reasonably expected to be sold separately are 
treated as single units of property.
    (d) Treatment of installations. If the taxpayer produces or is 
treated as producing any property that is installed on or in other 
property, the production activity and installation activity relating to 
each unit of property generally are not aggregated for purposes of this 
section. However, if the taxpayer is treated as producing and 
installing any property for use by the taxpayer or a related person or 
if the taxpayer enters into a contract requiring the taxpayer to 
install property for use by a customer, the production activity and 
installation activity are aggregated for purposes of this section.


Sec. 1.263A-11  Accumulated production expenditures.

    (a) General rule. Accumulated production expenditures generally 
means the cumulative amount of direct and indirect costs described in 
section 263A(a) that are required to be capitalized with respect to the 
unit of property (as defined in Sec. 1.263A-10), including interest 
capitalized in prior computation periods, plus the adjusted bases of 
any assets described in paragraph (d) of this section that are used to 
produce the unit of property during the period of their use. 
Accumulated production expenditures may also include the basis of any 
property received by the taxpayer in a nontaxable transaction.
    (b) When costs are first taken into account--(1) In general. Except 
as provided in paragraph (c)(1) of this section, costs are taken into 
account in the computation of accumulated production expenditures at 
the time and to the extent they would otherwise be taken into account 
under the taxpayer's method of accounting (e.g., after applying the 
requirements of section 461, including the economic performance 
requirement of section 461(h)). Costs that have been incurred and 
capitalized with respect to a unit of property prior to the beginning 
of the production period are taken into account as accumulated 
production expenditures beginning on the date on which the production 
period of the property begins (as defined in Sec. 1.263A-12(c)). Thus, 
for example, the cost of raw land acquired for development, the cost of 
a leasehold in mineral properties acquired for development, and the 
capitalized cost of planning and design activities are taken into 
account as accumulated production expenditures beginning on the first 
day of the production period. For purposes of determining accumulated 
production expenditures on any measurement date during a computation 
period, the interest required to be capitalized for the computation 
period is deemed to be capitalized on the day immediately following the 
end of the computation period. For any subsequent measurement dates and 
computation periods, that interest is included in accumulated 
production expenditures. If the cost of land or common features is 
allocated among planned units of property that are completed in phases, 
any portion of the cost properly allocated to completed units is not 
reallocated to any incomplete units of property.
    (2) Dedication rule for materials and supplies. The costs of raw 
materials, supplies, or similar items are taken into account as 
accumulated production expenditures when they are incurred and 
dedicated to production of a unit of property. Dedicated means the 
first date on which the raw materials, supplies, or similar items are 
specifically associated with the production of any unit of property, 
including by record, assignment to the specific job site, or physical 
incorporation. In contrast, in the case of a component or subassembly 
that is reasonably expected to be become a part of (e.g., be 
incorporated into) any unit of property, costs incurred (including 
dedicated raw materials) for the component or subassembly are taken 
into account as accumulated production expenditures during the 
production of any portion of the component or subassembly and prior to 
its connection with (e.g., incorporation into) any specific unit of 
property. For purposes of the preceding sentence, components and 
subassemblies must be aggregated at each measurement date in a 
reasonable manner that is consistent with the purposes of section 
263A(f).
    (c) Property produced under a contract--(1) Customer. If a unit of 
property produced under a contract is designated property under 
Sec. 1.263A-8(d)(2)(i) with respect to the customer, the customer's 
accumulated production expenditures include any payments under the 
contract that represent part of the purchase price of the unit of 
designated property or, to the extent costs are incurred earlier than 
payments are made (determined on a cumulative basis for each unit of 
designated property), any part of such price for which the requirements 
of section 461 have been satisfied. The customer has made a payment 
under this section if the transaction would be considered a payment by 
a taxpayer using the cash receipts and disbursements method of 
accounting. The customer's accumulated production expenditures also 
include any other costs incurred by the customer, such as interest, or 
any other direct or indirect costs that are required to be capitalized 
under section 263A(a) and the regulations thereunder with respect to 
the production of the unit of designated property.
    (2) Contractor. If a unit of property produced under a contract is 
designated property under Sec. 1,263A-8(d)(2)(ii) with respect to the 
contractor, the contractor must treat the cumulative amount of payments 
made by the customer under the contract attributable to the unit of 
property as a reduction in the contractor's accumulated production 
expenditures. The customer has made a payment under this section if the 
transaction would be considered a payment by a taxpayer using the cash 
receipts and disbursements method of accounting.
    (d) Property used to produce designated property--(1) In general. 
Accumulated production expenditures include the adjusted bases (or 
portion thereof) of any equipment, facilities, or other similar assets, 
used in a reasonably proximate manner for the production of a unit of 
designated property during any measurement period in which the asset is 
so used. Examples of assets used in a reasonably proximate manner 
include machinery and equipment used directly or indirectly in the 
production process, such as assembly-line structures, cranes, 
bulldozers, and buildings. A taxpayer apportions the adjusted basis of 
an asset used in the production of more than one unit of designated 
property in a measurement period among such units of designated 
property using reasonable criteria corresponding to the use of the 
asset, such as machine hours, mileage, or units of production, If an 
asset used in a reasonably proximate manner for the production of a 
unit of designated property is temporarily idle (within the meaning of 
Sec. 1.263A-1(e)(3)(iii)(E)) for an entire measurement period, the 
adjusted basis of the asset is excluded from the accumulated production 
expenditures for the unit during that measurement period. 
Notwithstanding this paragraph (d)(1), the portion of the depreciation 
allowance for equipment, facilities, or any other asset that is 
capitalized with respect to a unit of designated property in accordance 
with Sec. 1.263A-1(e)(3)(ii)(I) is included in accumulated production 
expenditures without regard to the extent of use under this paragraph 
(d)(1) (i.e., without regard to whether the asset is used in a 
reasonably proximate manner for the production of the unit of 
designated property).
    (2) Example. The following example illustrates how the basis of an 
asset is allocated on the basis of time:

    Example. In 1995, X uses a bulldozer exclusively to clear the 
land on several adjacent real estate development projects, A, B, and 
C. A, B, and C are treated as separate units of property under the 
principles of Sec. 1.263A-10. X decides to allocate the basis of the 
bulldozer among the three projects on the basis of time. At the end 
of the first quarter of 1995, the production period has commenced 
for all three projects. The bulldozer was operated for 30 hours on 
project A, 80 hours on project B, and 10 hours on project C, for a 
total of 120 hours for the entire period. For purposes of 
determining accumulated production expenditures as of the end of the 
first quarter, \1/4\ of the adjusted basis of the bulldozer is 
allocated to project A, \2/3\ to project B, and \1/12\ to project C. 
Nonworking hours, regularly scheduled nonworking days, or other 
periods in which the bulldozer is temporarily idle (within the 
meaning of Sec. 1.263A-1(e)(3)(iii)(E)) during the measurement 
period are not taken into account in allocating the basis of the 
bulldozer.

    (3) Excluded equipment and facilities. The adjusted bases of 
equipment, facilities, or other assets that are not used in a 
reasonably proximate manner to produce a unit of property are not 
included in the computation of accumulated production expenditures. For 
example, the adjusted bases of equipment and facilities, including 
buildings and other structures, used in service departments performing 
administrative, purchasing, personnel, legal, accounting, or similar 
functions, are excluded from the computation of accumulated production 
expenditures under this paragraph (d)(3).
    (e) Improvements--(1) General rule. If an improvement constitutes 
the production of designated property under $1.263A-8(d)(3), 
accumulated production expenditures with respect to the improvement 
consist of--
    (i) All direct and indirect costs required to be capitalized with 
respect to the improvement,
    (ii) In the case of an improvement to a unit of real property
    (A) An allocable portion of the cost of land, and
    (B) For any measurement period, the adjusted basis of any existing 
structure, common feature, or other property that is not placed in 
service or must be temporarily withdrawn from service to complete the 
improvement (associated property) during any part of the measurement 
period if the associated property directly benefits the property being 
improved, the associated property directly benefits from the 
improvement, or the improvement was incurred by reason of the 
associated property. See, however, the de minimis rule under paragraph 
(e)(2) of this section that applies in the case of associated property.
    (iii) In the case of an improvement to a unit of tangible personal 
property, the adjusted basis of the asset being improved if the asset 
either is not placed in service or must be temporarily withdrawn from 
service to complete the improvement.
    (2) De minimis rule. For purposes of paragraph (e)(1)(ii) of this 
section, the total costs of all associated property for an improvement 
unit (associated property costs are excluded from the accumulated 
production expenditures for the improvement unit during its production 
period if, on the date the production period of the unit begins, the 
taxpayer reasonably expects that at no time during the production 
period of the unit will the accumulated production expenditures for the 
unit, determined without regard to the associated property costs, 
exceed 5 percent of the associated property costs.
    (f) Mid-production purchases. If a taxpayer purchases a unit of 
property for further production, the taxpayer's accumulated production 
expenditures include the full purchase price of the property plus, in 
accordance with the principles of paragraph (e) of this section, 
additional direct and indirect costs incurred by the taxpayer.
    (g) Related person costs. The activities of a related person are 
taken into account in applying the classification thresholds under 
Sec. 1.263A-8(b)(1)(ii)(B) and (C), and in determining the production 
period of a unit of designated property under Sec. 1.263A-12. However, 
only those costs incurred by the taxpayer are taken into account in the 
taxpayer's accumulated production expenditures under this section 
because the related person includes its own capitalized costs in the 
related person's accumulated production expenditures with respect to 
any unit of designated property upon which the parties engage in mutual 
production activities. For purposes of the preceding sentence, the 
accumulated production expenditures of any property transferred to a 
taxpayer in a nontaxable transaction are treated as accumulated 
production expenditures incurred by the taxpayer.
    (h) Installation. If the taxpayer installs property that is 
purchased by the taxpayer, accumulated production expenditures include 
the cost of the property that is installed in addition to the direct 
and indirect costs of installation.


Sec. 1.263A-12  Production period.

    (a) In general. Capitalization of interest is required under 
Sec. 1.263A-9 for computation periods (within the meaning of 
Sec. 1.263A-9(f)(1)) that include the production period of a unit of 
designated property. In contrast, section 263A(a) requires the 
capitalization of all other direct or indirect costs, such as 
insurance, taxes, and storage, that directly benefit or are incurred by 
reason of the production of property without regard to whether they are 
incurred during a period in which production activity occurs.
    (b) Related person activities. Activities performed and costs 
incurred by a person related to the taxpayer that directly benefit or 
are incurred by reason of the taxpayer's production of designated 
property are taken into account in determining the taxpayer's 
production period (regardless of whether the related person is 
performing only a service or is producing a subassembly or component 
that the related person is required to treat as an item of designated 
property). These activities and the related person's costs are also 
taken into account in determining whether tangible personal property 
produced by the taxpayer is 1-year or 2-year property under 
Sec. 1.263A-8(b)(1)(ii) (B) and (C).
    (c) Beginning of production period--(1) In general. A separate 
production period is determined for each unit of property defined in 
Sec. 1.263A-10. The production period begins on the date that 
production of the unit of property begins.
    (2) Real property. The production period of a unit of real property 
begins on the first date that any physical production activity (as 
defined in paragraph (e) of this section) is performed with respect to 
a unit of real property. See Sec. 1.263A-10(b)(1). The production 
period of a unit of real property produced under a contract begins for 
the contractor on the date the contractor begins physical production 
activity on the property. The production period of a unit of real 
property produced under a contract begins for the customer on the date 
either the customer or the contractor begins physical production 
activity on the property.
    (3) Tangible personal property. The production period of a unit of 
tangible personal property begins on the first date by which the 
taxpayer's accumulated production expenditures, including planning and 
design expenditures, are at least 5 percent of the taxpayer's total 
estimated accumulated production expenditures for the property unit. 
Thus, the beginning of the production period is determined without 
regard to whether physical production activity has commenced. The 
production period of a unit of tangible personal property produced 
under a contract begins for the contractor when the contractor's 
accumulated production expenditures, without any reduction for payments 
from the customer, are at least 5 percent of the contractor's total 
estimated accumulated production expenditures. The production period 
for a unit of tangible personal property produced under a contract 
begins for the customer when the customer's accumulated production 
expenditures are at least 5 percent of the customer's total estimated 
accumulated production expenditures.
    (d) End of production period--(1) In general. The production period 
for a unit of property produced for self use ends on the date that the 
unit is placed in service and all production activities reasonably 
expected to be undertaken by, or for, the taxpayer or a related person 
are completed. The production period for a unit of property produced 
for sale ends on the date that the unit is ready to be held for sale 
and all production activities reasonably expected to be undertaken by, 
or for, the taxpayer or a related person are completed. See, however, 
Sec. 1.263A-10(b)(5)(iv) providing an exception for common features in 
the case of a benefitted property that is sold. In the case of a unit 
of property produced under a contract, the production period for the 
customer ends when the property is placed in service by the customer 
and all production activities reasonably expected to be undertaken are 
complete (i.e., generally, no earlier than when the customer takes 
delivery). In the case of property that is customarily aged (such as 
tobacco, wine, or whiskey) before it is sold, the production period 
includes the aging period.
    (2) Special rules. The production period does not end for a unit of 
property prior to the completion of physical production activities by 
the taxpayer even though the property is held for sale or lease, since 
all production activities reasonably expected to be undertaken by the 
taxpayer with respect to such property have not in fact been completed. 
See, however, Sec. 1.263A-10(b)(5) regarding separation of certain 
common features.
    (3) Sequential production or delivery. The production period ends 
with respect to each unit of property (as defined in Sec. 1.263A-10) 
and its associated accumulated production expenditures as the unit of 
property is completed within the meaning of paragraph (d)(1) of this 
section, without regard to the production activities or costs of any 
other units of property. Thus, for example, in the case of separate 
apartments in a multi-unit building, each of which is a separate unit 
of property within the meaning of Sec. 1.263A-10, the production period 
ends for each separate apartment when it is ready to be held for sale 
or placed in service within the meaning of paragraph (d)(1) of this 
section. In the case of a single unit of property that merely undergoes 
separate and distinct stages of production, the production period ends 
at the same time (i.e., when all separate stages of production are 
completed with respect to the entire amount of accumulated production 
expenditures for the property).
    (4) Examples. The provisions of paragraph (d) of this section are 
illustrated by the following example:

    Example 1. E is engaged in the original construction of a high-
rise office building with two wings. At the end of 1995, Wing #1, 
but not Wing #2, is placed in service. Moreover, at the end of 1995, 
all production activities reasonably expected to be undertaken on 
Wing #1 are completed. In accordance with Sec. 1.263A-10(b)(1), Wing 
#1 and Wing #2 are separate units of designated property. E may stop 
capitalizing interest on Wing #1 but not on Wing #2.
    Example 2. F is in the business of constructing finished houses. 
F generally paints and finishes the interior of the house, although 
this does not occur until a potential buyer is located. Because F 
reasonably expects to undertake production activity (painting and 
finishing), the production period of each house does not end until 
these activities are completed.

    (e) Physical production activities--(1) In general. The term 
physical production activities includes any physical activity that 
constitutes production within the meaning of Sec. 1.263A-8(d)(1). The 
production period begins and interest must be capitalized with respect 
to real property if any physical production activities are undertaken, 
whether alone or in preparation for the construction of buildings or 
other structures, or with respect to the improvement of existing 
structures. For example, the clearing of raw land constitutes the 
production of designated property, even if only cleared prior to 
resale.
    (2) Illustrations. THe following is a partial list of activities 
any one of which constitutes a physical production activity with 
respect to the production of real property:
    (i) Clearing, grading, or excavating of raw land;
    (ii) Demolishing a building or gutting a standing building;
    (iii) Engaging in the construction of infrastructure, such as 
roads, sewers, sidewalks, cables, and wiring;
    (iv) Undertaking structural, mechanical, or electrical activities 
with respect to a building or other structure; or
    (v) Engaging in landscaping activities.
    (f) Activities not considered physical production. The activities 
described in paragraphs (f)(1) and (f)(2) of this section are not 
considered physical production activities:
    (1) Planning and design. Soil testing, preparing architectural 
blueprints or models, or obtaining building permits.
    (2) Incidental repairs. Physical activities of an incidental nature 
that may be treated as repairs under Sec. 1.162-4.
    (g) Suspension of production period--(1) In general. If production 
activities related to the production of a unit of designated property 
cease for at least 120 consecutive days (cessation period), a taxpayer 
may suspend the capitalization of interest with respect to the unit of 
designated property starting with the first measurement period that 
begins after the first day in which production ceases. The taxpayer 
must resume the capitalization of interest with respect to a unit 
beginning with the measurement period during which production 
activities resume. In addition, production activities are not 
considered to have ceased if they cease because of circumstances 
inherent in the production process, such as normal adverse weather 
conditions, scheduled plant shutdowns, or delays due to design or 
construction flaws, the obtaining of a permit or license, or the 
settlement of groundfill to construct property. Interest incurred on 
debt that is traced debt with respect to a unit of designated property 
during the suspension period is subject to capitalization with respect 
to the production of other units of designated property as interest on 
nontraced debt. See Sec. 1.263A-9(c)(5)(i) of this section. For 
applications of the avoided cost method after the end of the suspension 
period, the accumulated production expenditures for the unit include 
the balance of accumulated production expenditures as of the beginning 
of the suspension period, plus any additional capitalized costs 
incurred during the suspension period. No further suspension of 
interest capitalization may occur unless the requirements for a new 
suspension period are satisfied.
    (2) Special rule. If a cessation period spans more than one taxable 
year, the taxpayer may suspend the capitalization of interest with 
respect to a unit beginning with the first measurement period of the 
taxable year in which the 120-day period is satisfied.
    (3) Method of accounting. An election to suspend interest 
capitalization under paragraph (g)(1) of this section is a method of 
accounting that must be consistently applied to all units that satisfy 
the requirements of paragraph (g)(1) of this section. However, the 
special rule in paragraph (g)(2) of this section is applied on an 
annual basis to all units of an electing taxpayer that satisfy the 
requirements of paragraph (g)(2) of this section.
    (4) Example. The provisions of paragraph (g)(1) of this section are 
illustrated by the following example.

    Example. (i) D, a calendar-year taxpayer, began production of a 
residential housing development on January 1, 1995. D, in applying 
the avoided cost method, chose a taxable year computation period and 
quarterly measurement dates. On April 10, 1995, all production 
activities ceased with respect to the units in the development until 
December 1, 1996. The cessation, which occurred for a period of at 
least 120 consecutive days, was not attributable to circumstances 
inherent in the production process. With respect to the units in the 
development, D incurred production expenditures of $2,000,000 from 
January 1, 1995 through April 10, 1995. D incurred interest of 
$100,000 on traced debt with respect to the units for the period 
beginning January 1, 1995, and ending June 30, 1995. D did not incur 
any production expenditures for the more than 20-month cessation 
beginning April 10, 1995, and ending December 1, 1996, but incurred 
$200,000 of production expenditures from December 1, 1996, through 
December 31, 1996.
    (ii) D is required to capitalize the $100,000 interest on traced 
debt incurred during the two measurement periods beginning January 
1, 1995, and ending June 30, 1995. Because D satisfied the 120-day 
rule under this paragraph (g), D is not required to capitalize 
interest with respect to the accumulated production expenditures for 
the units for the measurement period beginning July 1, 1995, and 
ending September 30, 1995, which is the first measurement period 
that begins after the date production activities cease. D is rquired 
to resume interest capitalization with respect to the $2,300,000 
(2,000,000+100,000+200,000) of accumulated production expenditures 
for the units for the measurement period beginning October 1, 1996, 
and ending December 31, 1996 (the measurement period during which 
production activities resume). Accordingly, D may suspend the 
capitalization of interest with respect to the units from July 1, 
1995, through September 30, 1996.


Sec. 1.263A-13  Oil and gas activities.

    (a) In general. This section provides rules that are to be applied 
in tandem with Secs. 1.263A-8 through 1.263A-12, 1.263A-14, and 1.263A-
15 in capitalizing interest with respect to the development (within the 
meaning of section 263A(g)) of oil or gas property. For this purpose, 
oil or gas property consists of each separate operating mineral 
interest in oil or gas as defined in section 614(a), or, if a taxpayer 
makes an election under section 614(b), the aggregate of two or more 
separate operating mineral interests in oil or gas as described in 
section 614(b) (section 614 property). Thus, an oil or gas property is 
designated property unless the de minimis rule applies. A taxpayer must 
apply the rules in paragraph (c) of this section if the taxpayer cannot 
establish, at the beginning of the production period of the first well 
drilled on the property, a definite plan that identifies the number and 
location of other wells planned with respect to the property. If a 
taxpayer can establish such a plan at the beginning of the production 
period of the first well drilled on the property, the taxpayer may 
either apply the rules of paragraph (c) of this section or treat each 
of the planned wells as a separate unit and partition the leasehold 
acquisition costs and costs of features based on the number of planned 
well units.
    (b) Generally applicable rules--(1) Beginning of production 
period--(i) Onshore activities. In the case of onshore oil or gas 
development activities, the production period for a unit begins on the 
first date physical site preparation activities (such as building an 
access road, leveling a site for a drilling rig, or excavating a mud 
pit) are undertaken with respect to the unit.
    (ii) Offshore activities. In the case of offshore development 
activities, the production period for a unit begins on the first date 
physical site preparation activities, other than activities undertaken 
with respect to expendable wells, are undertaken with respect to the 
unit. For purposes of the preceding sentence, the first physical site 
preparation activity undertaken with respect to a section 614 property 
is generally the first activity undertaken with respect to the 
anchoring of a platform (e.g., drilling to drive the piles). For 
purposes of this section, an expendable well is a well drilled solely 
to determine the location and delineation of offshore hydrocarbon 
deposits.
    (2) End of production period. The production period ends for a 
productive well unit on the date the well is placed in service and all 
production activities reasonably expected to be undertaken by, or for, 
the taxpayer or a related person are completed. See Sec. 1.263A-12(d).
    (3) Accumulated production expenditures--(i) Costs included. 
Accumulated production expenditures for a well unit include the 
following costs (to the extent they are not intangible drilling and 
development costs allowable as a deduction under section 263(c), 
263(i), or 291(b)(2)): the costs of acquiring the section 614 leasehold 
and the costs of taxes and similar items that are required to be 
capitalized under section 263A(a) with respect to the section 614 
leasehold; the cost of real property associated with developing the 
section 614 property (e.g., casing); the basis of real property that 
constitutes a common feature within the meaning of Sec. 1.263A-
10(b)(3); and the adjusted basis of property used to produce property 
(such as a mobile rig, drilling ship, or an offshore drilling 
platform).
    (ii) Improvement unit. To the extent section 614 costs are 
allocated to a well unit, the undepleted portion of those section 614 
costs must also be included in the accumulated production expenditures 
for any improvement unit (within the meaning of Sec. 1.263A-8(d)(3)) 
with respect to that well unit.
    (c) Special rules when definite plan not established--(1) In 
general. The special rules of this paragraph (c) must be applied by a 
taxpayer that cannot establish, at the beginning of the production 
period of the first well drilled on the property, a definite plan that 
identifies the number and location of the wells planned with respect to 
the property. A taxpayer than can establish such a plan is permitted, 
but not required, to apply the rules of this paragraph (c), provided 
the rules of this paragraph (c) are consistently applied for all the 
taxpayer's oil or gas properties for which a definite plan can be 
established.
    (2) Oil and gas units--(i) First productive well unit. Until the 
first productive well is placed in service and all production 
activities reasonably expected to be undertaken by, or for, the 
taxpayer or a related person are completed, a first productive well 
unit includes the section 614 property and all real property associated 
with the development of the section 614 property. Thus, for example, a 
first productive well unit includes the section 614 property and real 
property associated with any nonproductive well drilled on the section 
614 property on or before the date the first productive well is placed 
in service and all production activities reasonably expected to be 
undertaken by, or for, the taxpayer or a related person are completed. 
For purposes of this section, a productive well is a well that produces 
in commercial quantities. See paragraph (c)(5) of this section, which 
provides a special rule whereby the costs of a section 614 property and 
common feature costs for a section 614 property generally are included 
only in the accumulated production expenditures for the first 
productive well unit.
    (ii) Subsequent units. Generally, real property associated with 
each productive or nonproductive well with respect to which production 
activities begin after the date the first productive well is placed in 
service and all production activities reasonably expected to be 
undertaken by, or for, the taxpayer or a related person are completed, 
constitutes a unit of real property. Additionally, a productive or 
nonproductive well that is included in a first productive well unit and 
for which development continues after the date the first productive 
well is placed in service and all production activities reasonably 
expected to be undertaken by, or for, the taxpayer or a related person 
are completed, generally is treated as a separate unit of property 
after that date. See, however, paragraph (c)(5) of this section, which 
provides rules for the treatment of costs included in the accumulated 
production expenditures of a first productive well unit.
    (3) Beginning of production period--(i) First productive well unit. 
The beginning of the production period of the first productive well 
unit is determined as provided in paragraph (b) of this section.
    (ii) Subsequent wells. In applying paragraph (b) of this section to 
subsequent well units (as described in paragraph (c)(2)(ii) of this 
section), any activities occurring prior to the date the production 
period ends for the first productive well unit are not taken into 
account in determining the beginning of the production period for the 
subsequent well units.
    (4) End of production period. The end of the production period for 
both the first productive well unit and subsequent productive well 
units is determined as provided in paragraph (b)(2) of this section. 
See Sec. 1.263A-12(d). Nonproductive wells included in the first 
productive well unit need not be plugged and abandoned for the 
production period to end for a first productive well unit.
    (5) Accumulated production expenditures--(i) First productive well 
unit. The accumulated production expenditures for a first productive 
well unit include all costs incurred with respect to the section 614 
property and associated real property at any time through the end of 
the production period for the first productive well unit. Thus, the 
costs of acquiring the section 614 property, the costs of taxes and 
similar items that are required to be capitalized under section 263A(a) 
with respect to the section 614 property, and the costs of common 
features, that are incurred at any time through the end of the 
production period of the first productive well unit (section 614 costs) 
are included in the accumulated production expenditures for the first 
productive well unit.
    (ii) Subsequent well unit. The accumulated production expenditures 
for a subsequent well do not include any costs included in the 
accumulated production expenditures for a first productive well unit. 
In the event that section 614 costs or common feature costs with 
respect to a section 614 property are incurred subsequent to the end of 
the production period of the first productive well unit, those common 
feature costs and undepleted section 614 costs are allocated among the 
accumulated production expenditures of wells being drilled as of the 
date such costs are incurred.
    (6) Allocation of interest capitalized with respect to first 
productive well unit. Interest attributable to any productive or 
nonproductive well included in the first productive well unit (within 
the meaning of paragraph (c)(2)(ii) of this section) is allocated among 
and capitalized to the basis of the property associated with the first 
productive well unit. See Sec. 1.263A-8(a)(2).
    (7) Example. The provisions of this paragraph (c) are illustrated 
by the following example.

    Example. (i) Corporation Z, an oil company, acquired a section 
614 property in an onshore tract, Tract B, for development. In 1995, 
Corporation Z began site preparation activities on Tract B and also 
commenced drilling Well 1 on Tract B. Corporation Z was unable to 
establish, as provided in paragraph (a) of this section, a definite 
plan identifying the number and location of other wells planned on 
Tract B. In 1996, Corporation Z began drilling Well 2. On May 1, 
1997, Well 2, a productive well, was placed in service and all 
production activities reasonably expected to be undertaken with 
respect to Well 2 were completed. By that date, also, Well 1 was 
abandoned.
    (ii) Well 2 is a first productive well (within the meaning of 
paragraph (c)(2)(i)) of this section). Well 1 is a nonproductive 
well drilled prior to a first productive well. Under paragraph (c) 
of this section, Corporation Z must treat both Well 1 and Well 2 as 
part of the first productive well unit on the section 614 property. 
In accordance with paragraphs (c)(3) and (c)(4) of this section, the 
production period of the first productive well unit begins on the 
date physical site preparation activities are undertaken with 
respect to Well 1 in 1995 and ends on May 1, 1997, the date that 
Well 2 is placed in service and all production activities reasonably 
expected to be undertaken are completed. In accordance with 
paragraph (c)(5) of this section, the accumulated production 
expenditures for the first productive well unit include, among other 
capitalized costs, the entire section 614 property costs capitalized 
with respect to Tract B and all common feature costs incurred with 
respect to the section 614 property through May 1, 1997.
    (iii) Any well that Corporation Z begins after May 1, 1997, is a 
separate unit of property. See paragraph (c)(2)(ii) of this section. 
Under paragraph (c)(3)(ii) of this section, the production period 
for any such well unit begins on the first day after May 1, 1997, on 
which Corporation Z undertakes physical site preparation activities 
with respect to the well unit. Moreover, Corporation Z does not 
include any of the section 614 property costs in the accumulated 
production expenditures for any well unit begun after May 1, 1997.


Sec. 1.263A-14  Rules for related persons.

    Taxpayers must account for average excess expenditures allocated to 
related persons under applicable administrative pronouncements 
interpreting section 263A(f). See Sec. 601.601(d)(2)(ii)(b) of this 
chapter.


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

    (a) Effective dates--(1) Sections 1.263A-8 through 1.263A-15 
generally apply to interest incurred in taxable years beginning on or 
after January 1, 1995. In the case of property that is inventory in the 
hands of the taxpayer, however, these sections are effective for 
taxable years beginning on or after January 1, 1995. Changes in methods 
of accounting necessary as a result of the rules in Secs. 1.263A-8 
through 1.263A-15 must be made under the terms and conditions 
prescribed by the Commissioner. Under these terms and conditions, the 
principles of Sec. 1.263A-7T(e) generally must be applied in revaluing 
inventory property.
    (2) For taxable years beginning before January 1, 1995, taxpayers 
must take reasonable positions on their federal income tax returns when 
applying section 263A(f). For purposes of this paragraph (a)(2), a 
reasonable position is a position consistent with the temporary 
regulations, revenue rulings, revenue procedures, notices, and 
announcements concerning section 263A applicable in taxable years 
beginning before January 1, 1995. See Sec. 601.601(d)(2)(ii)(b) of this 
chapter. For this purpose, Notice 88-99, 1988-2 C.B. 422, applies to 
taxable years beginning after August 17, 1988, in the case of 
inventory, and to interest incurred in taxable years beginning after 
August 17, 1988, in all other cases. Finally, under administrative 
procedures issued by the Commissioner, taxpayers may elect early 
application of Secs. 1.263A-8 through 1.263A-15 to taxable years 
beginning on or after January 1, 1994, in the case of inventory 
property, and to interest incurred in taxable years beginning on or 
after January 1, 1994, in the case of property that is not inventory in 
the hands of the taxpayer.
    (b) Transitional rule for accumulated production expenditures--(1) 
In general. Except as provided in paragraph (b)(2) of this section, 
costs incurred before the effective date of section 263A are included 
in accumulated production expenditures (within the meaning of 
Sec. 1.263A-11) with respect to noninventory property only to the 
extent those costs were required to be capitalized under section 263 
when incurred and would have been taken into account in determining the 
amount of interest required to be capitalized under former section 189 
(relating to the capitalization of real property interest and taxes) or 
pursuant to an election that was in effect under section 266 (relating 
to the election to capitalize certain carrying charges).
    (2) Property used to produce designated property. The basis of 
property acquired prior to 1987 and used to produce designated 
noninventory property after December 31, 1986, is included in 
accumulated production expenditures in accordance with Sec. 1.263A-
11(d) without regard to whether the basis would have been taken into 
account under former section 189 or section 266.
    (c) Anti-abuse rule. The interest capitalization rules contained in 
Secs. 1.263A-8 through 1.263A-15 must be applied by the taxpayer in a 
manner that is consistent with and reasonably carries out the purposes 
of section 263A(f). For example, in applying Sec. 1.263A-10, regarding 
the definition of a unit of property, taxpayers may not divide a single 
unit of property to avoid property classifying the property as 
designated property. Similarly, taxpayers may not use loans in lieu of 
advance payments, tax-exempt parties, loan restructurings at 
measurement dates, or obligations bearing an unreasonably low rate of 
interest (even if such rate equals or exceeds the applicable Federal 
rate under section 1274(d)) to avoid the purposes of section 263A(f). 
For purposes of this paragraph (c), the presence of back-to-back loans 
with different rates of interest, and other uses of related parties to 
facilitate an avoidance of interest capitalization, evidences abuse. In 
such cases, the District Director may, based upon all the facts and 
circumstances, determine the amount of interest that must be 
capitalized in a manner that is consistent with and reasonably carries 
out the purposes of section 263A(f).
    Par. 6. Section 1.266-1(a) is redesignated as Sec. 1.266-1(a)(1) 
and Sec. 1.266-1(a)(2) is added to read as follows:


Sec. 1.266-1  Taxes and carrying charges chargeable to capital account 
and treated as capital items.

    (a) * * *
    (1) * * *
    (2) See Secs. 1.263A-8 through 1.263A-15 for rules regarding the 
requirement to capitalize interest, that apply prior to the application 
of this section. After applying Secs. 1.263A-8 through 1.263A-15, a 
taxpayer may elect to capitalize interest under section 266 with 
respect to designated property within the meaning of Sec. 1.263A-8(b), 
provided a computation under any provision of the Internal Revenue Code 
is not thereby materially distorted, including computations relating to 
the source of deductions.
* * * * *
    Par. 7. Section 1.1502-13 is amended by adding a sentence to the 
end of paragraph (c)(1)(i), and by adding a sentence to the end of 
paragraph (c)(2), to read as follows:


Sec. 1.1502-13  Intercompany transactions.

* * * * *
    (c) * * *
    (1) * * * (i) * * * See, however, paragraph (c)(2) of this section 
for determining the amount of deferred gain or loss on a deferred 
intercompany transaction that involves interest capitalized under 
section 263A(f).
* * * * *
    (2) * * * Additionally, see section 263A(f) and the regulations 
thereunder to determine the amount of deferred gain or loss on a 
deferred intercompany transaction that involves interest capitalized 
under section 263A(f).
* * * * *

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

    Par. 8. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.

    Par. 9. Section 602.101(c) is amended by adding entries in 
numerical order to the table to read as follows:


Sec. 1.602.101  OMB Control numbers.

* * * * *
    (c) * * *

------------------------------------------------------------------------
                                                            Current OMB 
   CRF part or section where identified and described       control No. 
------------------------------------------------------------------------
                                                                        
                                  *****                                 
1.263A-8(b)(2)(iii).....................................       1545-1265
1.263A-9(d)(1)..........................................       1545-1265
1.263A-9(f)(1)(ii)......................................       1545-1265
1.263A-9(f)(2)(iv)......................................       1545-1265
1.263A-9(g)(2)(iv)(C)...................................       1545-1265
1.263A-9(g)(3)(iv)......................................       1545-1265
                                                                        
                                  *****                                 
------------------------------------------------------------------------


    Dated: December 13, 1994.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
    Approved:
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 94-31431 Filed 12-28-94; 8:45 am]
BILLING CODE 4830-01-P-M