[Federal Register Volume 64, Number 99 (Monday, May 24, 1999)]
[Proposed Rules]
[Pages 27936-27941]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-12898]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-113910-98]
RIN 1545-AW54


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

AGENCY: Internal Revenue Service (IRS), Treasury.

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

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SUMMARY: This document contains proposed regulations under section 263A 
that relate to accounting for costs incurred in producing property and 
acquiring property for resale. The proposed regulations are necessary 
to address specific problems in the current section 263A regulations 
and affect persons who elect to use the simplified production or resale 
methods with historic absorption ratio election. This document also 
provides notice of a public hearing on these proposed regulations.

DATES: Written and electronic comments must be received by August 23, 
1999. Outlines of topics to be discussed at the public hearing 
scheduled for September 1, 1999, at 10 a.m., must be received by August 
11, 1999.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-113910-98), room 
5226, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered Monday through 
Friday between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-
113910-98), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC. Alternatively, taxpayers may submit 
comments electronically via the Internet by selecting the ``Tax Regs'' 
option on the IRS Home Page, or by submitting comments directly to the 
IRS Internet site at http://www.irs.ustreas.gov/tax__regs/
regslist.html. The public hearing will be held in room 2615, Internal 
Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Jennifer 
Nuding, (202) 622-4970; concerning submissions of comments, the 
hearing, and/or to be placed on the building access list to attend the 
hearing, LaNita Van Dyke at (202) 622-7180 (not toll-free calls).

SUPPLEMENTARY INFORMATION:

Background

    Section 263A provides uniform rules for capitalization of certain 
expenses. Section 263A requires the capitalization of the direct, and 
an allocable portion of the indirect, costs of real or tangible 
personal property produced by a taxpayer or real and personal property 
described in section 1221(1) that is acquired by the taxpayer for 
resale. The rules under section 263A, which were added by the Tax 
Reform Act of 1986, Public Law 99-514, section 803, 100 Stat. 2085, 
2350, were designed, in part, to properly match income with related 
expenses and, thus, more accurately reflect income. They also were 
intended to make the tax system more neutral by eliminating the 
differences in capitalization rules that created distortions in the 
allocation of economic resources and the manner in which certain 
economic activity was organized. See S. Rep. No. 313, 99th Cong., 2d 
Sess. 140 (1986), 1986-3 C.B. Vol. 3 140. However, the legislative 
history provides authority to the Secretary to prescribe simplifying 
methods and assumptions where the costs and other burdens of literal 
compliance with section 263A may outweigh the benefits of the provision 
(e.g., matching and neutrality). S. Rep. No. 313, 99th Cong., 2d Sess. 
142 (1986).
    Section 263A costs are the costs that a taxpayer must capitalize 
under section 263A and equal the sum of a taxpayer's section 471 costs, 
its additional section 263A costs, and interest capitalizable under 
section 263A(f). Additional section 263A costs are the costs, other 
than interest, that were not capitalized under the taxpayer's method of 
accounting immediately prior to the effective date of section 263A, but 
that are required to be capitalized under section 263A.
    Sections 1.263A-1 through 1.263A-3 of the final regulations (T.D. 
8482) were published in the Federal Register for August 9, 1993 (58 FR 
42207) and amended by T.D. 8559 (59 FR 39958), T.D. 8584 (59 FR 67187), 
T.D. 8597 (60 FR 36671), T.D. 8728 (62 FR 42051) and T.D. 8729 (62 FR 
44542). The final regulations provide simplified methods for 
determining the additional section 263A costs properly allocable to 
eligible property on hand at the end of the taxable year, including 
ending inventories of property produced and property acquired for 
resale. The final regulations include the simplified production method 
contained in the temporary regulations issued under 263A, Sec. 1.263A-
1T(b)(5), T.D. 8131 (58 FR 151), and the simplified resale method, a 
redesignation of the modified resale method set forth in Notice 89-67, 
1989-1 C.B. 723. A taxpayer using either the simplified production 
method or the simplified resale method determines the additional 
section 263A costs properly allocable to eligible property on hand at 
the end of the taxable year by multiplying its absorption ratio by the 
section 471 costs on hand at year-end. Under both the simplified 
production method and the simplified resale method, an absorption ratio 
is calculated annually and applied to determine the additional section 
263A costs allocated to ending inventory.
    In response to requests for additional simplification, the final 
regulations provide an election to use an historic absorption ratio to 
determine additional section 263A costs allocable to eligible property 
on hand at year-end that may be used in connection with either the 
simplified production method or the simplified resale method.
    The final regulations permit a taxpayer that properly elects to use 
the historic absorption ratio to determine the additional section 263A 
costs allocable to eligible property on hand at the end of the taxable 
year by using an historic absorption ratio in lieu of an

[[Page 27937]]

actual absorption ratio, i.e., by multiplying the historic absorption 
ratio by section 471 costs on hand at year-end. The historic absorption 
ratio is based on costs capitalized by a taxpayer during its test 
period, generally the three taxable-year period immediately prior to 
the taxable year that the taxpayer elects the historic absorption 
ratio. The historic absorption ratio equals the taxpayer's additional 
section 263A costs incurred during the test period divided by the 
section 471 costs incurred by the taxpayer during the test period. 
Under the final regulations, taxpayers are required to test the 
accuracy of the historic absorption ratio every six years. If the test 
of the ratio indicates more than one-half of one percentage point 
difference (plus or minus) from the historic absorption ratio, the 
taxpayer must redetermine its historic absorption ratio using a new 
updated test period. The final regulations provide that, if elected, 
the historic absorption ratio must be used for each taxable year within 
the qualifying period. Generally, the qualifying period includes each 
of the first five taxable years beginning with the first taxable year 
after a test period (or an updated test period).

Explanation of Provisions

    This document contains proposed amendments to the Income Tax 
Regulations (26 CFR part 1) that relate to the capitalization of 
certain costs under section 263A. More specifically, this document 
contains proposed amendments with respect to the historic absorption 
ratio election that are necessary to carry out the purpose of section 
263A. The rules under section 263A were designed to properly match 
income with related expenses by requiring all of the costs relating to 
an item produced or acquired for resale to be included in the basis or 
inventoriable cost of that item. The simplified production method and 
the simplified resale method were included in the regulations to 
provide taxpayers with a simplified method for determining the 
additional section 263A costs allocable to items on hand at year end. 
The historic absorption ratio election was provided in response to 
commentators' concerns that computations under the simplified 
production method and the simplified resale method are costly and time 
consuming because taxpayers must determine absorption ratios annually, 
even though there may have been little or no change in the taxpayers' 
business operations that would cause the absorption ratios to vary from 
year to year.
    The historic absorption ratio election in the final regulations is 
intended to permit taxpayers to determine additional section 263A costs 
allocable to items on hand at year-end without calculating actual 
absorption ratios while still capitalizing the costs properly allocable 
to property produced or acquired for resale. The historic absorption 
ratio was selected in lieu of an industry-based ratio because the IRS 
and Treasury Department believed that a ratio based on taxpayer 
specific historical data would more reasonably approximate the 
taxpayer's annual absorption ratio than an industry-based ratio.
    The IRS and Treasury Department have become aware that the historic 
absorption ratio may become materially inaccurate generally as the 
result of a significant change in a taxpayer's circumstances during the 
qualifying period, thus resulting in a failure to allocate the proper 
amount of additional section 263A costs to items on hand at year-end. 
Although the regulations provide that a taxpayer must test its historic 
absorption ratio every six years, a significant deviation from the 
taxpayer's actual absorption ratio could result in a substantial 
mismatching of the taxpayer's income and related expenses during the 
qualifying period.
    The IRS and Treasury Department considered many alternate 
approaches to revising the historic absorption ratio regulations in 
order to prevent a substantial mismatching of income and related 
expenses. Among the approaches considered and rejected were the 
following: (1) Eliminate the historic absorption ratio election 
entirely; (2) limit use of the historic absorption ratio election to 
small taxpayers; (3) require taxpayers to retest their historic 
absorption ratio more frequently, e.g., every three years; and (4) 
provide a general anti-abuse rule.
    These proposed regulations provide for early termination of the 
qualifying period if the taxpayer's historic absorption ratio is 
materially inaccurate. In such a case, the taxpayer must calculate a 
new historic absorption ratio beginning with the year in which the 
taxpayer's historic absorption ratio became materially inaccurate.
    Generally, a taxpayer's historic absorption ratio may become 
materially inaccurate when the taxpayer experiences a significant 
change in the taxpayer's normal business operations and that change has 
an effect on the taxpayer's section 263A absorption ratio. For example, 
the following changes may cause a taxpayer's historic absorption ratio 
to become materially inaccurate: a significant change in the taxpayer's 
manufacturing process, e.g. implementation of a new inventory 
management system; a significant change in the taxpayer's product 
offering; a significant addition or retirement of equipment used for 
manufacturing; a significant change in the taxpayer's components of 
cost, e.g., a manufacturing operation that becomes significantly more 
or less labor intensive; a significant change in the taxpayer's 
overhead costs, e.g. a new plant, building or building addition; and a 
significant change in the taxpayer's trade or business, e.g., the sale 
or acquisition of a division.
    The proposed regulations establish a high threshold for when the 
historic absorption ratio will be regarded as materially inaccurate. 
The regulations provide a definition of materially inaccurate that 
incorporates both a percentage test and a specific dollar amount test. 
The regulations provide that the historic absorption ratio is 
materially inaccurate if: (1) the taxpayer's actual absorption ratio 
deviates by more than 50% and by more than one-half of one percentage 
point from the taxpayer's historic absorption ratio; and (2) the amount 
of additional section 263A costs capitalizable to items on hand at 
year-end using the actual absorption ratio deviates by more than 
$100,000 from the amount of additional section 263A costs capitalizable 
to items on hand at year-end using the historic absorption ratio. This 
high threshold is provided so that annual actual absorption ratio 
computations will be unnecessary in the overwhelming majority of 
situations. For example, the placement in service of a significant 
amount of property may have a significant effect on a taxpayer's actual 
absorption ratio. However, it may not be necessary for a taxpayer to 
compute its actual absorption ratio for a year that the taxpayer placed 
property in service if, based on the taxpayer's knowledge of the 
difference between its tax depreciation and book depreciation, and its 
inventory turnover, the taxpayer knows that it would be impossible for 
the amount of additional section 263A costs allocable to items on hand 
at year-end to increase by $100,000 if the taxpayer used the simplified 
production method without the historic absorption ratio election. 
Therefore, the taxpayer would not need to calculate an actual 
absorption ratio for that year.

Proposed Effective Date

    The provisions of these regulations are proposed to be effective 
for taxable years beginning after May 24, 1999.

[[Page 27938]]

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in EO 12866. Therefore, 
a regulatory assessment is not required.
    It also has been determined that section 553(b) of the 
Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to 
these regulations, and because the regulations do not impose a 
collection of information on small entities, the Regulatory Flexibility 
Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of 
the Internal Revenue Code, this notice of proposed rulemaking will be 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) and electronic comments that are submitted timely 
to the IRS. The IRS and Treasury Department request comments on the 
clarity of the proposed rules and how they can be made easier to 
understand. All comments will be available for public inspection and 
copying.
    A public hearing has been scheduled for Wednesday, September 1, 
1999, in room 2615, Internal Revenue Building, 1111 Constitution 
Avenue, NW., Washington, DC. Due to building security procedures, 
visitors must enter at the 10th Street entrance, located between 
Constitution and Pennsylvania Avenues, NW. In addition, all visitors 
must present photo identification to enter the building. Because of 
access restrictions, visitors will not be admitted beyond the immediate 
entrance area more than 15 minutes before the hearing starts. For 
information about having your name placed on the building access list 
to attend the hearing, see the FOR FURTHER INFORMATION CONTACT section 
of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons who wish to present oral comments at the hearing must 
submit written or electronic comments by August 23, 1999 and submit an 
outline of the topics to be discussed and the time to be devoted to 
each topic (a signed original and eight (8) copies) by August 11, 1999.
    A period of 10 minutes will be allocated to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.
    Drafting Information: The principal author of these regulations is 
Jennifer Nuding of the Office of Assistant Chief Counsel (Income Tax 
and Accounting). However, other personnel from the IRS and Treasury 
Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

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

PART 1--INCOME TAXES

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

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

    Par. 2. Section 1.263A-2 is amended as follows:
    1. Paragraphs (b)(4)(ii)(C)(1) and (2) are revised;
    2. New paragraphs (b)(4)(ii)(C)(3) and (4) are added;
    3. Paragraph (b)(4)(vi) is amended by:
    a. Revising the paragraph heading and introductory text;
    b. Redesignating the Example as Example 1;
    c. Adding new Example 2 and Example 3.
    The revisions and additions read as follows:


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

* * * * *
    (b) * * *
    (4) * * *
    (ii) * * *
    (C) Qualifying period--(1) In general. A qualifying period 
generally includes each of the first five taxable years beginning with 
the first taxable year after a test period (or an updated test period). 
However, a qualifying period may be extended under the provisions of 
paragraph (b)(4)(ii)(C)(2) of this section or may terminate early under 
the provisions of paragraph (b)(4)(ii)(C)(3) of this section.
    (2) Extension of qualifying period. In the first taxable year 
following the close of each qualifying period, (e.g., the sixth taxable 
year following the test period), the taxpayer must compute the actual 
absorption ratio under the simplified production method. If the actual 
absorption ratio computed for this taxable year (the recomputation 
year) is within one-half of one percentage point (plus or minus) of the 
historic absorption ratio used in determining capitalizable costs for 
the qualifying period (e.g., the previous five taxable years), the 
qualifying period is extended to include the recomputation year and the 
following five taxable years (or a shorter period if the qualifying 
period is terminated early under the provisions of paragraph 
(b)(4)(ii)(C)(3) of this section), and the taxpayer must continue to 
use the historic absorption ratio throughout the extended qualifying 
period. If, however, the actual absorption ratio computed for the 
recomputation year is not within one-half of one percentage point (plus 
or minus) of the historic absorption ratio, the taxpayer must use 
actual absorption ratios beginning with the recomputation year under 
the simplified production method and throughout the updated test 
period. The taxpayer must resume using the historic absorption ratio 
(determined with reference to the updated test period) in the third 
taxable year following the recomputation year.
    (3) Earlier termination of the qualifying period. For taxable years 
beginning after May 24, 1999, a qualifying period closes immediately 
prior to a taxable year in which the taxpayer's historic absorption 
ratio becomes materially inaccurate (early recomputation year). If the 
taxpayer's historic absorption ratio is materially inaccurate, as 
defined in paragraph (b)(4)(ii)(C)(4) of this section, the taxpayer 
must use its actual absorption ratios computed using the simplified 
production method beginning with the early recomputation year and 
throughout the updated test period. The taxpayer must resume using the 
historic absorption ratio (determined with reference to the updated 
test period) in the third taxable year following the early 
recomputation year.
    (4) Materially inaccurate. For purposes of this paragraph (b)(4), a 
historic absorption ratio becomes materially inaccurate in a taxable 
year that--
    (i) The taxpayer's actual absorption ratio computed using the 
simplified production method deviates by more than 50 percent and by 
more than one-half of one percentage point from the taxpayer's historic 
absorption ratio for that year; and
    (ii) The amount of additional section 263A costs capitalizable to 
eligible property remaining on hand at the close of that year under the 
simplified production method (using the taxpayer's actual absorption 
ratio) deviates by more than $100,000 from the amount of

[[Page 27939]]

additional section 263A costs capitalizable to that property under the 
simplified production method with historic absorption ratio election 
for that year.
* * * * *
    (vi) Examples. The provisions of this paragraph (b)(4) are 
illustrated by the following examples:

    Example 1. * * *
    Example 2. (i) Taxpayer K uses the FIFO method of accounting for 
inventories and properly elects to use the historic absorption ratio 
with the simplified production method for 1998. K identifies the 
following costs incurred during the test period:
1995:
    Add'l section 263A costs--$3,500,000 Section 471 costs--
$75,000,000
1996:
    Add'l section 263A costs--$4,000,000 Section 471 costs--
$80,000,000
1997:
    Add'l section 263A costs--$4,500,000 Section 471 costs--
$85,000,000
    (ii) Therefore, K computes a 5% historic absorption ratio as 
follows:
[GRAPHIC] [TIFF OMITTED] TP24MY99.000

    (iii) In 1998, K incurs $90,000,000 of section 471 costs of 
which $15,000,000 remain in inventory at the end of the year. In 
addition, K places $50,000,000 of plant and equipment into service. 
K's book depreciation on the new plant and equipment is $5,000,000, 
while K's tax depreciation on the new plant and equipment is 
$10,000,000. K's book depreciation is a section 471 cost as 
described in Sec. 1.263A-1(d)(2) and the excess of K's tax 
depreciation over K's book depreciation, $5,000,000, is an 
additional section 263A cost. K also has $4,500,000 in other 
additional section 263A costs.
    (iv) K must determine whether K's historic absorption ratio is 
materially inaccurate in 1998. Under the simplified production 
method without the historic absorption ratio election, K determines 
its actual absorption ratio for 1998 as follows:
[GRAPHIC] [TIFF OMITTED] TP24MY99.001

    (v) The difference between K's actual absorption ratio (10%) 
under the simplified production method for 1998 and K's historic 
absorption ratio (5%) is 5%, which is greater than 50 percent of K's 
historic absorption ratio for that year (5% x 50% = 2.5%). Under the 
simplified production method without the historic absorption ratio 
election, K determines the additional section 263A costs allocable 
to its ending inventory by multiplying its actual absorption ratio 
(10%) by the section 471 costs remaining in its ending inventory as 
follows:
    Add'l section 263A costs = 10%  x  $15,000,000 = $1,500,000
    (vi) Under the simplified production method using the historic 
absorption ratio, K determines the additional section 263A costs 
allocable to its ending inventory by multiplying its historic 
absorption ratio (5%) by the section 471 costs remaining in its 
ending inventory as follows:
    Add'l section 263A costs = 5%  x  $15,000,000 = $750,000
    (vii) The difference between the amount of additional section 
263A costs allocable to eligible property remaining on hand at the 
close of 1998 under the simplified production method using the 
taxpayer's actual absorption ratio and the amount of additional 
section 263A costs allocable to that property under the simplified 
production method with historic absorption ratio election 
($1,500,000-$750,000 = $750,000) exceeds $100,000. Accordingly, K's 
historic absorption ratio is materially inaccurate for 1998.
    (viii) Since K's historic absorption ratio is materially 
inaccurate in 1998, K's qualifying period closes immediately prior 
to the beginning of K's 1998 taxable year. Therefore, K must update 
its test period beginning in 1998. K must use actual absorption 
ratios under the simplified production method beginning in 1998 and 
throughout the updated test period (1999 and 2000). K must resume 
using the historic absorption ratio (determined with reference to 
the updated test period) in 2001, the third taxable year following 
1998.
    Example 3. (i) Taxpayer L properly elects to use the historic 
absorption ratio with the simplified production method for 1999. L 
computes a 10% historic absorption ratio. On average, L's inventory 
turns over approximately fifteen times a year.
    (ii) In 1999, L incurs $8,000,000 of section 471 costs of which 
$500,000 remain in inventory at the end of the year. In addition, L 
places $5,000,000 of plant and equipment into service. The 
difference between L's tax depreciation on the new plant and 
equipment and L's book depreciation on that plant and equipment for 
1999 is $500,000, which is an additional section 263A cost. There 
were no other changes in L's additional 263A costs.
    (iii) L can determine, without calculating an actual absorption 
ratio, that its historic absorption ratio is not materially 
inaccurate for 1999. The difference between the amount of additional 
section 263A costs allocated to its ending inventory using its 
actual absorption ratio and the amount of additional section 263A 
costs allocated to its ending inventory using its historic 
absorption ratio will not exceed $100,000 and, therefore, L does not 
fall within the specific dollar amount test of paragraph 
(b)(4)(ii)(C)(4)(ii) of this section. Although L's additional 
section 263A costs increased by over $100,000 in 1999 (they 
increased by $500,000) as a result of placing the plant and 
equipment into service, only a portion of that amount will be 
allocated to ending inventory. L's inventory turns over 
approximately fifteen times a year. Of the $500,000 of additional 
section 263A costs incurred as the result of placing the plant and 
equipment into service in 1999, only about $33,000 ($500,000 
 15) will be allocated to ending inventory. Since $33,000 is 
well below the $100,000 threshold, L can determine without 
calculating an actual absorption ratio for 1999 that its historic 
absorption ratio is not materially inaccurate. Since L's historic 
absorption ratio is not materially inaccurate in 1999, L's 
qualifying period does not terminate early.
* * * * *
    Par. 3. Section 1.263A-3 is amended as follows:
    1. Paragraphs (d)(4)(ii)(C)(1) and (2) are revised;
    2. New paragraphs (d)(4)(ii)(C)(3) and (4) are added;
    3. Paragraph (d)(4)(vi) is amended by:
    a. Revising the paragraph heading and introductory text;
    b. Redesignating the Example as Example 1;
    c. Adding new Example 2.
    The revisions and additions read as follows:


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

* * * * *
    (d) * * *
    (4) * * *
    (ii) * * *
    (C) Qualifying period--(1) In general. A qualifying period 
generally includes each of the first five taxable years beginning with 
the first taxable year after a test period (or an updated test period). 
However, a qualifying period may be extended under the provisions of 
paragraph (d)(4)(ii)(C)(2) of this section or may terminate early under 
the provisions of paragraph (d)(4)(ii)(C)(3) of this section.

[[Page 27940]]

    (2) Extension of qualifying period. In the first taxable year 
following the close of each qualifying period, (e.g., the sixth taxable 
year following the test period), the taxpayer must compute the actual 
combined absorption ratio under the simplified resale method. If the 
actual combined absorption ratio computed for this taxable year (the 
recomputation year) is within one-half of one percentage point (plus or 
minus) of the historic absorption ratio used in determining 
capitalizable costs for the qualifying period (e.g., the previous five 
taxable years), the qualifying period is extended to include the 
recomputation year and the following five taxable years (or a shorter 
period if the qualifying period is terminated early under the 
provisions of paragraph (d)(4)(ii)(C)(3) of this section), and the 
taxpayer must continue to use the historic absorption ratio throughout 
the extended qualifying period. If, however, the actual combined 
absorption ratio computed for the recomputation year is not within one-
half of one percentage point (plus or minus) of the historic absorption 
ratio, the taxpayer must use actual combined absorption ratios 
beginning with the recomputation year under the simplified resale 
method and throughout the updated test period. The taxpayer must resume 
using the historic absorption ratio (determined with reference to the 
updated test period) in the third taxable year following the 
recomputation year.
    (3) Earlier termination of the qualifying period. For taxable years 
beginning after May 24, 1999, a qualifying period closes immediately 
prior to a taxable year in which the taxpayer's historic absorption 
ratio becomes materially inaccurate (early recomputation year). If the 
taxpayer's historic absorption ratio is materially inaccurate, as 
defined in paragraph (d)(4)(ii)(C)(4) of this section, the taxpayer 
must use its actual combined absorption ratios computed using the 
simplified resale method beginning with the early recomputation year 
and throughout the updated test period. The taxpayer must resume using 
the historic absorption ratio (determined with reference to the updated 
test period) in the third taxable year following the early 
recomputation year.
    (4) Materially inaccurate. For purposes of this paragraph (d)(4), a 
historic absorption ratio becomes materially inaccurate in a taxable 
year that--
    (i) The taxpayer's actual combined absorption ratio computed using 
the simplified resale method deviates by more than 50 percent and by 
more than one-half of one percentage point from the taxpayer's historic 
absorption ratio for that year; and
    (ii) The amount of additional section 263A costs capitalizable to 
eligible property remaining on hand at the close of that year under the 
simplified resale method (using the taxpayer's actual combined 
absorption ratio) deviates by more than $100,000 from the amount of 
additional section 263A costs capitalizable to that property under the 
simplified resale method with historic absorption ratio election for 
that year.
* * * * *
    (vi) Examples. The provisions of this paragraph (d)(4) are 
illustrated by the following examples:
    Example 1. * * *
    Example 2. (i) Taxpayer W operates a mail-order retail business 
and uses the FIFO method of accounting for inventories. In 1996, 
1997 and 1998, W used the simplified resale method without the 
historic absorption ratio election with the variation permitted in 
paragraph (d)(3)(iii)(A) of this section, exclusion of beginning 
inventories from the denominator in the storage and handling costs 
absorption ratio formula. Taxpayer W elects to use the historic 
absorption ratio with the simplified resale method for 1999. W 
identifies the following costs incurred during the test period:
1996:
    Add'l section 263A costs--$2,000,000 Section 471 costs--
$45,000,000
1997:
    Add'l section 263A costs--$2,500,000 Section 471 costs--
$50,000,000
1998:
    Add'l section 263A costs--$3,000,000 Section 471 costs--
$55,000,000
    (ii) Therefore, W computes a 5% historic absorption ratio as 
follows:
[GRAPHIC] [TIFF OMITTED] TP24MY99.002

    (iii) In 1999, W decides to automate part of its repackaging 
activities. Accordingly, W places new repackaging equipment into 
service. The repackaging equipment has a basis of $15,000,000 for 
tax purposes. W's tax depreciation on the new equipment for 1999 is 
$3,000,000. This depreciation allowance is an additional section 
263A cost and is a handling cost as defined in paragraph (c)(4) of 
this section. As a result of the new equipment, W's direct labor 
costs with respect to its repackaging activities decrease by 
$500,000 during 1999. In 1999, W incurs $60,000,000 of section 471 
costs, of which $6,000,000 remain on hand at the end of the year. W 
identifies $6,000,000 of storage and handling costs, including W's 
tax depreciation on the new equipment and taking into account the 
reduction in direct labor costs, and $450,000 of purchasing costs 
incurred in 1999.
    (iv) W must determine whether W's historic absorption ratio is 
materially inaccurate in 1999. In order to do so, W calculates W's 
actual combined absorption ratio for 1999 as follows:
[GRAPHIC] [TIFF OMITTED] TP24MY99.003

    Combined absorption ratio = 10% + 0.75% = 10.75%
    (v) The difference between W's actual combined absorption ratio 
(10.75%) under the simplified resale method for 1999 and W's 
historic absorption ratio (5%) is 5.75%, which is greater than 50 
percent of W's historic absorption ratio for that year (5%  x  50% = 
2.5%). Under the simplified resale method without the historic 
absorption ratio election, W determines the additional section 263A 
costs allocable to its ending inventory by multiplying its actual 
combined absorption ratio (10.75%) by the section 471 costs 
remaining in its ending inventory as follows:
    Add'l section 263A costs = 10.75%  x  $6,000,000 = $645,000
    (vi) Under the simplified resale method using the historic 
absorption ratio, W determines the additional section 263A costs 
allocable to its ending inventory by multiplying its historic 
absorption ratio (5%) by the section 471 costs remaining in its 
ending inventory as follows:
    Add'l section 263A costs = 5%  x  $6,000,000 = $300,000
    (vii) The difference between the amount of additional section 
263A costs allocable to eligible property remaining on hand at the 
close of 1999 under the simplified resale

[[Page 27941]]

method using the taxpayer's actual combined absorption ratio and the 
amount of additional section 263A costs allocable to that property 
under the simplified resale method with historic absorption ratio 
election ($645,000-$300,000 = $345,000) exceeds $100,000. 
Accordingly, W's historic absorption ratio is materially inaccurate 
for 1999.
    (viii) Since W's historic absorption ratio was materially 
inaccurate in 1999, W's qualifying period closes immediately prior 
to the beginning of W's 1999 taxable year. Therefore, W must update 
its test period beginning in 1999. W must use actual combined 
absorption ratios under the simplified resale method beginning in 
1999 and throughout the updated test period (2000 and 2001). W must 
resume using the historic absorption ratio (determined with 
reference to the updated test period) in 2002, the third taxable 
year following 1999.
* * * * *
Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 99-12898 Filed 5-21-99; 8:45 am]
BILLING CODE 4830-01-U