[Federal Register Volume 66, Number 8 (Thursday, January 11, 2001)]
[Rules and Regulations]
[Pages 2219-2241]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-6]



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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8929]
RIN 1545-AQ30


Accounting for Long-Term Contracts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations describing how income 
from a long-term contract must be accounted for under section 460 of 
the Internal Revenue Code, which was enacted by the Tax Reform Act of 
1986. A taxpayer manufacturing or constructing property under a long-
term contract will be affected by these regulations.

DATES: Effective Date: These regulations are effective on January 11, 
2001.
    Applicability Date: These regulations apply to any contract entered 
into on or after January 11, 2001.

FOR FURTHER INFORMATION CONTACT: Leo F. Nolan II or John M. Aramburu of 
the Office of Associate Chief Counsel (Income Tax and Accounting) at 
(202) 622-4960 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in these final regulations 
has been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 
3507(d)) under control number 1545-1650. Responses to this collection 
of information are mandatory.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    The estimated annual burden per respondent and/or recordkeeper is 
15 minutes.
    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, W:CAR:MP:FP:S:O, 
Washington, DC 20224, and to the Office of Management and Budget, Attn: 
Desk Officer for the Department of the Treasury, Office of Information 
and Regulatory Affairs, Washington, DC 20503.
    Books or records relating to a collection of information must be 
retained as long as their contents might become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    Section 460, which was enacted by section 804 of the Tax Reform Act 
of 1986, Public Law 99-514 (100 Stat. 2085, 2358-2361), generally 
requires a taxpayer to determine the taxable income from a long-term 
contract using the percentage-of-completion method. Section 460 was 
amended by section 10203 of the Omnibus Budget Reconciliation Act of 
1987, Public Law 100-203 (101 Stat. 1330, 1330-394); by sections 
1008(c) and 5041 of the Technical and Miscellaneous Revenue Act of 
1988, Public Law 100-647 (102 Stat. 3342, 3438-3439 and 3673-3676); by 
sections 7621 and 7811(e) of the Omnibus Budget Reconciliation Act of 
1989, Public Law 101-239 (103 Stat. 2106, 2375-2377 and 2408-2409); by 
section 11812 of the Omnibus Budget Reconciliation Act of 1990, Public 
Law 101-508 (104 Stat. 1388, 1388-534 to 1388-536); by sections 
1702(h)(15) and 1704(t)(28) of the Small Business Job Protection Act of 
1996, Public Law 104-188 (110 Stat. 1755, 1874, 1888); and by section 
1211 of the Taxpayer Relief Act of 1997, Public Law 105-34 (111 Stat. 
788, 998-1000).
    Section 460(h) directs the Secretary to prescribe regulations to 
the extent necessary or appropriate to carry out the purpose of section 
460, including regulations to prevent a taxpayer from avoiding section 
460 by using related parties, pass-through entities, intermediaries, 
options, and other similar arrangements.
    On May 5, 1999, the IRS and Treasury Department published a notice 
of proposed rulemaking (64 FR 24096 [REG-208156-91, 1999-22 I.R.B. 11]) 
relating to section 460. Comments responding to the notice were 
received, and a public hearing was scheduled for September 14, 1999.
    The IRS and Treasury Department received eleven comment letters 
concerning the notice of proposed rulemaking. After considering the 
comments contained in these letters, the IRS and Treasury Department 
adopt the proposed regulations as revised by this Treasury decision. 
The comments and revisions are discussed below.

Explanation of Provisions

1. Overview

    Section 460 generally requires the income from a long-term contract 
to be determined using the percentage-of-completion method based on a 
cost-to-cost comparison (PCM). However, the income from exempt 
construction contracts still may be determined using the completed-
contract method (CCM), the exempt-contract percentage-of-completion 
method (EPCM), or any other permissible method. Contracts that are not 
long-term contracts must be accounted for using a permissible method of 
accounting other than a long-term contract method (i.e., a method other 
than the PCM, the CCM, or the EPCM). See section 446 and the 
regulations thereunder.
    One commentator suggested that the exceptions to the mandatory use 
of the PCM included in the proposed regulations be expanded to include 
``any portion of the long-term manufacturing contract for which no 
payment for the manufacture of the subject matter of the contract is 
required to be made before the manufacture of the item is completed.'' 
The exceptions contained in the proposed regulations were specifically 
provided by the statute and the statute does not include the suggestion 
made by the commentator. Thus, the IRS and Treasury Department did not 
adopt this suggestion.

2. Definition of Long-Term Contract

    Under section 460(f), ``long-term contract'' generally means any 
contract for the building, installation, construction (construction), 
or the manufacture, of property if the contract is not completed within 
the taxable year the taxpayer enters into the contract (contracting 
year). However, a manufacturing contract is not a long-term contract 
unless it involves the manufacture of (1) a unique item of a type that 
is not normally included in the finished goods inventory of the 
taxpayer or (2) an item normally requiring more than 12 calendar months 
to complete, regardless of the duration of the contract.
    Continuing the policy established in Notice 89-15 (1989-1 C.B. 
634), the proposed regulations provide that it is not relevant whether 
the customer has title to, control over, or risk of loss with respect 
to the property. One commentator suggested that the final regulations 
should not retain the rule that requires a contractor to ignore title 
and risk-of-loss issues relative to the applicability of section 460 
because a contractor has little freedom to restructure a contract to 
``construct'' into a contract to ``sell.'' The IRS and Treasury 
Department did not adopt this suggestion because we believe that a 
contract's classification should be based on the performance required 
of the taxpayer under the contract regardless

[[Page 2220]]

of whether that contract otherwise would be classified as a sales 
contract or a construction or manufacturing contract. Moreover, the IRS 
and Treasury Department continue to believe that the rule in the 
proposed regulations is necessary to prevent a taxpayer from 
circumventing section 460 by structuring a construction contract to 
resemble a sales contract without changing the taxpayer's obligations 
under the contract. Another commentator asked whether a contract is 
subject to section 460 if it requires the taxpayer to manufacture or 
construct property in order to fulfill its contractual obligation but 
the property is never delivered to the customer (e.g., a research 
contract for test results). Again, the IRS and Treasury Department 
believe that a contract's classification should depend upon the 
performance required of the taxpayer under the contract. Thus, the 
final regulations clarify that it is irrelevant whether title in the 
property manufactured or constructed under the contract is delivered to 
the customer.
    The proposed regulations provide that a contract is not a 
construction contract if it requires the taxpayer to provide land to 
the customer and the estimated total allocable contract costs 
attributable to the taxpayer's construction activities are less than 10 
percent of the contract's total contract price. One commentator asked 
for clarification concerning whether the estimated total allocable 
contract costs attributable to the taxpayer's construction activities 
includes the cost of the land provided under the contract. The final 
regulations clarify that the cost of this land is not an allocable 
contract cost when the taxpayer determines whether the cost of its 
construction activities is less than 10 percent of the contract's total 
contract price.

3. Date Taxpayer Completes a Long-Term Contract

    The proposed regulations provide that a long-term contract is 
completed in the earlier taxable year (completion year) that: (1) The 
customer uses the subject matter of the contract (other than for 
testing) and at least 95 percent of the total allocable contract costs 
attributable to the subject matter have been incurred by the taxpayer; 
or (2) the subject matter of the contract is finally completed and 
accepted. To the extent that the ``customer-use'' rule requires a 
taxpayer to treat a contract as completed before final completion and 
acceptance have occurred, the proposed regulations explicitly adopt a 
rule different from that considered in Ball, Ball and Brosamer, Inc. v. 
Commissioner, 964 F.2d 890 (9th Cir. 1992), aff'g T.C. Memo. 1990-454.
    Some commentators argued against having a rule that will declare a 
contract completed earlier than under the finally-completed-and-
accepted standard illustrated in Ball. Some commentators also argued 
that the customer-use rule is confusing to subcontractors because it is 
unclear whether a subcontractor's ``customer'' is the general, or 
``prime,'' contractor or the ultimate owner of the property. On the 
other hand, one commentator asked for a bright-line standard for 
completion and suggested, among other possibilities, that completion 
occur when 95 percent of the estimated costs have been incurred.
    The IRS and Treasury Department continue to believe that a contract 
is complete for all practical purposes when the customer uses the 
subject matter of that contract and the taxpayer has only five percent 
or less of the total allocable contract costs remaining to be incurred. 
Delaying a contract's completion beyond this point, as the Tax Court 
permitted in Ball, does not reflect the substance of the transaction 
and could encourage the use of formalities to delay a contract's 
completion unreasonably. Thus, the final regulations do not 
substantively change the customer-use rule contained in the proposed 
regulations. However, the final regulations clarify that a 
subcontractor's customer is the general contractor.
    Several commentators expressed concern that the customer-use rule 
contained in the proposed regulations will create additional 
administrative burdens for taxpayers using the PCM because they often 
will have to apply the look-back method two times, first upon customer 
use and again upon final completion and acceptance. Though the IRS and 
Treasury Department believe that the customer-use rule results in an 
appropriate determination of completion, we understand these concerns. 
Thus, to simplify a taxpayer's reporting requirements under the look-
back method, the IRS and Treasury Department have modified the look-
back regulations to require a taxpayer to delay the first application 
of the look-back method until the taxable year in which a long-term 
contract is finally completed and accepted.

4. Severing and Aggregating Contracts

    The proposed regulations allow the Commissioner, and generally 
require a taxpayer, to sever and aggregate contracts when necessary to 
clearly reflect income. The proposed regulations provide the following 
criteria for determining whether severance or aggregation is required: 
Independent versus interdependent pricing, separate delivery or 
acceptance, and the reasonable businessperson standard. However, under 
the proposed regulations, a taxpayer may not sever a contract subject 
to the PCM. In addition, the proposed regulations require a taxpayer to 
notify the Commissioner when severing a long-term contract not 
accounted for using the PCM and provide agreement-specific information, 
including the criteria for severing or aggregating the agreement.
    Some commentators criticized the ``no severance'' rule for long-
term contracts subject to the PCM. The ``no severance'' rule is 
provided in the proposed regulations because the IRS and Treasury 
Department believe that in most cases, a taxpayer's use of the PCM and 
look-back method will clearly reflect the taxpayer's income from a 
long-term contract. To date, the only identified reason to allow 
severance of a contract subject to the PCM related to the application 
of the 10-percent method as shown in Sec. 1.460-1(j) Example 8 of the 
proposed income tax regulations. Conversely, the IRS and Treasury 
Department believe that permitting a taxpayer to sever a contract 
subject to the PCM could allow the taxpayer to manipulate taxable 
income (e.g., by severing to create a loss contract and accelerate the 
loss) or to avoid the application of section 460 (e.g., by 
``completing'' the contract during the contracting year). Nonetheless, 
the IRS and Treasury Department agree with the commentators' concerns 
that to the extent severance is necessary to clearly reflect income 
from a long-term contract (e.g., due to the application of the 10-
percent method), it should be permitted. Accordingly, the final 
regulations allow a taxpayer to sever a long-term contract if necessary 
to clearly reflect income, but only if the taxpayer has obtained the 
Commissioner's prior written consent.
    Some commentators criticized the notification requirement for 
severed and aggregated contracts as being unduly burdensome. The IRS 
and Treasury Department continue to believe that notification will help 
taxpayers and the IRS consistently apply the severing and aggregating 
rules. In recognition of the potential burden associated with the 
proposed notification requirement, however, the final regulations 
simplify the notification by only requiring that a taxpayer inform the 
IRS when it has severed or aggregated agreements. Thus, the taxpayer is 
no longer required to provide agreement-specific information.
    One commentator suggested that the reasonable businessperson 
standard be

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eliminated because it is merely a subset of independent pricing and 
interdependent pricing (the pricing standards), which should be the 
primary criteria for determining whether long-term contracts must be 
severed or aggregated to clearly reflect income. The IRS and Treasury 
Department agree that the pricing standards and the reasonable 
businessperson standard overlap, but believe that the pricing standard 
is a subset of the reasonable businessperson standard. Besides 
requiring an analysis of pricing, the reasonable businessperson 
standard requires an analysis of all the facts and circumstances of the 
business arrangement between the taxpayer and the customer. Thus, 
because the absence of the reasonable businessperson standard might 
change the decision to sever or aggregate in some cases, the final 
regulations retain this criterion and clarify its distinction from the 
pricing standards.

5. Hybrid Contracts

    Under the proposed regulations, a taxpayer generally must classify 
a contract that requires the taxpayer to manufacture personal property 
and to construct real property (hybrid contract) as separate 
manufacturing and construction contracts. If at least 95 percent of the 
estimated allocable contract costs are reasonably allocable to 
manufacturing (or construction) activities, the taxpayer may classify 
the contract as a manufacturing (or construction) contract.
    One commentator suggested that the final regulations allow a 
taxpayer to elect to use the PCM to account for a hybrid contract 
instead of requiring the taxpayer to account for both parts separately. 
The IRS and Treasury Department agree with the commentator's request 
for simplification. Accordingly, the final regulations allow a taxpayer 
to elect, on a contract-by-contract basis, to classify a hybrid 
contract as a long-term manufacturing contract subject to the PCM. In 
addition, because this election effectively supersedes the 95-percent 
election that would have applied to hybrid contracts that are primarily 
manufacturing contracts, the final regulations retain the 95-percent 
election as a second election that applies only to hybrid contracts 
that are primarily construction contracts.

6. Contracts of Related Parties

    The proposed regulations provide that if a related party and its 
customer enter into a long-term contract subject to the PCM, and a 
taxpayer performs any activity that is incident to or necessary for the 
related party's long-term contract, the taxpayer must account for the 
gross receipts and costs attributable to the activity using the PCM. 
However, the proposed regulations contain an inventory exception for 
components and subassemblies produced by the taxpayer if the taxpayer 
regularly carries these items in its finished goods inventories and 80 
percent or more of the gross receipts from the sale of these items 
typically comes from unrelated parties.
    One commentator suggested that the percentage threshold be lowered 
from 80 percent to 50 percent and that the exception not be limited to 
items regularly carried in the taxpayer's finished goods inventories. 
The IRS and Treasury Department included the related party rule, 
originally promulgated in Notice 89-15, in the proposed regulations to 
prevent taxpayers from establishing special-purpose subsidiaries to 
avoid the application of section 460. However, in recognition that a 
related party that sells most units of a manufactured item to unrelated 
parties was not established for the purpose of avoiding section 460, 
the IRS and Treasury Department added the inventory exception to the 
proposed regulations to reduce the related party's accounting burden. 
The IRS and Treasury Department agree, however, that the inventory 
exception is too narrow. Accordingly, the final regulations lower the 
percentage threshold from ``80 percent or more'' to ``more than 50 
percent'' and eliminate the requirement that the components or 
subassemblies be carried in finished goods inventories.

7. Unique Items

    Section 460 applies if a taxpayer manufactures a unique item of a 
type that is not normally included in the finished goods inventory of 
the taxpayer and if the contract is not completed by the close of the 
contracting year. The proposed regulations provide that ``unique'' 
means specifically designed for the needs of a customer. In addition, 
the proposed regulations contain three safe harbors concerning 
contracts to manufacture unique items. First, an item is not unique if 
the taxpayer normally completes the item within 90 days. Second, an 
item is not unique if the total allocable contract costs attributable 
to customizing activities that are incident to or necessary for the 
production of the item do not exceed 5 percent of the estimated total 
costs allocable to the item. Third, a unique item ceases to be unique 
no later than when the taxpayer normally includes similar items in its 
finished goods inventory. For an item that does not satisfy one of 
these three safe harbors, the determination of whether the item is 
unique is based on the facts and circumstances.
    Some commentators suggested that the final regulations contain 
either a 140-day or a 180-day safe harbor instead of the 90-day safe 
harbor. The IRS and Treasury Department did not adopt these suggestions 
because we believe that a 90-day safe harbor appropriately limits the 
meaning of ``unique'' in most cases. However, the IRS and Treasury 
Department have modified the 90-day safe harbor to clarify that in the 
case of a contract to manufacture multiple units of the same item, the 
90-day safe harbor applies only if each unit normally is completed 
within 90 days.
    Some commentators suggested that the final regulations contain 
either a 10-percent, 15-percent, or 20-percent safe harbor instead of 
the 5-percent safe harbor. In particular, these commentators stated 
that a 5-percent safe harbor will not alleviate any controversy between 
taxpayers and revenue agents because revenue agents generally do not 
raise the issue of unique items if the taxpayer's customizing costs do 
not exceed 5 percent. The IRS and Treasury Department agree that it is 
reasonable to assume that an item is not unique if the taxpayer's 
customizing costs do not exceed 10 percent. Thus, the customization 
safe harbor in the final regulations has been increased to 10 percent.
    One commentator suggested that the cost of a taxpayer's customizing 
activities should not include the cost of any customized equipment 
purchased by a taxpayer from an unrelated party under a ``special 
accommodation'' arrangement with the customer that requires the 
taxpayer to acquire and install that customized equipment. The IRS and 
Treasury Department did not adopt this suggestion because such a 
special accommodation rule could enable taxpayers to avoid section 460 
by having some long-term contract activities performed by outside 
parties.
    Several commentators questioned the relevance of the ``basic 
design'' concept included in Sec. 1.460-2(e) Example 1 of the proposed 
regulations. To determine whether an item is unique, the relevant 
analysis is whether an item is customized (or manufactured according to 
a customer's specifications) regardless of whether the item is 
customized from a basic design. Accordingly, the final regulations 
delete the reference to the taxpayer's basic design in the example to 
eliminate any confusion.

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    One commentator questioned how the safe harbor applies in the case 
of a contract to manufacture multiple units of the same item. The IRS 
and Treasury Department believe that if significant customization is 
necessary to produce an item for a customer under the contract, that 
item is specifically designed for the needs of the customer, and thus 
is a unique item, regardless of the number of units produced for the 
customer under the contract. Thus, the final regulations clarify that 
for the purposes of applying the 10-percent safe harbor to a contract 
to manufacture multiple units of the same item, a taxpayer must 
allocate all customization costs to the first unit manufactured under 
the contract.
    Some commentators suggested the addition of a fourth safe harbor 
that would exclude ``income on contracts for which progress payments 
have not been received by year end.'' The IRS and Treasury Department 
did not adopt this suggestion because we do not believe that such a 
rule bears any relationship to a determination of the uniqueness of an 
item and because such a rule is inconsistent with the statute.

8. 12-Month Completion Period

    The proposed regulations provide that a manufactured item normally 
requires more than 12 months to complete if its ``production period,'' 
as defined in Sec. 1.263A-12, is reasonably expected to exceed 12 
months, determined at the end of the contracting year. In general, the 
production period for an item or unit begins when the taxpayer incurs 
at least 5 percent of the estimated total allocable contract costs, 
including planning and design expenditures, allocable to the item or 
unit, and the production period ends when the item or unit is ready for 
shipment to the taxpayer's customer.
    Some commentators suggested that the final regulations be clarified 
to provide that ``normal time to complete'' includes only the time of 
physical production activity and not the time of any research, 
development, planning, or design activity. The IRS and Treasury 
Department did not adopt this suggestion because we believe that the 
definition of ``production period'' under Sec. 1.263A-12(c)(3), which 
includes the time required for planning and design activity, is 
consistent with the allocation of costs to extended-period long-term 
contracts under Sec. 1.451-3(d)(6) and with section 460(c)(1), which 
requires that costs be allocated under the rules applicable to 
extended-period long-term contracts. In addition, if an item 
manufactured under a long-term contract requires a significant amount 
of design time to produce, it is appropriate to include the time needed 
to perform these activities when determining that item's ``normal time 
to complete'' because these activities are directly attributable to 
that contract and are necessary to manufacture the subject matter of 
the contract. However, the final regulations clarify that a taxpayer is 
not required to consider activities related to costs that are not 
allocable contract costs under section 460 (e.g., independent research 
and development expenses, marketing expenses) when determining the 
item's normal time to complete.
    Some commentators asked how the 12-month rule applies in the case 
of a contract to manufacture multiple units of the same item. The final 
regulations clarify, that for the purposes of applying the 12-month 
rule to this type of contract, the time required to design and 
manufacture the first unit generally does not reflect the item's 
``normal time to complete.'' For example, the time required to design 
the first unit of an item should not be considered as time required to 
manufacture subsequent identical units. The final regulations also 
include an example illustrating the determination of normal time to 
complete an item in the case of a contract to manufacture multiple 
units of the same item.

9. Percentage-of-Completion Method

    The proposed regulations provide that, under the PCM, a taxpayer 
generally includes a portion of the total contract price in income for 
each taxable year that the taxpayer incurs contract costs allocable to 
the long-term contract. Under the proposed regulations, total contract 
price included all bonuses, awards, and incentive payments if it is 
reasonably estimated that they will be received, even if the all events 
test has not yet been met. If, by the end of the completion year, a 
taxpayer cannot reasonably estimate whether a contingency will be 
satisfied, the bonus, award, or incentive payment is not includible in 
total contract price.
    Some commentators argued that a taxpayer should not have to include 
contingent compensation in ``total contract price'' until the all 
events test for the item has been satisfied. The IRS and Treasury 
Department did not adopt this suggestion because the all events test is 
a judicially created test applying to taxpayers using an accrual 
method. U.S. v. Anderson, 269 U.S. 422 (1926). Conversely, section 460 
is a self-contained, statutorily created accounting method that 
requires taxpayers to use estimated amounts when computing taxable 
income under the PCM and to use actual amounts when applying the look-
back method. In addition, using the most accurate estimate of total 
contract price and total contract costs will produce the most accurate 
annual reporting of income and costs and will minimize discrepancies 
that could necessitate paying look-back interest. See Tutor-Saliba 
Corp. v. Commissioner, 115 T.C. No. 1 (July 17, 2000). However, in 
response to comments and questions concerning the contingent income 
rule, the final regulations provide that contingent income is 
includible in total contract price not later than when it is included 
in income for financial reporting purposes under generally accepted 
accounting principles.
    One commentator suggested that the final regulations incorporate 
the rule under Sec. 1.451-3(a)(1) that allows a taxpayer to account for 
long-term contracts of less-than-substantial duration using a method of 
accounting other than a long-term contract method of accounting. The 
IRS and Treasury Department did not adopt this suggestion because such 
a rule would be inconsistent with the statutory definition of ``long-
term contract.''
    One commentator asked how a contractor should account for the 
subject matter of a long-term contract when the customer breaches that 
contract before the contractor has transferred title to the customer 
but after the contractor has reported taxable income from that contract 
under the PCM (e.g., unfinished condominium unit). In response to this 
comment, the final regulations include new Sec. 1.460-4(b)(7), which 
provides that if a long-term contract is terminated before completion 
and, as a result, the taxpayer retains ownership of the property that 
is the subject matter of that contract, the taxpayer must reverse the 
previously reported gross income (loss) from the transaction in the 
taxable year of termination. As a result of reversing its previously 
reported gross income under this rule, a taxpayer generally will have 
an adjusted basis in the retained property equal to its previously 
deducted allocable contract costs. The look-back method does not apply 
to any terminated contract to the extent it is subject to this rule. 
The IRS and Treasury Department request suggestions for rules that will 
apply when the customer acquires ownership of some, but not all, of the 
property that is the subject matter of the contract.

10. Cost Allocation Rules

    The proposed and final regulations provide that a taxpayer 
generally must

[[Page 2223]]

allocate costs to a contract subject to section 460(a) in the same 
manner as direct and indirect costs are capitalized to property 
produced by a taxpayer under section 263A. The regulations provide 
exceptions, however, that reflect the differences in the cost 
allocation rules of sections 263A and 460.
    One commentator argued that the final regulations should contain a 
single standard for determining when the cost of a direct material is 
allocable to a long-term contract. In response to this comment, the 
final regulations contain a single standard linked to the uniform 
capitalization (UNICAP) rules of section 263A. The final regulations 
also clarify that, among other methods, a taxpayer dedicates direct 
materials by associating them with a specific contract (e.g., by 
purchase order, entry on books and records, shipping instructions).
    One commentator suggested that the final regulations clarify that 
taxpayers should not treat software development and software 
implementation costs as customization costs for the purposes of the 
proposed 5-percent safe harbor. The IRS and Treasury Department did not 
adopt this suggestion because we believe that software costs are 
allocable contract costs (and thus customization costs) to the extent 
they are incident to or necessary for the manufacture of the subject 
matter of the contract.
    This commentator also suggested that the final regulations clarify 
that taxpayers should not treat guarantee, warranty, and maintenance 
costs as customization costs for the purposes of the proposed 5-percent 
safe harbor. The IRS and Treasury Department modified Sec. 1.460-
1(d)(2) to clarify that these types of costs are not allocable contract 
costs.

11. Simplified Cost-to-Cost Method

    The proposed regulations generally permit a taxpayer to elect to 
allocate contract costs using the simplified cost-to-cost method. Under 
the simplified cost-to-cost method, a taxpayer must determine a 
contract's completion factor based upon only direct material costs; 
direct labor costs; and depreciation, amortization, and cost recovery 
allowances on equipment and facilities directly used to manufacture or 
construct property under the contract.
    One commentator suggested that the final regulations clarify 
whether a taxpayer using the simplified cost-to-cost method is allowed 
or required to include subcontracted costs in a contract's completion 
factor. In response to this comment, the final regulations clarify that 
subcontracted costs represent either direct material or direct labor 
costs and thus must be allocated to a contract under the simplified 
cost-to-cost method when incurred under Sec. 1.461-4(d)(2)(ii). In 
addition, a taxpayer must allocate subcontracted costs for all section 
460 purposes (e.g., applying the 10-percent safe harbor under 
Sec. 1.460-2(b)(2)(ii)).

12. Statute of Limitations and Compound Interest on Look-Back Interest

    One commentator requested guidance concerning the statute of 
limitations applicable to payments of, and claims for, look-back 
interest. The final regulations amend Sec. 1.460-6(f)(1) and (2) to 
clarify the reporting requirements and add new Sec. 1.460-6(f)(3). New 
Sec. 1.460-6(f)(3) provides guidance on the statute of limitations 
applicable to the assessment and collection of look-back interest owed 
by a taxpayer. In addition, new Sec. 1.460-6(f)(3) provides that a 
taxpayer's claim for credit or refund of look-back interest previously 
paid by or collected from the taxpayer is a claim for credit or refund 
of an overpayment of tax for federal income tax purposes, which is 
subject to the section 6511 statute of limitations. In contrast, new 
Sec. 1.460-6(f)(3) provides that a taxpayer's claim for look-back 
interest (or interest payable on look-back interest) that is not 
attributable to an amount previously paid by or collected from the 
taxpayer is a general claim against the federal government, which is 
subject to the statutes of limitations found in 28 U.S.C. sections 2401 
and 2501.

13. Effective Date

    These final regulations apply to any contract entered into on or 
after January 11, 2001.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 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. Pursuant to 
section 7805(f) of the Internal Revenue Code, this Treasury decision 
was submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business. It is 
hereby certified that the collection of information in this Treasury 
decision will not have a significant economic impact on a substantial 
number of small entities. The regulations require a taxpayer to attach 
a statement to its original federal income tax return if the taxpayer 
severs or aggregates a long-term contract. The statement is needed so 
the Commissioner can determine whether the taxpayer properly severed or 
aggregated the contract. It is uncommon for a taxpayer that has a long-
term contract to sever or aggregate that contract. In addition, if a 
contract is severed or aggregated and a statement is required, it is 
estimated that it will, on average, require only 15 minutes to 
complete.

Drafting Information

    The principal author of these regulations is Leo F. Nolan II, 
Office of Associate Chief Counsel (Income Tax and Accounting). However, 
other personnel from the IRS 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:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation is amended by removing the 
entry for ``Section 1.451-3 and 1.451-5'', revising the entry for 
``Section 1.460-4'', and adding the following entries in numerical 
order to read as follows:

    Authority: 26 U.S.C. 7805 * * *
* * * * *
    Section 1.451-5 also issued under 96 Stat. 324, 493.
* * * * *
    Section 1.460-1 also issued under 26 U.S.C. 460(h).
    Section 1.460-2 also issued under 26 U.S.C. 460(h).
    Section 1.460-3 also issued under 26 U.S.C. 460(h).
    Section 1.460-4 also issued under 26 U.S.C. 460(h) and 1502.
    Section 1.460-5 also issued under 26 U.S.C. 460(h).
* * * * *


Sec. 1.446-1  [Amended]

    Par. 2. Section 1.446-1 is amended as follows:
    1. In the second sentence of paragraph (c)(1)(iii), the language 
``451'' is removed and ``460'' is added in its place.
    2. In the fourth sentence of paragraph (e)(2)(ii)(a), the language 
``Sec. 1.451-3'' is

[[Page 2224]]

removed and ``Sec. 1.460-4'' is added in its place.


Sec. 1.451-3  [Removed]

    Par. 3. Section 1.451-3 is removed.


Sec. 1.451-5  [Amended]

    Par. 4. Section 1.451-5 is amended by removing the language 
``Sec. 1.451-3'' and adding ``Sec. 1.460-4'' in its place in the first 
sentence of paragraph (b)(3).

    Par. 5. Section 1.460-0 is amended by:
    1. Revising the introductory text.
    2. Revising the entries for Secs. 1.460-1 through 1.460-3, 1.460-
4(a) through (i), and 1.460-5.
    3. Adding an entry for Sec. 1.460-4(k).
    4. Removing the entry for Sec. 1.460-6(c)(4)(iv).
    5. Adding an entry for Sec. 1.460-6(f)(3).
    6. Removing the entries for Secs. 1.460-7 and 1.460-8.
    The revisions and addition read as follows:


Sec. 1.460-0  Outline of regulations under section 460.

    This section lists the paragraphs contained in Sec. 1.460-1 through 
Sec. 1.460-6.

 1.460-1  Long-term contracts.

(a) Overview.
(1) In general.
(2) Exceptions to required use of PCM.
(i) Exempt construction contract.
(ii) Qualified ship or residential construction contract.
(b) Terms.
(1) Long-term contract.
(2) Contract for the manufacture, building, installation, or 
construction of property.
(i) In general.
(ii) De minimis construction activities.
(3) Allocable contract costs.
(4) Related party.
(5) Contracting year.
(6) Completion year.
(7) Contract commencement date.
(8) Incurred.
(9) Independent research and development expenses.
(10) Long-term contract methods of accounting.
(c) Entering into and completing long-term contracts.
(1) In general.
(2) Date contract entered into.
(i) In general.
(ii) Options and change orders.
(3) Date contract completed.
(i) In general.
(ii) Secondary items.
(iii) Subcontracts.
(iv) Final completion and acceptance.
(A) In general.
(B) Contingent compensation.
(C) Assembly or installation.
(D) Disputes.
(d) Allocation among activities.
(1) In general.
(2) Non-long-term contract activity.
(e) Severing and aggregating contracts.
(1) In general.
(2) Facts and circumstances.
(i) Pricing.
(ii) Separate delivery or acceptance.
(iii) Reasonable businessperson.
(3) Exceptions.
(i) Severance for PCM.
(ii) Options and change orders.
(4) Statement with return.
(f) Classifying contracts.
(1) In general.
(2) Hybrid contracts.
(i) In general.
(ii) Elections.
(3) Method of accounting.
(4) Use of estimates.
(i) Estimating length of contract.
(ii) Estimating allocable contract costs.
(g) Special rules for activities benefitting long-term contracts of 
a related party.
(1) Related party use of PCM.
(i) In general.
(ii) Exception for components and subassemblies.
(2) Total contract price.
(3) Completion factor.
(h) Effective date.
(1) In general.
(2) Change in method of accounting.
(i) [Reserved]
(j) Examples.

 1.460-2  Long-term manufacturing contracts.

(a) In general.
(b) Unique.
(1) In general.
(2) Safe harbors.
(i) Short production period.
(ii) Customized item.
(iii) Inventoried item.
(c) Normal time to complete.
(1) In general.
(2) Production by related parties.
(d) Qualified ship contracts.
(e) Examples.

 1.460-3  Long-term construction contracts.

(a) In general.
(b) Exempt construction contracts.
(1) In general.
(2) Home construction contract.
(i) In general.
(ii) Townhouses and rowhouses.
(iii) Common improvements.
(iv) Mixed use costs.
(3) $10,000,000 gross receipts test.
(i) In general.
(ii) Single employer.
(iii) Attribution of gross receipts.
(c) Residential construction contracts.

 1.460-4  Methods of accounting for long-term contracts.

(a) Overview.
(b) Percentage-of-completion method.
(1) In general.
(2) Computations.
(3) Post-completion-year income.
(4) Total contract price.
(i) In general.
(A) Definition.
(B) Contingent compensation.
(C) Non-long-term contract activities.
(ii) Estimating total contract price.
(5) Completion factor.
(i) Allocable contract costs.
(ii) Cumulative allocable contract costs.
(iii) Estimating total allocable contract costs.
(iv) Pre-contracting-year costs.
(v) Post-completion-year costs.
(6) 10-percent method.
(i) In general.
(ii) Election.
(7) Terminated contract.
(i) Reversal of income.
(ii) Adjusted basis.
(iii) Look-back method.
(c) Exempt contract methods.
(1) In general.
(2) Exempt-contract percentage-of-completion method.
(i) In general.
(ii) Determination of work performed.
(d) Completed-contract method.
(1) In general.
(2) Post-completion-year income and costs.
(3) Gross contract price.
(4) Contracts with disputed claims.
(i) In general.
(ii) Taxpayer assured of profit or loss.
(iii) Taxpayer unable to determine profit or loss.
(iv) Dispute resolved.
(e) Percentage-of-completion/capitalized-cost method.
(f) Alternative minimum taxable income.
(1) In general.
(2) Election to use regular completion factors.
(g) Method of accounting.
(h) Examples.
(i) [Reserved]
* * * * *
(k) Mid-contract change in taxpayer [Reserved]

 1.460-5  Cost allocation rules.

(a) Overview.
(b) Cost allocation method for contracts subject to PCM.
(1) In general.
(2) Special rules.
(i) Direct material costs.
(ii) Components and subassemblies.
(iii) Simplified production methods.
(iv) Costs identified under cost-plus long-term contracts and 
federal long-term contracts.
(v) Interest.
(A) In general.
(B) Production period.
(C) Application of section 263A(f).
(vi) Research and experimental expenses.
(vii) Service costs.
(A) Simplified service cost method.
(1) In general.
(2) Example.
(B) Jobsite costs.
(C) Limitation on other reasonable cost allocation methods.
(c) Simplified cost-to-cost method for contracts subject to the PCM.
(1) In general.
(2) Election.
(d) Cost allocation rules for exempt construction contracts reported 
using CCM.
(1) In general.
(2) Indirect costs.
(i) Indirect costs allocable to exempt construction contracts.

[[Page 2225]]

(ii) Indirect costs not allocable to exempt construction contracts.
(3) Large homebuilders.
(e) Cost allocation rules for contracts subject to the PCCM.
(f) Special rules applicable to costs allocated under this section.
(1) Nondeductible costs.
(2) Costs incurred for non-long-term contract activities.
(g) Method of accounting.

 1.460-6  Look-back method.

* * * * *
(f) * * *
(3) Statutes of limitations and compounding of interest on look-back 
interest.
* * * * *

    Par. 6. Sections 1.460-1 through 1.460-3 are revised to read as 
follows:


Sec. 1.460-1  Long-term contracts.

    (a) Overview--(1) In general. This section provides rules for 
determining whether a contract for the manufacture, building, 
installation, or construction of property is a long-term contract under 
section 460 and what activities must be accounted for as a single long-
term contract. Specific rules for long-term manufacturing and 
construction contracts are provided in Secs. 1.460-2 and 1.460-3, 
respectively. A taxpayer generally must determine the income from a 
long-term contract using the percentage-of-completion method described 
in Sec. 1.460-4(b) (PCM) and the cost allocation rules described in 
Sec. 1.460-5(b) or (c). In addition, after a contract subject to the 
PCM is completed, a taxpayer generally must apply the look-back method 
described in Sec. 1.460-6 to determine the amount of interest owed on 
any hypothetical underpayment of tax, or earned on any hypothetical 
overpayment of tax, attributable to accounting for the long-term 
contract under the PCM.
    (2) Exceptions to required use of PCM--(i) Exempt construction 
contract. The requirement to use the PCM does not apply to any exempt 
construction contract described in Sec. 1.460-3(b). Thus, a taxpayer 
may determine the income from an exempt construction contract using any 
accounting method permitted by Sec. 1.460-4(c) and, for contracts 
accounted for using the completed-contract method (CCM), any cost 
allocation method permitted by Sec. 1.460-5(d). Exempt construction 
contracts that are not subject to the PCM or CCM are not subject to the 
cost allocation rules of Sec. 1.460-5 except for the production-period 
interest rules of Sec. 1.460-5(b)(2)(v). Exempt construction 
contractors that are large homebuilders described in Sec. 1.460-5(d)(3) 
must capitalize costs under section 263A. All other exempt construction 
contractors must account for the cost of construction using the 
appropriate rules contained in other sections of the Internal Revenue 
Code or regulations.
    (ii) Qualified ship or residential construction contract. The 
requirement to use the PCM applies only to a portion of a qualified 
ship contract described in Sec. 1.460-2(d) or residential construction 
contract described in Sec. 1.460-3(c). A taxpayer generally may 
determine the income from a qualified ship contract or residential 
construction contract using the percentage-of-completion/capitalized-
cost method (PCCM) described in Sec. 1.460-4(e), but must use a cost 
allocation method described in Sec. 1.460-5(b) for the entire contract.
    (b) Terms--(1) Long-term contract. A long-term contract generally 
is any contract for the manufacture, building, installation, or 
construction of property if the contract is not completed within the 
contracting year, as defined in paragraph (b)(5) of this section. 
However, a contract for the manufacture of property is a long-term 
contract only if it also satisfies either the unique item or 12-month 
requirements described in Sec. 1.460-2. A contract for the manufacture 
of personal property is a manufacturing contract. In contrast, a 
contract for the building, installation, or construction of real 
property is a construction contract.
    (2) Contract for the manufacture, building, installation, or 
construction of property--(i) In general. A contract is a contract for 
the manufacture, building, installation, or construction of property if 
the manufacture, building, installation, or construction of property is 
necessary for the taxpayer's contractual obligations to be fulfilled 
and if the manufacture, building, installation, or construction of that 
property has not been completed when the parties enter into the 
contract. If a taxpayer has to manufacture or construct an item to 
fulfill its obligations under the contract, the fact that the taxpayer 
is not required to deliver that item to the customer is not relevant. 
Whether the customer has title to, control over, or bears the risk of 
loss from, the property manufactured or constructed by the taxpayer 
also is not relevant. Furthermore, how the parties characterize their 
agreement (e.g., as a contract for the sale of property) is not 
relevant.
    (ii) De minimis construction activities. Notwithstanding paragraph 
(b)(2)(i) of this section, a contract is not a construction contract 
under section 460 if the contract includes the provision of land by the 
taxpayer and the estimated total allocable contract costs, as defined 
in paragraph (b)(3) of this section, attributable to the taxpayer's 
construction activities are less than 10 percent of the contract's 
total contract price, as defined in Sec. 1.460-4(b)(4)(i). For the 
purposes of this paragraph (b)(2)(ii), the allocable contract costs 
attributable to the taxpayer's construction activities do not include 
the cost of the land provided to the customer. In addition, a 
contract's estimated total allocable contract costs include a 
proportionate share of the estimated cost of any common improvement 
that benefits the subject matter of the contract if the taxpayer is 
contractually obligated, or required by law, to construct the common 
improvement.
    (3) Allocable contract costs. Allocable contract costs are costs 
that are allocable to a long-term contract under Sec. 1.460-5.
    (4) Related party. A related party is a person whose relationship 
to a taxpayer is described in section 707(b) or 267(b), determined 
without regard to section 267(f)(1)(A) and determined by replacing ``at 
least 80 percent'' with ``more than 50 percent'' for the purposes of 
determining the ownership of the stock of a corporation in sections 
267(b)(2), (8), (10)(A), and (12).
    (5) Contracting year. The contracting year is the taxable year in 
which a taxpayer enters into a contract as described in paragraph 
(c)(2) of this section.
    (6) Completion year. The completion year is the taxable year in 
which a taxpayer completes a contract as described in paragraph (c)(3) 
of this section.
    (7) Contract commencement date. The contract commencement date is 
the date that a taxpayer or related party first incurs any allocable 
contract costs, such as design and engineering costs, other than 
expenses attributable to bidding and negotiating activities. Generally, 
the contract commencement date is relevant in applying Sec. 1.460-
6(b)(3) (concerning the de minimis exception to the look-back method 
under section 460(b)(3)(B)); Sec. 1.460-5(b)(2)(v)(B)(1)(i) (concerning 
the production period subject to interest allocation); Sec. 1.460-2(d) 
(concerning qualified ship contracts); and Sec. 1.460-3(b)(1)(ii) 
(concerning the construction period for exempt construction contracts).
    (8) Incurred. Incurred has the meaning given in Sec. 1.461-1(a)(2) 
(concerning the taxable year a liability is incurred under the accrual 
method of accounting), regardless of a taxpayer's overall method of 
accounting. See Sec. 1.461-4(d)(2)(ii) for economic performance rules 
concerning the PCM.
    (9) Independent research and development expenses. Independent

[[Page 2226]]

research and development expenses are any expenses incurred in the 
performance of research or development, except that this term does not 
include any expenses that are directly attributable to a particular 
long-term contract in existence when the expenses are incurred and this 
term does not include any expenses under an agreement to perform 
research or development.
    (10) Long-term contract methods of accounting. Long-term contract 
methods of accounting, which include the PCM, the CCM, the PCCM, and 
the exempt-contract percentage-of-completion method (EPCM), are methods 
of accounting that may be used only for long-term contracts.
    (c) Entering into and completing long-term contracts--(1) In 
general. To determine when a contract is entered into under paragraph 
(c)(2) of this section and completed under paragraph (c)(3) of this 
section, a taxpayer must consider all relevant allocable contract costs 
incurred and activities performed by itself, by related parties on its 
behalf, and by the customer, that are incident to or necessary for the 
long-term contract. In addition, to determine whether a contract is 
completed in the contracting year, the taxpayer may not consider when 
it expects to complete the contract.
    (2) Date contract entered into--(i) In general. A taxpayer enters 
into a contract on the date that the contract binds both the taxpayer 
and the customer under applicable law, even if the contract is subject 
to unsatisfied conditions not within the taxpayer's control (such as 
obtaining financing). If a taxpayer delays entering into a contract for 
a principal purpose of avoiding section 460, however, the taxpayer will 
be treated as having entered into a contract not later than the 
contract commencement date.
    (ii) Options and change orders. A taxpayer enters into a new 
contract on the date that the customer exercises an option or similar 
provision in a contract if that option or similar provision must be 
severed from the contract under paragraph (e) of this section. 
Similarly, a taxpayer enters into a new contract on the date that it 
accepts a change order or other similar agreement if the change order 
or other similar agreement must be severed from the contract under 
paragraph (e) of this section.
    (3) Date contract completed--(i) In general. A taxpayer's contract 
is completed upon the earlier of--
    (A) Use of the subject matter of the contract by the customer for 
its intended purpose (other than for testing) and at least 95 percent 
of the total allocable contract costs attributable to the subject 
matter have been incurred by the taxpayer; or
    (B) Final completion and acceptance of the subject matter of the 
contract.
    (ii) Secondary items. The date a contract accounted for using the 
CCM is completed is determined without regard to whether one or more 
secondary items have been used or finally completed and accepted. If 
any secondary items are incomplete at the end of the taxable year in 
which the primary subject matter of a contract is completed, the 
taxpayer must separate the portion of the gross contract price and the 
allocable contract costs attributable to the incomplete secondary 
item(s) from the completed contract and account for them using a 
permissible method of accounting. A permissible method of accounting 
includes a long-term contract method of accounting only if a separate 
contract for the secondary item(s) would be a long-term contract, as 
defined in paragraph (b)(1) of this section.
    (iii) Subcontracts. In the case of a subcontract, a subcontractor's 
customer is the general contractor. Thus, the subject matter of the 
subcontract is the relevant subject matter under paragraph (c)(3)(i) of 
this section.
    (iv) Final completion and acceptance--(A) In general. Except as 
otherwise provided in this paragraph (c)(3)(iv), to determine whether 
final completion and acceptance of the subject matter of a contract 
have occurred, a taxpayer must consider all relevant facts and 
circumstances. Nevertheless, a taxpayer may not delay the completion of 
a contract for the principal purpose of deferring federal income tax.
    (B) Contingent compensation. Final completion and acceptance is 
determined without regard to any contractual term that provides for 
additional compensation that is contingent on the successful 
performance of the subject matter of the contract. A taxpayer must 
account for all contingent compensation that is not includible in total 
contract price under Sec. 1.460-4(b)(4)(i), or in gross contract price 
under Sec. 1.460-4(d)(3), using a permissible method of accounting. For 
application of the look-back method for contracts accounted for using 
the PCM, see Sec. 1.460-6(c)(1)(ii) and (2)(vi).
    (C) Assembly or installation. Final completion and acceptance is 
determined without regard to whether the taxpayer has an obligation to 
assist or supervise assembly or installation of the subject matter of 
the contract where the assembly or installation is not performed by the 
taxpayer or a related party. A taxpayer must account for the gross 
receipts and costs attributable to such an obligation using a 
permissible method of accounting, other than a long-term contract 
method.
    (D) Disputes. Final completion and acceptance is determined without 
regard to whether a dispute exists at the time the taxpayer tenders the 
subject matter of the contract to the customer. For contracts accounted 
for using the CCM, see Sec. 1.460-4(d)(4). For application of the look-
back method for contracts accounted for using the PCM, see Sec. 1.460-
6(c)(1)(ii) and (2)(vi).
    (d) Allocation among activities--(1) In general. Long-term contract 
methods of accounting apply only to the gross receipts and costs 
attributable to long-term contract activities. Gross receipts and costs 
attributable to long-term contract activities means amounts included in 
total contract price or gross contract price, whichever is applicable, 
as determined under Sec. 1.460-4, and costs allocable to the contract, 
as determined under Sec. 1.460-5. Gross receipts and costs attributable 
to non-long-term contract activities (as defined in paragraph (d)(2) of 
this section) generally must be taken into account using a permissible 
method of accounting other than a long-term contract method. See 
section 446(c) and Sec. 1.446-1(c). However, if the performance of a 
non-long-term contract activity is incident to or necessary for the 
manufacture, building, installation, or construction of the subject 
matter of one or more of the taxpayer's long-term contracts, the gross 
receipts and costs attributable to that activity must be allocated to 
the long-term contract(s) benefitted as provided in Secs. 1.460-
4(b)(4)(i) and 1.460-5(f)(2), respectively. Similarly, if a single 
long-term contract requires a taxpayer to perform a non-long-term 
contract activity that is not incident to or necessary for the 
manufacture, building, installation, or construction of the subject 
matter of the long-term contract, the gross receipts and costs 
attributable to that non-long-term contract activity must be separated 
from the contract and accounted for using a permissible method of 
accounting other than a long-term contract method. But see paragraph 
(g) of this section for related party rules.
    (2) Non-long-term contract activity. Non-long-term contract 
activity means the performance of an activity other than manufacturing, 
building, installation, or construction, such as the provision of 
architectural, design, engineering, and construction management 
services, and the development or implementation of computer software. 
In addition, performance under a guaranty,

[[Page 2227]]

warranty, or maintenance agreement is a non-long-term contract activity 
that is never incident to or necessary for the manufacture or 
construction of property under a long-term contract.
    (e) Severing and aggregating contracts--(1) In general. After 
application of the allocation rules of paragraph (d) of this section, 
the severing and aggregating rules of this paragraph (e) may be applied 
by the Commissioner or the taxpayer as necessary to clearly reflect 
income (e.g., to prevent the unreasonable deferral (or acceleration) of 
income or the premature recognition (or deferral) of loss). Under the 
severing and aggregating rules, one agreement may be treated as two or 
more contracts, and two or more agreements may be treated as one 
contract. Except as provided in paragraph (e)(3)(ii) of this section, a 
taxpayer must determine whether to sever an agreement or to aggregate 
two or more agreements based on the facts and circumstances known at 
the end of the contracting year.
    (2) Facts and circumstances. Whether an agreement should be 
severed, or two or more agreements should be aggregated, depends on the 
following factors:
    (i) Pricing. Independent pricing of items in an agreement is 
necessary for the agreement to be severed into two or more contracts. 
In the case of an agreement for similar items, if the price to be paid 
for the items is determined under different terms or formulas (e.g., if 
some items are priced under a cost-plus incentive fee arrangement and 
later items are to be priced under a fixed-price arrangement), then the 
difference in the pricing terms or formulas indicates that the items 
are independently priced. Similarly, interdependent pricing of items in 
separate agreements is necessary for two or more agreements to be 
aggregated into one contract. A single price negotiation for similar 
items ordered under one or more agreements indicates that the items are 
interdependently priced.
    (ii) Separate delivery or acceptance. An agreement may not be 
severed into two or more contracts unless it provides for separate 
delivery or separate acceptance of items that are the subject matter of 
the agreement. However, the separate delivery or separate acceptance of 
items by itself does not necessarily require an agreement to be 
severed.
    (iii) Reasonable businessperson. Two or more agreements to perform 
manufacturing or construction activities may not be aggregated into one 
contract unless a reasonable businessperson would not have entered into 
one of the agreements for the terms agreed upon without also entering 
into the other agreement(s). Similarly, an agreement to perform 
manufacturing or construction activities may not be severed into two or 
more contracts if a reasonable businessperson would not have entered 
into separate agreements containing terms allocable to each severed 
contract. Analyzing the reasonable businessperson standard requires an 
analysis of all the facts and circumstances of the business arrangement 
between the taxpayer and the customer. For purposes of this paragraph 
(e)(2)(iii), a taxpayer's expectation that the parties would enter into 
another agreement, when agreeing to the terms contained in the first 
agreement, is not relevant.
    (3) Exceptions--(i) Severance for PCM. A taxpayer may not sever 
under this paragraph (e) a long-term contract that would be subject to 
the PCM without obtaining the Commissioner's prior written consent.
    (ii) Options and change orders. Except as provided in paragraph 
(e)(3)(i) of this section, a taxpayer must sever an agreement that 
increases the number of units to be supplied to the customer, such as 
through the exercise of an option or the acceptance of a change order, 
if the agreement provides for separate delivery or separate acceptance 
of the additional units.
    (4) Statement with return. If a taxpayer severs an agreement or 
aggregates two or more agreements under this paragraph (e) during the 
taxable year, the taxpayer must attach a statement to its original 
federal income tax return for that year. This statement must contain 
the following information--
    (i) The legend NOTIFICATION OF SEVERANCE OR AGGREGATION UNDER SEC. 
1.460-1(e);
    (ii) The taxpayer's name; and
    (iii) The taxpayer's employer identification number or social 
security number.
    (f) Classifying contracts--(1) In general. After applying the 
severing and aggregating rules of paragraph (e) of this section, a 
taxpayer must determine the classification of a contract (e.g., as a 
long-term manufacturing contract, long-term construction contract, non-
long-term contract) based on all the facts and circumstances known no 
later than the end of the contracting year. Classification is 
determined on a contract-by-contract basis. Consequently, a requirement 
to manufacture a single unique item under a long-term contract will 
subject all other items in that contract to section 460.
    (2) Hybrid contracts--(i) In general. A long-term contract that 
requires a taxpayer to perform both manufacturing and construction 
activities (hybrid contract) generally must be classified as two 
contracts, a manufacturing contract and a construction contract. A 
taxpayer may elect, on a contract-by-contract basis, to classify a 
hybrid contract as a long-term construction contract if at least 95 
percent of the estimated total allocable contract costs are reasonably 
allocable to construction activities. In addition, a taxpayer may 
elect, on a contract-by-contract basis, to classify a hybrid contract 
as a long-term manufacturing contract subject to the PCM.
    (ii) Elections. A taxpayer makes an election under this paragraph 
(f)(2) by using its method of accounting for similar construction 
contracts or for manufacturing contracts, whichever is applicable, to 
account for a hybrid contract entered into during the taxable year of 
the election on its original federal income tax return for the election 
year. If an electing taxpayer's method is the PCM, the taxpayer also 
must use the PCM to apply the look-back method under Sec. 1.460-6 and 
to determine alternative minimum taxable income under Sec. 1.460-4(f).
    (3) Method of accounting. Except as provided in paragraph 
(f)(2)(ii) of this section, a taxpayer's method of classifying 
contracts is a method of accounting under section 446 and, thus, may 
not be changed without the Commissioner's consent. If a taxpayer's 
method of classifying contracts is unreasonable, that classification 
method is an impermissible accounting method.
    (4) Use of estimates--(i) Estimating length of contract. A taxpayer 
must use a reasonable estimate of the time required to complete a 
contract when necessary to classify the contract (e.g., to determine 
whether the five-year completion rule for qualified ship contracts 
under Sec. 1.460-2(d), or the two-year completion rule for exempt 
construction contracts under Sec. 1.460-3(b), is satisfied, but not to 
determine whether a contract is completed within the contracting year 
under paragraph (b)(1) of this section). To be considered reasonable, 
an estimate of the time required to complete the contract must include 
anticipated time for delay, rework, change orders, technology or design 
problems, or other problems that reasonably can be anticipated 
considering the nature of the contract and prior experience. A contract 
term that specifies an expected completion or delivery date may be 
considered evidence that the taxpayer reasonably expects to complete or 
deliver the

[[Page 2228]]

subject matter of the contract on or about the date specified, 
especially if the contract provides bona fide penalties for failing to 
meet the specified date. If a taxpayer classifies a contract based on a 
reasonable estimate of completion time, the contract will not be 
reclassified based on the actual (or another reasonable estimate of) 
completion time. A taxpayer's estimate of completion time will not be 
considered unreasonable if a contract is not completed within the 
estimated time primarily because of unforeseeable factors not within 
the taxpayer's control, such as third-party litigation, extreme weather 
conditions, strikes, or delays in securing permits or licenses.
    (ii) Estimating allocable contract costs. A taxpayer must use a 
reasonable estimate of total allocable contract costs when necessary to 
classify the contract (e.g., to determine whether a contract is a home 
construction contract under Sec. 1.460-(3)(b)(2)). If a taxpayer 
classifies a contract based on a reasonable estimate of total allocable 
contract costs, the contract will not be reclassified based on the 
actual (or another reasonable estimate of) total allocable contract 
costs.
    (g) Special rules for activities benefitting long-term contracts of 
a related party--(1) Related party use of PCM--(i) In general. Except 
as provided in paragraph (g)(1)(ii) of this section, if a related party 
and its customer enter into a long-term contract subject to the PCM, 
and a taxpayer performs any activity that is incident to or necessary 
for the related party's long-term contract, the taxpayer must account 
for the gross receipts and costs attributable to this activity using 
the PCM, even if this activity is not otherwise subject to section 
460(a). This type of activity may include, for example, the performance 
of engineering and design services, and the production of components 
and subassemblies that are reasonably expected to be used in the 
production of the subject matter of the related party's contract.
    (ii) Exception for components and subassemblies. A taxpayer is not 
required to use the PCM under this paragraph (g) to account for a 
component or subassembly that benefits a related party's long-term 
contract if more than 50 percent of the average annual gross receipts 
attributable to the sale of this item for the 3-taxable-year-period 
ending with the contracting year comes from unrelated parties.
    (2) Total contract price. If a taxpayer is required to use the PCM 
under paragraph (g)(1)(i) of this section, the total contract price (as 
defined in Sec. 1.460-4(b)(4)(i)) is the fair market value of the 
taxpayer's activity that is incident to or necessary for the 
performance of the related party's long-term contract. The related 
party also must use the fair market value of the taxpayer's activity as 
the cost it incurs for the activity. The fair market value of the 
taxpayer's activity may or may not be the same as the amount the 
related party pays the taxpayer for that activity.
    (3) Completion factor. To compute a contract's completion factor 
(as described in Sec. 1.460-4(b)(5)), the related party must take into 
account the fair market value of the taxpayer's activity that is 
incident to or necessary for the performance of the related party's 
long-term contract when the related party incurs the liability to the 
taxpayer for the activity, rather than when the taxpayer incurs the 
costs to perform the activity.
    (h) Effective date--(1) In general. Except as otherwise provided, 
this section and Secs. 1.460-2 through 1.460-5 are applicable for 
contracts entered into on or after January 11, 2001.
    (2) Change in method of accounting. Any change in a taxpayer's 
method of accounting necessary to comply with this section and 
Secs. 1.460-2 through 1.460-5 is a change in method of accounting to 
which the provisions of section 446 and the regulations thereunder 
apply. For the first taxable year that includes January 11, 2001, a 
taxpayer is granted the consent of the Commissioner to change its 
method of accounting to comply with the provisions of this section and 
Secs. 1.460-2 through 1.460-5 for long-term contracts entered into on 
or after January 11, 2001. A taxpayer that wants to change its method 
of accounting under this paragraph (h)(2) must follow the automatic 
consent procedures in Rev. Proc. 99-49 (1999-52 I.R.B. 725) (see 
Sec. 601.601(d)(2) of this chapter), except that the scope limitations 
in section 4.02 of Rev. Proc. 99-49 do not apply. Because a change 
under this paragraph (h)(2) is made on a cut-off basis, a section 
481(a) adjustment is not permitted or required. Moreover, the taxpayer 
does not receive audit protection under section 7 of Rev. Proc. 99-49 
for a change in method of accounting under this paragraph (h)(2). A 
taxpayer that wants to change its exempt-contract method of accounting 
is not granted the consent of the Commissioner under this paragraph 
(h)(2) and must file a Form 3115, ``Application for Change in 
Accounting Method,'' to obtain consent. See Rev. Proc. 97-27 (1997-1 
C.B. 680) (see Sec. 601.601(d)(2) of this chapter).
    (i) [Reserved]
    (j) Examples. The following examples illustrate the rules of this 
section:

    Example 1. Contract for manufacture of property. B notifies C, 
an aircraft manufacturer, that it wants to purchase an aircraft of a 
particular type. At the time C receives the order, C has on hand 
several partially completed aircraft of this type; however, C does 
not have any completed aircraft of this type on hand. C and B agree 
that B will purchase one of these aircraft after it has been 
completed. C retains title to and risk of loss with respect to the 
aircraft until the sale takes place. The agreement between C and B 
is a contract for the manufacture of property under paragraph 
(b)(2)(i) of this section, even if labeled as a contract for the 
sale of property, because the manufacture of the aircraft is 
necessary for C's obligations under the agreement to be fulfilled 
and the manufacturing was not complete when B and C entered into the 
agreement.
    Example 2. De minimis construction activity. C, a master 
developer whose taxable year ends December 31, owns 5,000 acres of 
undeveloped land with a cost basis of $5,000,000 and a fair market 
value of $50,000,000. To obtain permission from the local county 
government to improve this land, a service road must be constructed 
on this land to benefit all 5,000 acres. In 2001, C enters into a 
contract to sell a 1,000-acre parcel of undeveloped land to B, a 
residential developer, for its fair market value, $10,000,000. In 
this contract, C agrees to construct a service road running through 
the land that C is selling to B and through the 4,000 adjacent acres 
of undeveloped land that C has sold or will sell to other 
residential developers for its fair market value, $40,000,000. C 
reasonably estimates that it will incur allocable contract costs of 
$50,000 (excluding the cost of the land) to construct this service 
road, which will be owned and maintained by the county. C must 
reasonably allocate the cost of the service road among the 
benefitted parcels. The portion of the estimated total allocable 
contract costs that C allocates to the 1,000-acre parcel being sold 
to B (based upon its fair market value) is $10,000 ($50,000 x 
($10,000,000 $50,000,000)). Construction of the service road is 
finished in 2002. Because the estimated total allocable contract 
costs attributable to C's construction activities, $10,000, are less 
than 10 percent of the contract's total contract price, $10,000,000, 
C's contract with B is not a construction contract under paragraph 
(b)(2)(ii) of this section. Thus, C's contract with B is not a long-
term contract under paragraph (b)(2)(i) of this section, 
notwithstanding that construction of the service road is not 
completed in 2001.
    Example 3. Completion--customer use. In 2002, C, whose taxable 
year ends December 31, enters into a contract to construct a 
building for B. In November of 2003, the building is completed in 
every respect necessary for its intended use, and B occupies the 
building. In early December of 2003, B notifies C of some minor 
deficiencies that need to be corrected, and C agrees to correct them 
in January 2004. C reasonably estimates that the cost of correcting 
these deficiencies will be less than five percent of

[[Page 2229]]

the total allocable contract costs. C's contract is complete under 
paragraph (c)(3)(i)(A) of this section in 2003 because in that year, 
B used the building and C had incurred at least 95 percent of the 
total allocable contract costs attributable to the building. C must 
use a permissible method of accounting for any deficiency-related 
costs incurred after 2003.
    Example 4. Completion--customer use. In 2001, C, whose taxable 
year ends December 31, agrees to construct a shopping center, which 
includes an adjoining parking lot, for B. By October 2002, C has 
finished constructing the retail portion of the shopping center. By 
December 2002, C has graded the entire parking lot, but has paved 
only one-fourth of it because inclement weather conditions prevented 
C from laying asphalt on the remaining three-fourths. In December 
2002, B opens the retail portion of the shopping center and the 
paved portion of the parking lot to the general public. C reasonably 
estimates that the cost of paving the remaining three-fourths of the 
parking lot when weather permits will exceed five percent of C's 
total allocable contract costs. Even though B is using the subject 
matter of the contract, C's contract is not completed in December 
2002 under paragraph (c)(3)(i)(A) of this section because C has not 
incurred at least 95 percent of the total allocable contract costs 
attributable to the subject matter.
    Example 5. Completion--customer use. In 2001, C, whose taxable 
year ends December 31, agrees to manufacture 100 machines for B. By 
December 31, 2002, C has delivered 99 of the machines to B. C 
reasonably estimates that the cost of finishing the related work on 
the contract will be less than five percent of the total allocable 
contract costs. C's contract is not complete under paragraph 
(c)(3)(i)(A) of this section in 2002 because in that year, B is not 
using the subject matter of the contract (all 100 machines) for its 
intended purpose.
    Example 6. Non-long-term contract activity. On January 1, 2001, 
C, whose taxable year ends December 31, enters into a single long-
term contract to design and manufacture a satellite and to develop 
computer software enabling B to operate the satellite. At the end of 
2001, C has not finished manufacturing the satellite. Designing the 
satellite and developing the computer software are non-long-term 
contract activities that are incident to and necessary for the 
taxpayer's manufacturing of the subject matter of a long-term 
contract because the satellite could not be manufactured without the 
design and would not operate without the software. Thus, under 
paragraph (d)(1) of this section, C must allocate these non-long-
term contract activities to the long-term contract and account for 
the gross receipts and costs attributable to designing the satellite 
and developing computer software using the PCM.
    Example 7. Non-long-term contract activity. C agrees to 
manufacture equipment for B under a long-term contract. In a 
separate contract, C agrees to design the equipment being 
manufactured for B under the long-term contract. Under paragraph 
(d)(1) of this section, C must allocate the gross receipts and costs 
related to the design to the long-term contract because designing 
the equipment is a non-long-term contract activity that is incident 
to and necessary for the manufacture of the subject matter of the 
long-term contract.
    Example 8. Severance. On January 1, 2001, C, a construction 
contractor, and B, a real estate investor, enter into an agreement 
requiring C to build two office buildings in different areas of a 
large city. The agreement provides that the two office buildings 
will be completed by C and accepted by B in 2002 and 2003, 
respectively, and that C will be paid $1,000,000 and $1,500,000 for 
the two office buildings, respectively. The agreement will provide C 
with a reasonable profit from the construction of each building. 
Unless C is required to use the PCM to account for the contract, C 
is required to sever this contract under paragraph (e)(2) of this 
section because the buildings are independently priced, the 
agreement provides for separate delivery and acceptance of the 
buildings, and, as each building will generate a reasonable profit, 
a reasonable businessperson would have entered into separate 
agreements for the terms agreed upon for each building.
    Example 9. Severance. C, a large construction contractor whose 
taxable year ends December 31, accounts for its construction 
contracts using the PCM and has elected to use the 10-percent method 
described in Sec. 1.460-4(b)(6). In September 2001, C enters into an 
agreement to construct four buildings in four different cities. The 
buildings are independently priced and the contract provides a 
reasonable profit for each of the buildings. In addition, the 
agreement requires C to complete one building per year in 2002, 
2003, 2004, and 2005. As of December 31, 2001, C has incurred 25 
percent of the estimated total allocable contract costs attributable 
to one of the buildings, but only five percent of the estimated 
total allocable contract costs attributable to all four buildings 
included in the agreement. C does not request the Commissioner's 
consent to sever this contract. Using the 10-percent method, C does 
not take into account any portion of the total contract price or any 
incurred allocable contract costs attributable to this agreement in 
2001. Upon examination of C's 2001 tax return, the Commissioner 
determines that C entered into one agreement for four buildings 
rather than four separate agreements each for one building solely to 
take advantage of the deferral obtained under the 10-percent method. 
Consequently, to clearly reflect the taxpayer's income, the 
Commissioner may require C to sever the agreement into four separate 
contracts under paragraph (e)(2) of this section because the 
buildings are independently priced, the agreement provides for 
separate delivery and acceptance of the buildings, and a reasonable 
businessperson would have entered into separate agreements for these 
buildings.
    Example 10. Aggregation. In 2001, C, a shipbuilder, enters into 
two agreements with the Department of the Navy as the result of a 
single negotiation. Each agreement obligates C to manufacture a 
submarine. Because the submarines are of the same class, their 
specifications are similar. Because C has never manufactured 
submarines of this class, however, C anticipates that it will incur 
substantially higher costs to manufacture the first submarine, to be 
delivered in 2007, than to manufacture the second submarine, to be 
delivered in 2010. If the agreements are treated as separate 
contracts, the first contract probably will produce a substantial 
loss, while the second contract probably will produce substantial 
profit. Based upon these facts, aggregation is required under 
paragraph (e)(2) of this section because the submarines are 
interdependently priced and a reasonable businessperson would not 
have entered the first agreement without also entering into the 
second.
    Example 11. Aggregation. In 2001, C, a manufacturer of aircraft 
and related equipment, agrees to manufacture 10 military aircraft 
for foreign government B and to deliver the aircraft by the end of 
2003. When entering into the agreement, C anticipates that it might 
receive production orders from B over the next 20 years for as many 
as 300 more of these aircraft. The negotiated contract price 
reflects C's and B's consideration of the expected total cost of 
manufacturing the 10 aircraft, the risks and opportunities 
associated with the agreement, and the additional factors the 
parties considered relevant. The negotiated price provides a profit 
on the sale of the 10 aircraft even if C does not receive any 
additional production orders from B. It is unlikely, however, that C 
actually would have wanted to manufacture the 10 aircraft but for 
the expectation that it would receive additional production orders 
from B. In 2003, B accepts delivery of the 10 aircraft. At that 
time, B orders an additional 20 aircraft of the same type for 
delivery in 2007. When negotiating the price for the additional 20 
aircraft, C and B consider the fact that the expected unit cost for 
this production run of 20 aircraft will be lower than the unit cost 
of the 10 aircraft completed and accepted in 2003, but substantially 
higher than the expected unit cost of future production runs. Based 
upon these facts, aggregation is not permitted under paragraph 
(e)(2) of this section. Because the parties negotiated the prices of 
both agreements considering only the expected production costs and 
risks for each agreement standing alone, the terms and conditions 
agreed upon for the first agreement are independent of the terms and 
conditions agreed upon for the second agreement. The fact that the 
agreement to manufacture 10 aircraft provides a profit for C 
indicates that a reasonable businessperson would have entered into 
that agreement without entering into the agreement to manufacture 
the additional 20 aircraft.
    Example 12. Classification and completion. In 2001, C, whose 
taxable year ends December 31, agrees to manufacture and install an 
industrial machine for B. C elects under paragraph (f) of this 
section to classify the agreement as a long-term manufacturing 
contract and to account for it using the PCM. The agreement requires 
C to deliver the machine in August 2003 and to install and test the 
machine in B's factory. In addition, the agreement requires B to 
accept the machine when the tests prove that the machine's 
performance will satisfy the environmental standards set by the 
Environmental Protection Agency (EPA),

[[Page 2230]]

even if B has not obtained the required operating permit. Because of 
technical difficulties, C cannot deliver the machine until December 
2003, when B conditionally accepts delivery. C installs the machine 
in December 2003 and then tests it through February 2004. B accepts 
the machine in February 2004, but does not obtain the operating 
permit from the EPA until January 2005. Under paragraph (c)(3)(i)(B) 
of this section, C's contract is finally completed and accepted in 
February 2004, even though B does not obtain the operating permit 
until January 2005, because C completed all its obligations under 
the contract and B accepted the machine in February 2004.


Sec. 1.460-2  Long-term manufacturing contracts.

    (a) In general. Section 460 generally requires a taxpayer to 
determine the income from a long-term manufacturing contract using the 
percentage-of-completion method described in Sec. 1.460-4(b) (PCM). A 
contract not completed in the contracting year is a long-term 
manufacturing contract if it involves the manufacture of personal 
property that is--
    (1) A unique item of a type that is not normally carried in the 
finished goods inventory of the taxpayer; or
    (2) An item that normally requires more than 12 calendar months to 
complete (regardless of the duration of the contract or the time to 
complete a deliverable quantity of the item).
    (b) Unique--(1) In general. Unique means designed for the needs of 
a specific customer. To determine whether an item is designed for the 
needs of a specific customer, a taxpayer must consider the extent to 
which research, development, design, engineering, retooling, and 
similar activities (customizing activities) are required to manufacture 
the item and whether the item could be sold to other customers with 
little or no modification. A contract may require the taxpayer to 
manufacture more than one unit of a unique item. If a contract requires 
a taxpayer to manufacture more than one unit of the same item, the 
taxpayer must determine whether that item is unique by considering the 
customizing activities that would be needed to produce only the first 
unit. For the purposes of this paragraph (b), a taxpayer must consider 
the activities performed on its behalf by a subcontractor.
    (2) Safe harbors. Notwithstanding paragraph (b)(1) of this section, 
an item is not unique if it satisfies one or more of the safe harbors 
in this paragraph (b)(2). If an item does not satisfy one or more safe 
harbors, the determination of uniqueness will depend on the facts and 
circumstances. The safe harbors are:
    (i) Short production period. An item is not unique if it normally 
requires 90 days or less to complete. In the case of a contract for 
multiple units of an item, the item is not unique only if it normally 
requires 90 days or less to complete each unit of the item in the 
contract.
    (ii) Customized item. An item is not unique if the total allocable 
contract costs attributable to customizing activities that are incident 
to or necessary for the manufacture of the item do not exceed 10 
percent of the estimated total allocable contract costs allocable to 
the item. In the case of a contract for multiple units of an item, this 
comparison must be performed on the first unit of the item and the 
total allocable contract costs attributable to customizing activities 
that are incident to or necessary for the manufacture of the item must 
be allocated to the first unit.
    (iii) Inventoried item. A unique item ceases to be unique no later 
than when the taxpayer normally includes similar items in its finished 
goods inventory.
    (c) Normal time to complete--(1) In general. The amount of time 
normally required to complete an item is the item's reasonably expected 
production period, as described in Sec. 1.263A-12, determined at the 
end of the contracting year. Thus, in general, the expected production 
period for an item begins when a taxpayer incurs at least five percent 
of the costs that would be allocable to the item under Sec. 1.460-5 and 
ends when the item is ready to be held for sale and all reasonably 
expected production activities are complete. In the case of components 
that are assembled or reassembled into an item or unit at the 
customer's facility by the taxpayer's employees or agents, the 
production period ends when the components are assembled or reassembled 
into an operable item or unit. To the extent that several distinct 
activities related to the production of the item are expected to occur 
simultaneously, the period during which these distinct activities occur 
is not counted more than once. Furthermore, when determining the normal 
time to complete an item, a taxpayer is not required to consider 
activities performed or costs incurred that would not be allocable 
contract costs under section 460 (e.g., independent research and 
development expenses (as defined in Sec. 1.460-1(b)(9)) and marketing 
expenses). Moreover, the time required to design and manufacture the 
first unit of an item for which the taxpayer intends to produce 
multiple units generally does not indicate the normal time to complete 
the item.
    (2) Production by related parties. To determine the time normally 
required to complete an item, a taxpayer must consider all relevant 
production activities performed and costs incurred by itself and by 
related parties, as defined in Sec. 1.460-1(b)(4). For example, if a 
taxpayer's item requires a component or subassembly manufactured by a 
related party, the taxpayer must consider the time the related party 
takes to complete the component or subassembly and, for purposes of 
determining the beginning of an item's production period, the costs 
incurred by the related party that are allocable to the component or 
subassembly. However, if both requirements of the exception for 
components and subassemblies under Sec. 1.460-1(g)(1)(ii) are 
satisfied, a taxpayer does not consider the activities performed or the 
costs incurred by a related party when determining the normal time to 
complete an item.
    (d) Qualified ship contracts. A taxpayer may determine the income 
from a long-term manufacturing contract that is a qualified ship 
contract using either the PCM or the percentage-of-completion/
capitalized-cost method (PCCM) of accounting described in Sec. 1.460-
4(e). A qualified ship contract is any contract entered into after 
February 28, 1986, to manufacture in the United States not more than 5 
seagoing vessels if the vessels will not be manufactured directly or 
indirectly for the United States Government and if the taxpayer 
reasonably expects to complete the contract within 5 years of the 
contract commencement date. Under Sec. 1.460-1(e)(3)(i), a contract to 
produce more than 5 vessels for which the PCM would be required cannot 
be severed in order to be classified as a qualified ship contract.
    (e) Examples. The following examples illustrate the rules of this 
section:

    Example 1. Unique item and classification. In December 2001, C 
enters into a contract with B to design and manufacture a new type 
of industrial equipment. C reasonably expects the normal production 
period for this type of equipment to be eight months. Because the 
new type of industrial equipment requires a substantial amount of 
research, design, and engineering to produce, C determines that the 
equipment is a unique item and its contract with B is a long-term 
contract. After delivering the equipment to B in September 2002, C 
contracts with B to produce five additional units of that industrial 
equipment with certain different specifications. These additional 
units, which also are expected to take eight months to produce, will 
be delivered to B in 2003. C determines that the research, design,

[[Page 2231]]

engineering, retooling, and similar customizing costs necessary to 
produce the five additional units of equipment does not exceed 10 
percent of the first unit's share of estimated total allocable 
contract costs. Consequently, the additional units of equipment 
satisfy the safe harbor in paragraph (b)(2)(ii) of this section and 
are not unique items. Although C's contract with B to produce the 
five additional units is not completed within the contracting year, 
the contract is not a long-term contract since the additional units 
of equipment are not unique items and do not normally require more 
than 12 months to produce. C must classify its second contract with 
B as a non-long term contract, notwithstanding that it classified 
the previous contract with B for a similar item as a long-term 
contract, because the determination of whether a contract is a long-
term contract is made on a contract-by-contract basis. A change in 
classification is not a change in method of accounting because the 
change in classification results from a change in underlying facts.
    Example 2. 12-month rule--related party. C manufactures cranes. 
C purchases one of the crane's components from R, a related party 
under Sec. 1.460-1(b)(4). Less than 50 percent of R's gross receipts 
attributable to the sale of this component comes from sales to 
unrelated parties; thus, the exception for components and 
subassemblies under Sec. 1.460-1(g)(1)(ii) is not satisfied. 
Consequently, C must consider the activities of R as R incurs costs 
and performs the activities rather than as C incurs a liability to 
R. The normal time period between the time that both C and R incur 
five percent of the costs allocable to the crane and the time that R 
completes the component is five months. C normally requires an 
additional eight months to complete production of the crane after 
receiving the integral component from R. C's crane is an item of a 
type that normally requires more than 12 months to complete under 
paragraph (c) of this section because the production period from the 
time that both C and R incur five percent of the costs allocable to 
the crane until the time that production of the crane is complete is 
normally 13 months.
    Example 3. 12-month rule--duration of contract.  The facts are 
the same as in Example 2, except that C enters into a sales contract 
with B on December 31, 2001 (the last day of C's taxable year), and 
delivers a completed crane to B on February 1, 2002. C's contract 
with B is a long-term contract under paragraph (a)(2) of this 
section because the contract is not completed in the contracting 
year, 2001, and the crane is an item that normally requires more 
than 12 calendar months to complete (regardless of the duration of 
the contract).
    Example 4. 12-month rule--normal time to complete.  The facts 
are the same as in Example 2, except that C (and R) actually 
complete B's crane in only 10 calendar months. The contract is a 
long-term contract because the normal time to complete a crane, not 
the actual time to complete a crane, is the relevant criterion for 
determining whether an item is subject to paragraph (a)(2) of this 
section.
    Example 5. Normal time to complete.  C enters into a multi-unit 
contract to produce four units of an item. C does not anticipate 
producing any additional units of the item. C expects to perform the 
research, design, and development that are directly allocable to the 
particular item and to produce the first unit in the first 24 
months. C reasonably expects the production period for each of the 
three remaining units will be 3 months. This contract is not a 
contract that involves the manufacture of an item that normally 
requires more than 12 months to complete because the normal time to 
complete the item is 3 months. However, the contract does not 
satisfy the 90-day safe harbor for unique items because the normal 
time to complete the first unit of this item exceeds 90 days. Thus, 
the contract might involve the manufacture of a unique item 
depending on the facts and circumstances.


Sec. 1.460-3  Long-term construction contracts.

    (a) In general. Section 460 generally requires a taxpayer to 
determine the income from a long-term construction contract using the 
percentage-of-completion method described in Sec. 1.460-4(b) (PCM). A 
contract not completed in the contracting year is a long-term 
construction contract if it involves the building, construction, 
reconstruction, or rehabilitation of real property; the installation of 
an integral component to real property; or the improvement of real 
property (collectively referred to as construction). Real property 
means land, buildings, and inherently permanent structures, as defined 
in Sec. 1.263A-8(c)(3), such as roadways, dams, and bridges. Real 
property does not include vessels, offshore drilling platforms, or 
unsevered natural products of land. An integral component to real 
property includes property not produced at the site of the real 
property but intended to be permanently affixed to the real property, 
such as elevators and central heating and cooling systems. Thus, for 
example, a contract to install an elevator in a building is a 
construction contract because a building is real property, but a 
contract to install an elevator in a ship is not a construction 
contract because a ship is not real property.
    (b) Exempt construction contracts--(1) In general. The general 
requirement to use the PCM and the cost allocation rules described in 
Sec. 1.460-5(b) or (c) does not apply to any long-term construction 
contract described in this paragraph (b) (exempt construction 
contract). Exempt construction contract means any--
    (i) Home construction contract; and
    (ii) Other construction contract that a taxpayer estimates (when 
entering into the contract) will be completed within 2 years of the 
contract commencement date, provided the taxpayer satisfies the 
$10,000,000 gross receipts test described in paragraph (b)(3) of this 
section.
    (2) Home construction contract--(i) In general. A long-term 
construction contract is a home construction contract if a taxpayer 
(including a subcontractor working for a general contractor) reasonably 
expects to attribute 80 percent or more of the estimated total 
allocable contract costs (including the cost of land, materials, and 
services), determined as of the close of the contracting year, to the 
construction of--
    (A) Dwelling units, as defined in section 168(e)(2)(A)(ii)(I), 
contained in buildings containing 4 or fewer dwelling units (including 
buildings with 4 or fewer dwelling units that also have commercial 
units); and
    (B) Improvements to real property directly related to, and located 
at the site of, the dwelling units.
    (ii) Townhouses and rowhouses. Each townhouse or rowhouse is a 
separate building.
    (iii) Common improvements. A taxpayer includes in the cost of the 
dwelling units their allocable share of the cost that the taxpayer 
reasonably expects to incur for any common improvements (e.g., sewers, 
roads, clubhouses) that benefit the dwelling units and that the 
taxpayer is contractually obligated, or required by law, to construct 
within the tract or tracts of land that contain the dwelling units.
    (iv) Mixed use costs. If a contract involves the construction of 
both commercial units and dwelling units within the same building, a 
taxpayer must allocate the costs among the commercial units and 
dwelling units using a reasonable method or combination of reasonable 
methods, such as specific identification, square footage, or fair 
market value.
    (3) $10,000,000 gross receipts test--(i) In general. Except as 
otherwise provided in paragraphs (b)(3)(ii) and (iii) of this section, 
the $10,000,000 gross receipts test is satisfied if a taxpayer's (or 
predecessor's) average annual gross receipts for the 3 taxable years 
preceding the contracting year do not exceed $10,000,000, as determined 
using the principles of the gross receipts test for small resellers 
under Sec. 1.263A-3(b).
    (ii) Single employer. To apply the gross receipts test, a taxpayer 
is not required to aggregate the gross receipts of persons treated as a 
single employer solely under section 414(m) and any regulations 
prescribed under section 414.
    (iii) Attribution of gross receipts. A taxpayer must aggregate a 
proportionate

[[Page 2232]]

share of the construction-related gross receipts of any person that has 
a five percent or greater interest in the taxpayer. In addition, a 
taxpayer must aggregate a proportionate share of the construction-
related gross receipts of any person in which the taxpayer has a five 
percent or greater interest. For this purpose, a taxpayer must 
determine ownership interests as of the first day of the taxpayer's 
contracting year and must include indirect interests in any 
corporation, partnership, estate, trust, or sole proprietorship 
according to principles similar to the constructive ownership rules 
under sections 1563(e), (f)(2), and (f)(3)(A). However, a taxpayer is 
not required to aggregate under this paragraph (b)(3)(iii) any 
construction-related gross receipts required to be aggregated under 
paragraph (b)(3)(i) of this section.
    (c) Residential construction contracts. A taxpayer may determine 
the income from a long-term construction contract that is a residential 
construction contract using either the PCM or the percentage-of-
completion/capitalized-cost method (PCCM) of accounting described in 
Sec. 1.460-4(e). A residential construction contract is a home 
construction contract, as defined in paragraph (b)(2) of this section, 
except that the building or buildings being constructed contain more 
than 4 dwelling units.
    Par. 7. Section 1.460-4 is amended by adding paragraphs (a) through 
(i) to read as follows:


Sec. 1.460-4  Methods of accounting for long-term contracts.

    (a) Overview. This section prescribes permissible methods of 
accounting for long-term contracts. Paragraph (b) of this section 
describes the percentage-of-completion method under section 460(b) 
(PCM) that a taxpayer generally must use to determine the income from a 
long-term contract. Paragraph (c) of this section lists permissible 
methods of accounting for exempt construction contracts described in 
Sec. 1.460-3(b)(1) and describes the exempt-contract percentage-of-
completion method (EPCM). Paragraph (d) of this section describes the 
completed-contract method (CCM), which is one of the permissible 
methods of accounting for exempt construction contracts. Paragraph (e) 
of this section describes the percentage-of-completion/capitalized-cost 
method (PCCM), which is a permissible method of accounting for 
qualified ship contracts described in Sec. 1.460-2(d) and residential 
construction contracts described in Sec. 1.460-3(c). Paragraph (f) of 
this section provides rules for determining the alternative minimum 
taxable income (AMTI) from long-term contracts that are not exempted 
under section 56. Paragraph (g) of this section provides rules 
concerning consistency in methods of accounting for long-term 
contracts. Paragraph (h) of this section provides examples illustrating 
the principles of this section. Paragraph (j) of this section provides 
rules for taxpayers that file consolidated tax returns.
    (b) Percentage-of-completion method--(1) In general. Under the PCM, 
a taxpayer generally must include in income the portion of the total 
contract price, as defined in paragraph (b)(4)(i) of this section, that 
corresponds to the percentage of the entire contract that the taxpayer 
has completed during the taxable year. The percentage of completion 
must be determined by comparing allocable contract costs incurred with 
estimated total allocable contract costs. Thus, the taxpayer includes a 
portion of the total contract price in gross income as the taxpayer 
incurs allocable contract costs.
    (2) Computations. To determine the income from a long-term 
contract, a taxpayer--
    (i) Computes the completion factor for the contract, which is the 
ratio of the cumulative allocable contract costs that the taxpayer has 
incurred through the end of the taxable year to the estimated total 
allocable contract costs that the taxpayer reasonably expects to incur 
under the contract;
    (ii) Computes the amount of cumulative gross receipts from the 
contract by multiplying the completion factor by the total contract 
price;
    (iii) Computes the amount of current-year gross receipts, which is 
the difference between the amount of cumulative gross receipts for the 
current taxable year and the amount of cumulative gross receipts for 
the immediately preceding taxable year (the difference can be a 
positive or negative number); and
    (iv) Takes both the current-year gross receipts and the allocable 
contract costs incurred during the current year into account in 
computing taxable income.
    (3) Post-completion-year income. If a taxpayer has not included the 
total contract price in gross income by the completion year, as defined 
in Sec. 1.460-1(b)(6), the taxpayer must include the remaining portion 
of the total contract price in gross income for the taxable year 
following the completion year. For the treatment of post-completion 
costs, see paragraph (b)(5)(v) of this section. See Sec. 1.460-
6(c)(1)(ii) for application of the look-back method as a result of 
adjustments to total contract price.
    (4) Total contract price--(i) In general--(A) Definition. Total 
contract price means the amount that a taxpayer reasonably expects to 
receive under a long-term contract, including holdbacks, retainages, 
and cost reimbursements. See Sec. 1.460-6(c)(1)(ii) and (2)(vi) for 
application of the look-back method as a result of changes in total 
contract price.
    (B) Contingent compensation. Any amount related to a contingent 
right under a contract, such as a bonus, award, incentive payment, and 
amount in dispute, is included in total contract price as soon as the 
taxpayer can reasonably predict that the amount will be earned, even if 
the all events test has not yet been met. For example, if a bonus is 
payable to a taxpayer for meeting an early completion date, the bonus 
is includible in total contract price at the time and to the extent 
that the taxpayer can reasonably predict the achievement of the 
corresponding objective. Similarly, a portion of the contract price 
that is in dispute is includible in total contract price at the time 
and to the extent that the taxpayer can reasonably predict that the 
dispute will be resolved in the taxpayer's favor (regardless of when 
the taxpayer actually receives payment or when the dispute is finally 
resolved). Total contract price does not include compensation that 
might be earned under any other agreement that the taxpayer expects to 
obtain from the same customer (e.g., exercised option or follow-on 
contract) if that other agreement is not aggregated under Sec. 1.460-
1(e). For the purposes of this paragraph (b)(4)(i)(B), a taxpayer can 
reasonably predict that an amount of contingent income will be earned 
not later than when the taxpayer includes that amount in income for 
financial reporting purposes under generally accepted accounting 
principles. If a taxpayer has not included an amount of contingent 
compensation in total contract price under this paragraph (b)(4)(i) by 
the taxable year following the completion year, the taxpayer must 
account for that amount of contingent compensation using a permissible 
method of accounting. If it is determined after the taxable year 
following the completion year that an amount included in total contract 
price will not be earned, the taxpayer should deduct that amount in the 
year of the determination.
    (C) Non-long-term contract activities. Total contract price 
includes an allocable share of the gross receipts attributable to a 
non-long-term contract activity, as defined in Sec. 1.460-1(d)(2), if 
the activity is incident to or necessary

[[Page 2233]]

for the manufacture, building, installation, or construction of the 
subject matter of the long-term contract. Total contract price also 
includes amounts reimbursed for independent research and development 
expenses (as defined in Sec. 1.460-1(b)(9)), or for bidding and 
proposal costs, under a federal or cost-plus long-term contract (as 
defined in section 460(d)), regardless of whether the research and 
development, or bidding and proposal, activities are incident to or 
necessary for the performance of that long-term contract.
    (ii) Estimating total contract price. A taxpayer must estimate the 
total contract price based upon all the facts and circumstances known 
as of the last day of the taxable year. For this purpose, an event that 
occurs after the end of the taxable year must be taken into account if 
its occurrence was reasonably predictable and its income was subject to 
reasonable estimation as of the last day of that taxable year.
    (5) Completion factor--(i) Allocable contract costs. A taxpayer 
must use a cost allocation method permitted under either Sec. 1.460-
5(b) or (c) to determine the amount of cumulative allocable contract 
costs and estimated total allocable contract costs that are used to 
determine a contract's completion factor. Allocable contract costs 
include a reimbursable cost that is allocable to the contract.
    (ii) Cumulative allocable contract costs. To determine a contract's 
completion factor for a taxable year, a taxpayer must take into account 
the cumulative allocable contract costs that have been incurred, as 
defined in Sec. 1.460-1(b)(8), through the end of the taxable year.
    (iii) Estimating total allocable contract costs. A taxpayer must 
estimate total allocable contract costs for each long-term contract 
based upon all the facts and circumstances known as of the last day of 
the taxable year. For this purpose, an event that occurs after the end 
of the taxable year must be taken into account if its occurrence was 
reasonably predictable and its cost was subject to reasonable 
estimation as of the last day of that taxable year. To be considered 
reasonable, an estimate of total allocable contract costs must include 
costs attributable to delay, rework, change orders, technology or 
design problems, or other problems that reasonably can be predicted 
considering the nature of the contract and prior experience. However, 
estimated total allocable contract costs do not include any contingency 
allowance for costs that, as of the end of the taxable year, are not 
reasonably predicted to be incurred in the performance of the contract. 
For example, estimated total allocable contract costs do not include 
any costs attributable to factors not reasonably predictable at the end 
of the taxable year, such as third-party litigation, extreme weather 
conditions, strikes, and delays in securing required permits and 
licenses. In addition, the estimated costs of performing other 
agreements that are not aggregated with the contract under Sec. 1.460-
1(e) that the taxpayer expects to incur with the same customer (e.g., 
follow-on contracts) are not included in estimated total allocable 
contract costs for the initial contract.
    (iv) Pre-contracting-year costs. If a taxpayer reasonably expects 
to enter into a long-term contract in a future taxable year, the 
taxpayer must capitalize all costs incurred prior to entering into the 
contract that will be allocable to that contract (e.g., bidding and 
proposal costs). A taxpayer is not required to compute a completion 
factor, or to include in gross income any amount, related to allocable 
contract costs for any taxable year ending before the contracting year 
or, if applicable, the 10-percent year defined in paragraph (b)(6)(i) 
of this section. In that year, the taxpayer is required to compute a 
completion factor that includes all allocable contract costs that have 
been incurred as of the end of that taxable year (whether previously 
capitalized or deducted) and to take into account in computing taxable 
income the related gross receipts and the previously capitalized 
allocable contract costs. If, however, a taxpayer determines in a 
subsequent year that it will not enter into the long-term contract, the 
taxpayer must account for these pre-contracting-year costs in that year 
(e.g., as a deduction or an inventoriable cost) using the appropriate 
rules contained in other sections of the Code or regulations.
    (v) Post-completion-year costs. If a taxpayer incurs an allocable 
contract cost after the completion year, the taxpayer must account for 
that cost using a permissible method of accounting. See Sec. 1.460-
6(c)(1)(ii) for application of the look-back method as a result of 
adjustments to allocable contract costs.
    (6) 10-percent method--(i) In general. Instead of determining the 
income from a long-term contract beginning with the contracting year, a 
taxpayer may elect to use the 10-percent method under section 
460(b)(5). Under the 10-percent method, a taxpayer does not include in 
gross income any amount related to allocable contract costs until the 
taxable year in which the taxpayer has incurred at least 10 percent of 
the estimated total allocable contract costs (10-percent year). A 
taxpayer must treat costs incurred before the 10-percent year as pre-
contracting-year costs described in paragraph (b)(5)(iv) of this 
section.
    (ii) Election. A taxpayer makes an election under this paragraph 
(b)(6) by using the 10-percent method for all long-term contracts 
entered into during the taxable year of the election on its original 
federal income tax return for the election year. This election is a 
method of accounting and, thus, applies to all long-term contracts 
entered into during and after the taxable year of the election. An 
electing taxpayer must use the 10-percent method to apply the look-back 
method under Sec. 1.460-6 and to determine alternative minimum taxable 
income under paragraph (f) of this section. This election is not 
available if a taxpayer uses the simplified cost-to-cost method 
described in Sec. 1.460-5(c) to compute the completion factor of a 
long-term contract.
    (7) Terminated contract--(i) Reversal of income. If a long-term 
contract is terminated before completion and, as a result, the taxpayer 
retains ownership of the property that is the subject matter of that 
contract, the taxpayer must reverse the transaction in the taxable year 
of termination. To reverse the transaction, the taxpayer reports a loss 
(or gain) equal to the cumulative allocable contract costs reported 
under the contract in all prior taxable years less the cumulative gross 
receipts reported under the contract in all prior taxable years.
    (ii) Adjusted basis. As a result of reversing the transaction under 
paragraph (b)(7)(i) of this section, a taxpayer will have an adjusted 
basis in the retained property equal to the cumulative allocable 
contract costs reported under the contract in all prior taxable years. 
However, if the taxpayer received and retains any consideration or 
compensation from the customer, the taxpayer must reduce the adjusted 
basis in the retained property (but not below zero) by the fair market 
value of that consideration or compensation. To the extent that the 
amount of the consideration or compensation described in the preceding 
sentence exceeds the adjusted basis in the retained property, the 
taxpayer must include the excess in gross income for the taxable year 
of termination.
    (iii) Look-back method. The look-back method does not apply to a 
terminated contract that is subject to this paragraph (b)(7).
    (c) Exempt contract methods--(1) In general. An exempt contract 
method means the method of accounting that a

[[Page 2234]]

taxpayer must use to account for all its long-term contracts (and any 
portion of a long-term contract) that are exempt from the requirements 
of section 460(a). Thus, an exempt contract method applies to exempt 
construction contracts, as defined in Sec. 1.460-3(b); the non-PCM 
portion of a qualified ship contract, as defined in Sec. 1.460-2(d); 
and the non-PCM portion of a residential construction contract, as 
defined in Sec. 1.460-3(c). Permissible exempt contract methods include 
the PCM, the EPCM described in paragraph (c)(2) of this section, the 
CCM described in paragraph (d) of this section, or any other 
permissible method. See section 446.
    (2) Exempt-contract percentage-of-completion method--(i) In 
general. Similar to the PCM described in paragraph (b) of this section, 
a taxpayer using the EPCM generally must include in income the portion 
of the total contract price, as described in paragraph (b)(4) of this 
section, that corresponds to the percentage of the entire contract that 
the taxpayer has completed during the taxable year. However, under the 
EPCM, the percentage of completion may be determined as of the end of 
the taxable year by using any method of cost comparison (such as 
comparing direct labor costs incurred to date to estimated total direct 
labor costs) or by comparing the work performed on the contract with 
the estimated total work to be performed, rather than by using the 
cost-to-cost comparison required by paragraphs (b)(2)(i) and (5) of 
this section, provided such method is used consistently and clearly 
reflects income. In addition, paragraph (b)(3) of this section 
(regarding post-completion-year income), paragraph (b)(6) of this 
section (regarding the 10-percent method) and Sec. 1.460-6 (regarding 
the look-back method) do not apply to the EPCM.
    (ii) Determination of work performed. For purposes of the EPCM, the 
criteria used to compare the work performed on a contract as of the end 
of the taxable year with the estimated total work to be performed must 
clearly reflect the earning of income with respect to the contract. For 
example, in the case of a roadbuilder, a standard of completion solely 
based on miles of roadway completed in a case where the terrain is 
substantially different may not clearly reflect the earning of income 
with respect to the contract.
    (d) Completed-contract method--(1) In general. Except as otherwise 
provided in paragraph (d)(4) of this section, a taxpayer using the CCM 
to account for a long-term contract must take into account in the 
contract's completion year, as defined in Sec. 1.460-1(b)(6), the gross 
contract price and all allocable contract costs incurred by the 
completion year. A taxpayer may not treat the cost of any materials and 
supplies that are allocated to a contract, but actually remain on hand 
when the contract is completed, as an allocable contract cost.
    (2) Post-completion-year income and costs. If a taxpayer has not 
included an item of contingent compensation (i.e., amounts for which 
the all events test has not been satisfied) in gross contract price 
under paragraph (d)(3) of this section by the completion year, the 
taxpayer must account for this item of contingent compensation using a 
permissible method of accounting. If a taxpayer incurs an allocable 
contract cost after the completion year, the taxpayer must account for 
that cost using a permissible method of accounting.
    (3) Gross contract price. Gross contract price includes all amounts 
(including holdbacks, retainages, and reimbursements) that a taxpayer 
is entitled by law or contract to receive, whether or not the amounts 
are due or have been paid. In addition, gross contract price includes 
all bonuses, awards, and incentive payments, such as a bonus for 
meeting an early completion date, to the extent the all events test is 
satisfied. If a taxpayer performs a non-long-term contract activity, as 
defined in Sec. 1.460-1(d)(2), that is incident to or necessary for the 
manufacture, building, installation, or construction of the subject 
matter of one or more of the taxpayer's long-term contracts, the 
taxpayer must include an allocable share of the gross receipts 
attributable to that activity in the gross contract price of the 
contract(s) benefitted by that activity. Gross contract price also 
includes amounts reimbursed for independent research and development 
expenses (as defined in Sec. 1.460-1(b)(9)), or bidding and proposal 
costs, under a federal or cost-plus long-term contract (as defined in 
section 460(d)), regardless of whether the research and development, or 
bidding and proposal, activities are incident to or necessary for the 
performance of that long-term contract.
    (4) Contracts with disputed claims--(i) In general. The special 
rules in this paragraph (d)(4) apply to a long-term contract accounted 
for using the CCM with a dispute caused by a customer's requesting a 
reduction of the gross contract price or the performance of additional 
work under the contract or by a taxpayer's requesting an increase in 
gross contract price, or both, on or after the date a taxpayer has 
tendered the subject matter of the contract to the customer.
    (ii) Taxpayer assured of profit or loss. If the disputed amount 
relates to a customer's claim for either a reduction in price or 
additional work and the taxpayer is assured of either a profit or a 
loss on a long-term contract regardless of the outcome of the dispute, 
the gross contract price, reduced (but not below zero) by the amount 
reasonably in dispute, must be taken into account in the completion 
year. If the disputed amount relates to a taxpayer's claim for an 
increase in price and the taxpayer is assured of either a profit or a 
loss on a long-term contract regardless of the outcome of the dispute, 
the gross contract price must be taken into account in the completion 
year. If the taxpayer is assured a profit on the contract, all 
allocable contract costs incurred by the end of the completion year are 
taken into account in that year. If the taxpayer is assured a loss on 
the contract, all allocable contract costs incurred by the end of the 
completion year, reduced by the amount reasonably in dispute, are taken 
into account in the completion year.
    (iii) Taxpayer unable to determine profit or loss. If the amount 
reasonably in dispute affects so much of the gross contract price or 
allocable contract costs that a taxpayer cannot determine whether a 
profit or loss ultimately will be realized from a long-term contract, 
the taxpayer may not take any of the gross contract price or allocable 
contract costs into account in the completion year.
    (iv) Dispute resolved. Any part of the gross contract price and any 
allocable contract costs that have not been taken into account because 
of the principles described in paragraph (d)(4)(i), (ii), or (iii) of 
this section must be taken into account in the taxable year in which 
the dispute is resolved. If a taxpayer performs additional work under 
the contract because of the dispute, the term taxable year in which the 
dispute is resolved means the taxable year the additional work is 
completed, rather than the taxable year in which the outcome of the 
dispute is determined by agreement, decision, or otherwise.
    (e) Percentage-of-completion/capitalized-cost method. Under the 
PCCM, a taxpayer must determine the income from a long-term contract 
using the PCM for the applicable percentage of the contract and its 
exempt contract method, as defined in paragraph (c) of this section, 
for the remaining percentage of the contract. For residential 
construction contracts described in Sec. 1.460-3(c), the applicable 
percentage is 70 percent, and the

[[Page 2235]]

remaining percentage is 30 percent. For qualified ship contracts 
described in Sec. 1.460-2(d), the applicable percentage is 40 percent, 
and the remaining percentage is 60 percent.
    (f) Alternative minimum taxable income--(1) In general. Under 
section 56(a)(3), a taxpayer (not exempt from the AMT under section 
55(e)) must use the PCM to determine its AMTI from any long-term 
contract entered into on or after March 1, 1986, that is not a home 
construction contract, as defined in Sec. 1.460-3(b)(2). For AMTI 
purposes, the PCM must include any election under paragraph (b)(6) of 
this section (concerning the 10-percent method) or under Sec. 1.460-
5(c) (concerning the simplified cost-to-cost method) that the taxpayer 
has made for regular tax purposes. For exempt construction contracts 
described in Sec. 1.460-3(b)(1)(ii), a taxpayer must use the simplified 
cost-to-cost method to determine the completion factor for AMTI 
purposes. Except as provided in paragraph (f)(2) of this section, a 
taxpayer must use AMTI costs and AMTI methods, such as the depreciation 
method described in section 56(a)(1), to determine the completion 
factor of a long-term contract (except a home construction contract) 
for AMTI purposes.
    (2) Election to use regular completion factors. Under this 
paragraph (f)(2), a taxpayer may elect for AMTI purposes to determine 
the completion factors of all of its long-term contracts using the 
methods of accounting and allocable contract costs used for regular 
federal income tax purposes. A taxpayer makes this election by using 
regular methods and regular costs to compute the completion factors of 
all long-term contracts entered into during the taxable year of the 
election for AMTI purposes on its original federal income tax return 
for the election year. This election is a method of accounting and, 
thus, applies to all long-term contracts entered into during and after 
the taxable year of the election. Although a taxpayer may elect to 
compute the completion factor of its long-term contracts using regular 
methods and regular costs, an election under this paragraph (f)(2) does 
not eliminate a taxpayer's obligation to comply with the requirements 
of section 55 when computing AMTI. For example, although a taxpayer may 
elect to use the depreciation methods used for regular tax purposes to 
compute the completion factor of its long-term contracts for AMTI 
purposes, the taxpayer must use the depreciation methods permitted by 
section 56 to compute AMTI.
    (g) Method of accounting. A taxpayer that uses the PCM, EPCM, CCM, 
PCCM, or elects the 10-percent method or special AMTI method (or 
changes to another method of accounting with the Commissioner's 
consent) must apply the method(s) consistently for all similarly 
classified long-term contracts, until the taxpayer obtains the 
Commissioner's consent under section 446(e) to change to another method 
of accounting. A taxpayer-initiated change in method of accounting will 
be permitted only on a cut-off basis (i.e., for contracts entered into 
on or after the year of change), and thus, a section 481(a) adjustment 
will not be permitted or required.
    (h) Examples. The following examples illustrate the rules of this 
section:

    Example 1. PCM--estimating total contract price. C, whose 
taxable year ends December 31, determines the income from long-term 
contracts using the PCM. On January 1, 2001, C enters into a 
contract to design and manufacture a satellite (a unique item). The 
contract provides that C will be paid $10,000,000 for delivering the 
completed satellite by December 1, 2002. The contract also provides 
that C will receive a $3,000,000 bonus for delivering the satellite 
by July 1, 2002, and an additional $4,000,000 bonus if the satellite 
successfully performs its mission for five years. C is unable to 
reasonably predict if the satellite will successfully perform its 
mission for five years. If on December 31, 2001, C should reasonably 
expect to deliver the satellite by July 1, 2002, the estimated total 
contract price is $13,000,000 ($10,000,000 unit price + $3,000,000 
production-related bonus). Otherwise, the estimated total contract 
price is $10,000,000. In either event, the $4,000,000 bonus is not 
includible in the estimated total contract price as of December 31, 
2001, because C is unable to reasonably predict that the satellite 
will successfully perform its mission for five years.
    Example 2. PCM--computing income. (i) C, whose taxable year ends 
December 31, determines the income from long-term contracts using 
the PCM. During 2001, C agrees to manufacture for the customer, B, a 
unique item for a total contract price of $1,000,000. Under C's 
contract, B is entitled to retain 10 percent of the total contract 
price until it accepts the item. By the end of 2001, C has incurred 
$200,000 of allocable contract costs and estimates that the total 
allocable contract costs will be $800,000. By the end of 2002, C has 
incurred $600,000 of allocable contract costs and estimates that the 
total allocable contract costs will be $900,000. In 2003, after 
completing the contract, C determines that the actual cost to 
manufacture the item was $750,000.
    (ii) For each of the taxable years, C's income from the contract 
is computed as follows:

------------------------------------------------------------------------
                                              Taxable Year
                               -----------------------------------------
                                    2001          2002          2003
------------------------------------------------------------------------
(A) Cumulative incurred costs.     $200,000      $600,000      $750,000
(B) Estimated total costs.....      800,000       900,000       750,000
                               -----------------------------------------
(C) Completion factor: (A)           25.00%        66.67%       100.00%
  (B).................
                               -----------------------------------------
(D) Total contract price......    1,000,000     1,000,000     1,000,000
                               -----------------------------------------
(E) Cumulative gross receipts:      250,000       666,667     1,000,000
 (C)  x  (D)..................
(F) Cumulative gross receipts            (0)     (250,000)     (666,667)
 (prior year).................
                               -----------------------------------------
(G) Current-year gross              250,000       416,667       333,333
 receipts.....................
                               -----------------------------------------
(H) Cumulative incurred costs.      200,000       600,000       750,000
(I) Cumulative incurred costs            (0)     (200,000)     (600,000)
 (prior year).................
                               -----------------------------------------
(J) Current-year costs........      200,000       400,000       150,000
                               -----------------------------------------
(K) Gross income: (G) - (J)...      $50,000       $16,667      $183,333
------------------------------------------------------------------------


[[Page 2236]]

    Example 3. PCM--computing income with cost sharing. (i) C, whose 
taxable year ends December 31, determines the income from long-term 
contracts using the PCM. During 2001, C enters into a contract to 
manufacture a unique item. The contract specifies a target price of 
$1,000,000, a target cost of $600,000, and a target profit of 
$400,000. C and B will share the savings of any cost underrun 
(actual total incurred cost is less than target cost) and the 
additional cost of any cost overrun (actual total incurred cost is 
greater than target cost) as follows: 30 percent to C and 70 percent 
to B. By the end of 2001, C has incurred $200,000 of allocable 
contract costs and estimates that the total allocable contract costs 
will be $600,000. By the end of 2002, C has incurred $300,000 of 
allocable contract costs and estimates that the total allocable 
contract costs will be $400,000. In 2003, after completing the 
contract, C determines that the actual cost to manufacture the item 
was $700,000.
    (ii) For each of the taxable years, C's income from the contract 
is computed as follows (note that the sharing of any cost underrun 
or cost overrun is reflected as an adjustment to C's target price 
under paragraph (b)(4)(i) of this section):

------------------------------------------------------------------------
                                              Taxable Year
                               -----------------------------------------
                                    2001          2002          2003
------------------------------------------------------------------------
(A) Cumulative incurred costs.     $200,000      $300,000      $700,000
(B) Estimated total costs.....      600,000       400,000       700,000
                               -----------------------------------------
(C) Completion factor: (A)           33.33%        75.00%       100.00%
  (B).................
                               =========================================
(D) Target price..............   $1,000,000    $1,000,000    $1,000,000
                               -----------------------------------------
(E) Estimated total costs.....      600,000       400,000       700,000
(F) Target costs..............      600,000       600,000       600,000
                               -----------------------------------------
(G) Cost (underrun)/overrun:              0      (200,000)      100,000
 (E) - (F)....................
(H) Adjustment rate...........          70%           70%           70%
                               -----------------------------------------
(I) Target price adjustment...            0      (140,000)       70,000
                               -----------------------------------------
(J) Total contract price: (D)    $1,000,000      $860,000    $1,070,000
 + (I)........................
                               =========================================
(K) Cumulative gross receipts:     $333,333      $645,000    $1,070,000
 (C)  x  (J)..................
(L) Cumulative gross receipts            (0)     (333,333)     (645,000)
 (prior year):................
                               -----------------------------------------
(M) Current-year gross              333,333       311,667       425,000
 receipts.....................
                               -----------------------------------------
(N) Cumulative incurred costs.      200,000       300,000       700,000
(O) Cumulative incurred costs            (0)     (200,000)     (300,000)
 (prior year):................
                               -----------------------------------------
(P) Current-year costs........      200,000       100,000       400,000
                               -----------------------------------------
(Q) Gross income: (M) - (P)...     $133,333      $211,667       $25,000
------------------------------------------------------------------------

    Example 4. PCM--10 percent method. (i) C, whose taxable year 
ends December 31, determines the income from long-term contracts 
using the PCM. In November 2001, C agrees to manufacture a unique 
item for $1,000,000. C reasonably estimates that the total allocable 
contract costs will be $600,000. By December 31, 2001, C has 
received $50,000 in progress payments and incurred $40,000 of costs. 
C elects to use the 10 percent method effective for 2001 and all 
subsequent taxable years. During 2002, C receives $500,000 in 
progress payments and incurs $260,000 of costs. In 2003, C incurs an 
additional $300,000 of costs, C finishes manufacturing the item, and 
receives the final $450,000 payment.
    (ii) For each of the taxable years, C's income from the contract 
is computed as follows:

------------------------------------------------------------------------
                                              Taxable Year
                               -----------------------------------------
                                    2001          2002          2003
------------------------------------------------------------------------
(A) Cumulative incurred costs.      $40,000      $300,000      $600,000
(B) Estimated total costs.....      600,000       600,000       600,000
                               -----------------------------------------
(C) Completion factor (A)             6.67%        50.00%       100.00%
  (B).................
                               -----------------------------------------
(D) Total contract price......    1,000,000     1,000,000     1,000,000
                               -----------------------------------------
(E) Cumulative gross receipts:            0       500,000     1,000,000
 (C)  x  (D)*.................
(F) Cumulative gross receipts            (0)           (0)     (500,000)
 (prior year):................
                               -----------------------------------------
(G) Current-year gross                    0       500,000       500,000
 receipts.....................
                               -----------------------------------------
(H) Cumulative incurred costs.            0       300,000       600,000
(I) Cumulative incurred costs            (0)           (0)     (300,000)
 (prior year):................
                               -----------------------------------------
(J) Current-year costs........            0       300,000       300,000
                               -----------------------------------------
(K) Gross income: (G) - (J)...           $0      $200,000     $200,000
------------------------------------------------------------------------
*Unless (C) 10 percent.


[[Page 2237]]

    Example 5. PCM--contract terminated. C, whose taxable year ends 
December 31, determines the income from long-term contracts using 
the PCM. During 2001, C buys land and begins constructing a building 
that will contain 50 condominium units on that land. C enters into a 
contract to sell one unit in this condominium to B for $240,000. B 
gives C a $5,000 deposit toward the purchase price. By the end of 
2001, C has incurred $50,000 of allocable contract costs on B's unit 
and estimates that the total allocable contract costs on B's unit 
will be $150,000. Thus, for 2001, C reports gross receipts of 
$80,000 ($50,000  $150,000  x  $240,000), current-year costs 
of $50,000, and gross income of $30,000 ($80,000--$50,000). In 2002, 
after C has incurred an additional $25,000 of allocable contract 
costs on B's unit, B files for bankruptcy protection and defaults on 
the contract with C, who is permitted to keep B's $5,000 deposit as 
liquidated damages. In 2002, C reverses the transaction with B under 
paragraph (b)(7) of this section and reports a loss of $30,000 
($50,000-$80,000). In addition, C obtains an adjusted basis in the 
unit sold to B of $70,000 ($50,000 (current-year costs deducted in 
2001)--$5,000 (B's forfeited deposit) + $25,000 (current-year costs 
incurred in 2002). C may not apply the look-back method to this 
contract in 2002.
    Example 6. CCM--contracts with disputes from customer claims. In 
2001, C, whose taxable year ends December 31, uses the CCM to 
account for exempt construction contracts. C enters into a contract 
to construct a bridge for B. The terms of the contract provide for a 
$1,000,000 gross contract price. C finishes the bridge in 2002 at a 
cost of $950,000. When B examines the bridge, B insists that C 
either repaint several girders or reduce the contract price. The 
amount reasonably in dispute is $10,000. In 2003, C and B resolve 
their dispute, C repaints the girders at a cost of $6,000, and C and 
B agree that the contract price is not to be reduced. Because C is 
assured a profit of $40,000 ($1,000,000--$10,000--$950,000) in 2002 
even if the dispute is resolved in B's favor, C must take this 
$40,000 into account in 2002. In 2003, C will earn an additional 
$4,000 profit ($1,000,000--$956,000--$40,000) from the contract with 
B. Thus, C must take into account an additional $10,000 of gross 
contract price and $6,000 of additional contract costs in 2003.
    Example 7. CCM--contracts with disputes from taxpayer claims. In 
2003, C, whose taxable year ends December 31, uses the CCM to 
account for exempt construction contracts. C enters into a contract 
to construct a building for B. The terms of the contract provide for 
a $1,000,000 gross contract price. C finishes the building in 2004 
at a cost of $1,005,000. B examines the building in 2004 and agrees 
that it meets the contract's specifications; however, at the end of 
2004, C and B are unable to agree on the merits of C's claim for an 
additional $10,000 for items that C alleges are changes in contract 
specifications and B alleges are within the scope of the contract's 
original specifications. In 2005, B agrees to pay C an additional 
$2,000 to satisfy C's claims under the contract. Because the amount 
in dispute affects so much of the gross contract price that C cannot 
determine in 2004 whether a profit or loss will ultimately be 
realized, C may not taken any of the gross contract price or 
allocable contract costs into account in 2004. C must take into 
account $1,002,000 of gross contract price and $1,005,000 of 
allocable contract costs in 2005.
    Example 8. CCM--contracts with disputes from taxpayer and 
customer claims. C, whose taxable year ends December 31, uses the 
CCM to account for exempt construction contracts. C constructs a 
factory for B pursuant to a long-term contract. Under the terms of 
the contract, B agrees to pay C a total of $1,000,000 for 
construction of the factory. C finishes construction of the factory 
in 2002 at a cost of $1,020,000. When B takes possession of the 
factory and begins operations in December 2002, B is dissatisfied 
with the location and workmanship of certain heating ducts. As of 
the end of 2002, C contends that the heating ducts are constructed 
in accordance with contract specifications. The amount of the gross 
contract price reasonably in dispute with respect to the heating 
ducts is $6,000. As of this time, C is claiming $14,000 in addition 
to the original contract price for certain changes in contract 
specifications which C alleges have increased his costs. B denies 
that these changes have increased C's costs. In 2003, the disputes 
between C and B are resolved by performance of additional work by C 
at a cost of $1,000 and by an agreement that the contract price 
would be revised downward to $996,000. Under these circumstances, C 
must include in his gross income for 2002, $994,000 (the gross 
contract price less the amount reasonably in dispute because of B's 
claim, or $1,000,000--$6,000). In 2002, C must also take into 
account $1,000,000 of allocable contract costs (costs incurred less 
the amounts in dispute attributable to both B's and C's claims, or 
$1,020,000--$6,000--$14,000). In 2003, C must take into account an 
additional $2,000 of gross contract price ($996,000--$994,000) and 
$21,000 of allocable contract costs ($1,021,000--$1,000,000).

    (i) [Reserved]
* * * * *
    (k) Mid-contract change in taxpayer. [Reserved]
    Par. 8. Section 1.460-5 is added to read as follows:


Sec. 1.460-5  Cost allocation rules.

    (a) Overview. This section prescribes methods of allocating costs 
to long-term contracts accounted for using the percentage-of-completion 
method described in Sec. 1.460-4(b) (PCM), the completed-contract 
method described in Sec. 1.460-4(d) (CCM), or the percentage-of-
completion/capitalized-cost method described in Sec. 1.460-4(e) (PCCM). 
Exempt construction contracts described in Sec. 1.460-3(b) accounted 
for using a method other than the PCM or CCM are not subject to the 
cost allocation rules of this section (other than the requirement to 
allocate production-period interest under paragraph (b)(2)(v) of this 
section). Paragraph (b) of this section describes the regular cost 
allocation methods for contracts subject to the PCM. Paragraph (c) of 
this section describes an elective simplified cost allocation method 
for contracts subject to the PCM. Paragraph (d) of this section 
describes the cost allocation methods for exempt construction contracts 
reported using the CCM. Paragraph (e) of this section describes the 
cost allocation rules for contracts subject to the PCCM. Paragraph (f) 
of this section describes additional rules applicable to the cost 
allocation methods described in this section. Paragraph (g) of this 
section provides rules concerning consistency in method of allocating 
costs to long-term contracts.
    (b) Cost allocation method for contracts subject to PCM--(1) In 
general. Except as otherwise provided in paragraph (b)(2) of this 
section, a taxpayer must allocate costs to each long-term contract 
subject to the PCM in the same manner that direct and indirect costs 
are capitalized to property produced by a taxpayer under Sec. 1.263A-
1(e) through (h). Thus, a taxpayer must allocate to each long-term 
contract subject to the PCM all direct costs and certain indirect costs 
properly allocable to the long-term contract (i.e., all costs that 
directly benefit or are incurred by reason of the performance of the 
long-term contract). However, see paragraph (c) of this section 
concerning an election to allocate contract costs using the simplified 
cost-to-cost method. As in section 263A, the use of the practical 
capacity concept is not permitted. See Sec. 1.263A-2(a)(4).
    (2) Special rules--(i) Direct material costs. The costs of direct 
materials must be allocated to a long-term contract when dedicated to 
the contract under principles similar to those in Sec. 1.263A-11(b)(2). 
Thus, a taxpayer dedicates direct materials by associating them with a 
specific contract, including by purchase order, entry on books and 
records, or shipping instructions. A taxpayer maintaining inventories 
under Sec. 1.471-1 must determine allocable contract costs attributable 
to direct materials using its method of accounting for those 
inventories (e.g., FIFO, LIFO, specific identification).
    (ii) Components and subassemblies. The costs of a component or 
subassembly (component) produced by the taxpayer must be allocated to a 
long-term contract as the taxpayer incurs costs to produce the 
component if the taxpayer reasonably expects to incorporate the 
component into the subject matter of the contract. Similarly,

[[Page 2238]]

the cost of a purchased component (including a component purchased from 
a related party) must be allocated to a long-term contract as the 
taxpayer incurs the cost to purchase the component if the taxpayer 
reasonably expects to incorporate the component into the subject matter 
of the contract. In all other cases, the cost of a component must be 
allocated to a long-term contract when the component is dedicated, 
under principles similar to those in Sec. 1.263A-11(b)(2). A taxpayer 
maintaining inventories under Sec. 1.471-1 must determine allocable 
contract costs attributable to components using its method of 
accounting for those inventories (e.g., FIFO, LIFO, specific 
identification).
    (iii) Simplified production methods. A taxpayer may not determine 
allocable contract costs using the simplified production methods 
described in Sec. 1.263A-2(b) and (c).
    (iv) Costs identified under cost-plus long-term contracts and 
federal long-term contracts. To the extent not otherwise allocated to 
the contract under this paragraph (b), a taxpayer must allocate any 
identified costs to a cost-plus long-term contract or federal long-term 
contract (as defined in section 460(d)). Identified cost means any 
cost, including a charge representing the time-value of money, 
identified by the taxpayer or related person as being attributable to 
the taxpayer's cost-plus long-term contract or federal long-term 
contract under the terms of the contract itself or under federal, 
state, or local law or regulation.
    (v) Interest--(A) In general. If property produced under a long-
term contract is designated property, as defined in Sec. 1.263A-8(b) 
(without regard to the exclusion for long-term contracts under 
Sec. 1.263A-8(d)(2)(v)), a taxpayer must allocate interest incurred 
during the production period to the long-term contract in the same 
manner as interest is allocated to property produced by a taxpayer 
under section 263A(f). See Secs. 1.263A-8 to 1.263A-12 generally.
    (B) Production period. Notwithstanding Sec. 1.263A-12(c) and (d), 
for purposes of this paragraph (b)(2)(v), the production period of a 
long-term contract--
    (1) Begins on the later of--
    (i) The contract commencement date, as defined in Sec. 1.460-
1(b)(7); or
    (ii) For a taxpayer using the accrual method of accounting for 
long-term contracts, the date by which 5 percent or more of the total 
estimated costs, including design and planning costs, under the 
contract have been incurred; and
    (2) Ends on the date that the contract is completed, as defined in 
Sec. 1.460-1(c)(3).
    (C) Application of section 263A(f). For purposes of this paragraph 
(b)(2)(v), section 263A(f)(1)(B)(iii) (regarding an estimated 
production period exceeding 1 year and a cost exceeding $1,000,000) 
must be applied on a contract-by-contract basis; except that, in the 
case of a taxpayer using an accrual method of accounting, that section 
must be applied on a property-by-property basis.
    (vi) Research and experimental expenses. Notwithstanding 
Sec. 1.263A-1(e)(3)(ii)(P) and (iii)(B), a taxpayer must allocate 
research and experimental expenses, other than independent research and 
development expenses (as defined in Sec. 1.460-1(b)(9)), to its long-
term contracts.
    (vii) Service costs--(A) Simplified service cost method--(1) In 
general. To use the simplified service cost method under Sec. 1.263A-
1(h), a taxpayer must allocate the otherwise capitalizable mixed 
service costs among its long-term contracts using a reasonable method. 
For example, otherwise capitalizable mixed service costs may be 
allocated to each long-term contract based on labor hours or contract 
costs allocable to the contract. To be considered reasonable, an 
allocation method must be applied consistently and must not 
disproportionately allocate service costs to contracts expected to be 
completed in the near future.
    (2) Example. The following example illustrates the rule of this 
paragraph (b)(2)(vii)(A):

    Example. Simplified service cost method. During 2001, C, whose 
taxable year ends December 31, produces electronic equipment for 
inventory and enters into long-term contracts to manufacture 
specialized electronic equipment. C's method of allocating mixed 
service costs to the property it produces is the labor-based, 
simplified service cost method described in Sec. 1.263A-1(h)(4). For 
2001, C's total mixed service costs are $100,000, C's section 263A 
labor costs are $500,000, C's section 460 labor costs (i.e., labor 
costs allocable to C's long-term contracts) are $250,000, and C's 
total labor costs are $1,000,000. To determine the amount of mixed 
service costs capitalizable under section 263A for 2001, C 
multiplies its total mixed service costs by its section 263A 
allocation ratio (section 263A labor costs  total labor 
costs). Thus, C's capitalizable mixed service costs for 2001 are 
$50,000 ($100,000 x $500,000  $1,000,000). Thereafter, C 
allocates its capitalizable mixed service costs to produced property 
remaining in ending inventory using its 263A allocation method 
(e.g., burden rate, simplified production). Similarly, to determine 
the amount of mixed service costs that are allocable to C's long-
term contracts for 2001, C multiplies its total mixed service costs 
by its section 460 allocation ratio (section 460 labor  
total labor costs). Thus, C's allocable mixed service contract costs 
for 2001 are $25,000 ($100,000 x $250,000  $1,000,000). 
Thereafter, C allocates its allocable mixed service costs to its 
long-term contracts proportionately based on its section 460 labor 
costs allocable to each long-term contract.

    (B) Jobsite costs. If an administrative, service, or support 
function is performed solely at the jobsite for a specific long-term 
contract, the taxpayer may allocate all the direct and indirect costs 
of that administrative, service, or support function to that long-term 
contract. Similarly, if an administrative, service, or support function 
is performed at the jobsite solely for the taxpayer's long-term 
contract activities, the taxpayer may allocate all the direct and 
indirect costs of that administrative, service, or support function 
among all the long-term contracts performed at that jobsite. For this 
purpose, jobsite means a production plant or a construction site.
    (C) Limitation on other reasonable cost allocation methods. A 
taxpayer may use any other reasonable method of allocating service 
costs, as provided in Sec. 1.263A-1(f)(4), if, for the taxpayer's long-
term contracts considered as a whole, the--
    (1) Total amount of service costs allocated to the contracts does 
not differ significantly from the total amount of service costs that 
would have been allocated to the contracts under Sec. 1.263A-1(f)(2) or 
(3);
    (2) Service costs are not allocated disproportionately to contracts 
expected to be completed in the near future because of the taxpayer's 
cost allocation method; and
    (3) Taxpayer's cost allocation method is applied consistently.
    (c) Simplified cost-to-cost method for contracts subject to the 
PCM--(1) In general. Instead of using the cost allocation method 
prescribed in paragraph (b) of this section, a taxpayer may elect to 
use the simplified cost-to-cost method, which is authorized under 
section 460(b)(3)(A), to allocate costs to a long-term contract subject 
to the PCM. Under the simplified cost-to-cost method, a taxpayer 
determines a contract's completion factor based upon only direct 
material costs; direct labor costs; and depreciation, amortization, and 
cost recovery allowances on equipment and facilities directly used to 
manufacture or construct the subject matter of the contract. For this 
purpose, the costs associated with any manufacturing or construction 
activities performed by a subcontractor are considered either direct 
material or direct labor costs, as appropriate, and

[[Page 2239]]

therefore must be allocated to the contract under the simplified cost-
to-cost method. An electing taxpayer must use the simplified cost-to-
cost method to apply the look-back method under Sec. 1.460-6 and to 
determine alternative minimum taxable income under Sec. 1.460-4(f).
    (2) Election. A taxpayer makes an election under this paragraph (c) 
by using the simplified cost-to-cost method for all long-term contracts 
entered into during the taxable year of the election on its original 
federal income tax return for the election year. This election is a 
method of accounting and, thus, applies to all long-term contracts 
entered into during and after the taxable year of the election. This 
election is not available if a taxpayer does not use the PCM to account 
for all long-term contracts or if a taxpayer elects to use the 10-
percent method described in Sec. 1.460-4(b)(6).
    (d) Cost allocation rules for exempt construction contracts 
reported using the CCM--(1) In general. For exempt construction 
contracts reported using the CCM, other than contracts described in 
paragraph (d)(3) of this section (concerning contracts of homebuilders 
that do not satisfy the $10,000,000 gross receipts test described in 
Sec. 1.460-3(b)(3) or will not be completed within two years of the 
contract commencement date), a taxpayer must annually allocate the cost 
of any activity that is incident to or necessary for the taxpayer's 
performance under a long-term contract. A taxpayer must allocate to 
each exempt construction contract all direct costs as defined in 
Sec. 1.263A-1(e)(2)(i) and all indirect costs either as provided in 
Sec. 1.263A-1(e)(3) or as provided in paragraph (d)(2) of this section.
    (2) Indirect costs--(i) Indirect costs allocable to exempt 
construction contracts. A taxpayer allocating costs under this 
paragraph (d)(2) must allocate the following costs to an exempt 
construction contract, other than a contract described in paragraph 
(d)(3) of this section, to the extent incurred in the performance of 
that contract--
    (A) Repair of equipment or facilities;
    (B) Maintenance of equipment or facilities;
    (C) Utilities, such as heat, light, and power, allocable to 
equipment or facilities;
    (D) Rent of equipment or facilities;
    (E) Indirect labor and contract supervisory wages, including basic 
compensation, overtime pay, vacation and holiday pay, sick leave pay 
(other than payments pursuant to a wage continuation plan under section 
105(d) as it existed prior to its repeal in 1983), shift differential, 
payroll taxes, and contributions to a supplemental unemployment 
benefits plan;
    (F) Indirect materials and supplies;
    (G) Noncapitalized tools and equipment;
    (H) Quality control and inspection;
    (I) Taxes otherwise allowable as a deduction under section 164, 
other than state, local, and foreign income taxes, to the extent 
attributable to labor, materials, supplies, equipment, or facilities;
    (J) Depreciation, amortization, and cost-recovery allowances 
reported for the taxable year for financial purposes on equipment and 
facilities to the extent allowable as deductions under chapter 1 of the 
Internal Revenue Code;
    (K) Cost depletion;
    (L) Administrative costs other than the cost of selling or any 
return on capital;
    (M) Compensation paid to officers other than for incidental or 
occasional services;
    (N) Insurance, such as liability insurance on machinery and 
equipment; and
    (O) Interest, as required under paragraph (b)(2)(v) of this 
section.
    (ii) Indirect costs not allocable to exempt construction contracts. 
A taxpayer allocating costs under this paragraph (d)(2) is not required 
to allocate the following costs to an exempt construction contract 
reported using the CCM--
    (A) Marketing and selling expenses, including bidding expenses;
    (B) Advertising expenses;
    (C) Other distribution expenses;
    (D) General and administrative expenses attributable to the 
performance of services that benefit the taxpayer's activities as a 
whole (e.g., payroll expenses, legal and accounting expenses);
    (E) Research and experimental expenses (described in section 174 
and the regulations thereunder);
    (F) Losses under section 165 and the regulations thereunder;
    (G) Percentage of depletion in excess of cost depletion;
    (H) Depreciation, amortization, and cost recovery allowances on 
equipment and facilities that have been placed in service but are 
temporarily idle (for this purpose, an asset is not considered to be 
temporarily idle on non-working days, and an asset used in construction 
is considered to be idle when it is neither en route to nor located at 
a job-site), and depreciation, amortization and cost recovery 
allowances under chapter 1 of the Internal Revenue Code in excess of 
depreciation, amortization, and cost recovery allowances reported by 
the taxpayer in the taxpayer's financial reports;
    (I) Income taxes attributable to income received from long-term 
contracts;
    (J) Contributions paid to or under a stock bonus, pension, profit-
sharing, or annuity plan or other plan deferring the receipt of 
compensation whether or not the plan qualifies under section 401(a), 
and other employee benefit expenses paid or accrued on behalf of labor, 
to the extent the contributions or expenses are otherwise allowable as 
deductions under chapter 1 of the Internal Revenue Code. Other employee 
benefit expenses include (but are not limited to): Worker's 
compensation; amounts deductible or for whose payment reduction in 
earnings and profits is allowed under section 404A and the regulations 
thereunder; payments pursuant to a wage continuation plan under section 
105(d) as it existed prior to its repeal in 1983; amounts includible in 
the gross income of employees under a method or arrangement of employer 
contributions or compensation which has the effect of a stock bonus, 
pension, profit-sharing, or annuity plan, or other plan deferring the 
receipt of compensation or providing deferred benefits; premiums on 
life and health insurance; and miscellaneous benefits provided for 
employees such as safety, medical treatment, recreational and eating 
facilities, membership dues, etc.;
    (K) Cost attributable to strikes, rework labor, scrap and spoilage; 
and
    (L) Compensation paid to officers attributable to the performance 
of services that benefit the taxpayer's activities as a whole.
    (3) Large homebuilders. A taxpayer must capitalize the costs of 
home construction contracts under section 263A and the regulations 
thereunder, unless the contract will be completed within two years of 
the contract commencement date and the taxpayer satisfies the 
$10,000,000 gross receipts test described in Sec. 1.460-3(b)(3).
    (e) Cost allocation rules for contracts subject to the PCCM. A 
taxpayer must use the cost allocation rules described in paragraph (b) 
of this section to determine the costs allocable to the entire 
qualified ship contract or residential construction contract accounted 
for using the PCCM and may not use the simplified cost-to-cost method 
described in paragraph (c) of this section.
    (f) Special rules applicable to costs allocated under this 
section--(1) Nondeductible costs. A taxpayer may not allocate any 
otherwise allocable contract cost to a long-term contract if any 
section of the Internal Revenue Code disallows a deduction for that 
type of payment or expenditure (e.g., an illegal bribe described in 
section 162(c)).

[[Page 2240]]

    (2) Costs incurred for non-long-term contract activities. If a 
taxpayer performs a non-long-term contract activity, as defined in 
Sec. 1.460-1(d)(2), that is incident to or necessary for the 
manufacture, building, installation, or construction of the subject 
matter of one or more of the taxpayer's long-term contracts, the 
taxpayer must allocate the costs attributable to that activity to such 
contract(s).
    (g) Method of accounting. A taxpayer that adopts or elects a cost 
allocation method of accounting (or changes to another cost allocation 
method of accounting with the Commissioner's consent) must apply that 
method consistently for all similarly classified contracts, until the 
taxpayer obtains the Commissioner's consent under section 446(e) to 
change to another cost allocation method. A taxpayer-initiated change 
in cost allocation method will be permitted only on a cut-off basis 
(i.e., for contracts entered into on or after the year of change) and 
thus, a section 481(a) adjustment will not be permitted or required.
    Par. 9. Section 1.460-6 is amended as follows:
    1. A sentence is added to the end of paragraph (a)(2).
    2. The third sentence of paragraph (b)(1) is removed.
    3. In the fourth sentence of paragraph (b)(1), ``Therefore, to the 
extent that the percentage of completion method is required to be 
used'' is removed and ``To the extent that the percentage of completion 
method is required to be used under Sec. 1.460-1(g)'' is added in its 
place.
    4. The first sentence of paragraph (c)(1)(ii)(A) is revised.
    5. In the first sentence of paragraph (c)(1)(ii)(B), the language 
``no later than the year'' is removed and ``in the year'' is added in 
its place and ``Sec. 1.451-3(b)(2)'' is removed and ``Sec. 1.460-
1(c)(3)'' is added in its place.
    6. The last two sentences of paragraph (c)(1)(ii)(B) are removed.
    7. In the last sentence of paragraph (c)(1)(ii)(C)(2), the language 
``Sec. 5h.6'' is removed and ``Sec. 301.9100-8 of this chapter'' is 
added in its place.
    8. In the fourth sentence of paragraph (c)(2)(v)(A), the language 
``similarly'' is removed.
    9. The first, second, fifth, and sixth sentences of paragraph 
(c)(2)(v)(A) are removed.
    10. In the first sentence of paragraph (c)(2)(vi)(B), the language 
``Sec. 1.453(b)(2)(ii), (iii), (iv), and Sec. 1.451-3(d)(2), (3), and 
(4)'' is removed and ``Sec. 1.460-4(b)(4)(i)'' is added in its place.
    11. In the second sentence of paragraph (c)(2)(vi)(B), the language 
``the percentage of completion method and'' is removed.
    12. In the third sentence of paragraph (c)(2)(vi)(B), the language 
``, for purposes of both the percentage of completion method and the 
look-back method'' is removed.
    13. In the fourth sentence of paragraph (c)(2)(vi)(B), the language 
``Similarly, a'' is removed and ``A'' is added in its place.
    14. In the first sentence of paragraph (c)(2)(vi)(C), the language 
``Sec. 1.451-3(e)'' is removed and ``Sec. 1.460-1(e)'' is added in its 
place.
    15. Paragraph (c)(4)(iv) is removed.
    16. In the first sentence of paragraph (d)(4)(ii)(C), the language 
``within the meaning of section 1504(a)'' is removed and ``, as defined 
in Sec. 1.1502-1(h)'' is added in its place.
    17. In the fourth sentence of paragraph (e)(2), the language 
``within the meaning of section 1504(a)'' is removed and ``, as defined 
in Sec. 1.1502-1(h)'' is added in its place.
    18. In the first sentence of paragraph (f)(1), the language ``or to 
be refunded'' is removed and ``from, or payable to, a taxpayer'' is 
added in its place.
    19. In the first sentence of paragraph (f)(1), the language ``and 
reported'' is removed.
    20. In the second sentence of paragraph (f)(1), the language ``and 
Form 8697 is filed by'' is removed.
    21. In the second sentence of paragraph (f)(2)(i), the language 
``fails to file Form 8697 with respect to interest required to be paid 
or that'' is removed.
    22. In the second sentence of paragraph (f)(2)(i), the language ``a 
penalty for failing to file Form 8697'' is removed and ``an 
underpayment penalty under section 6651, and the taxpayer also is 
liable for underpayment interest under section 6601'' is added in its 
place.
    23. In the third sentence of paragraph (f)(2)(i), the language 
``penalty'' is removed and ``subtitle F'' is added in its place.
    24. In the fourth sentence of paragraph (f)(2)(i), the language 
``or a tax refund'' is added after ``liability''.
    25. In the first sentence of paragraph (f)(2)(ii), the language 
``refunded'' is removed and ``payable'' is added in its place.
    26. Paragraph (f)(3) is added.
    The revisions and additions read as follows:


Sec. 1.460-6  Look-back method.

    (a) * * *
    (2) * * * Paragraph (j) of this section provides guidance 
concerning the election not to apply the look-back method in de minimis 
cases.
* * * * *
    (c) * * * (1) * * *
    (ii) * * * (A) In general. Except as otherwise provided in section 
460(b)(6) (see Sec. 1.460-6(j) for method of electing) or Sec. 1.460-
6(e), a taxpayer must apply the look-back method to a long-term 
contract in the completion year and in any post-completion year for 
which the taxpayer must adjust total contract price or total allocable 
contract costs, or both, under the PCM. * * *
* * * * *
    (f) * * *
    (3) Statute of limitations and compounding of interest on look-back 
interest. For guidance on the statute of limitations applicable to the 
assessment and collection of look-back interest owed by a taxpayer, see 
sections 6501 and 6502. A taxpayer's claim for credit or refund of 
look-back interest previously paid by or collected from a taxpayer is a 
claim for credit or refund of an overpayment of tax and is subject to 
the statute of limitations provided in section 6511. A taxpayer's claim 
for look-back interest (or interest payable on look-back interest) that 
is not attributable to an amount previously paid by or collected from a 
taxpayer is a general, non-tax claim against the federal government. 
For guidance on the statute of limitations that applies to general, 
non-tax claims against the federal government, see 28 U.S.C. sections 
2401 and 2501. For guidance applicable to the compounding of interest 
when the look-back interest is not paid, see sections 6601 to 6622.
* * * * *


Secs. 1.460-7 and 1.460-8  [Removed]

    Par. 10. Sections 1.460-7 and 1.460-8 are removed.


Sec. 1.471-10  [Amended]

    Par. 11. Section 1.471-10 is amended by removing the language 
``Sec. 1.451-3'' and adding ``Sec. 1.460-2'' in its place.

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

    Par. 12. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.

    Par. 13. In Sec. 602.101, paragraph (b) is amended by:
    1. Removing the entry for ``1.451-3''.
    2. The following entries are added in numerical order to the table:


Sec. 602.101  OMB Control numbers.

* * * * *
    (b) * * *

[[Page 2241]]



------------------------------------------------------------------------
                                                            Current OMB
   CFR part or section where identified and described       control No.
------------------------------------------------------------------------
 
                  *        *        *        *        *
1.460-1.................................................       1545-1650
 
                  *        *        *        *        *
------------------------------------------------------------------------


Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
    Approved: December 20, 2000.
Jonathan Talisman,
Acting Assistant Secretary of the Treasury.
[FR Doc. 01-6 Filed 1-10-01; 8:45 am]
BILLING CODE 4830-01-U