This document contains amendments to 26 CFR part 1. On July 22, 2008, temporary regulations (T.D. 9417, 2008-2 C.B. 693) were published in the Federal Register (73 FR 42522) relating to the averaging of farm and fishing income in computing tax liability. A notice of proposed rulemaking (REG-161695-04, 2008-37 I.R.B. 699) cross-referencing the temporary regulations also was published in the Federal Register (73 FR 42538) on July 22, 2008. No comments in response to the notice of proposed rulemaking or requests to hold a public hearing were received, and no hearing was held. This Treasury decision adopts the proposed regulations with minor changes and removes the temporary regulations.

Section 504 of the Tax Extenders and Alternative Minimum Tax Relief Act of 2008, Div. C of Public Law 110-343 (122 Stat. 3765), enacted on October 3, 2008, provides that a taxpayer may treat qualified settlement income received in connection with the civil action In re Exxon Valdez, No. 8-095-CV (HRH) (Consolidated) (D. Alaska), as income from a fishing business eligible for income averaging. Therefore, these final regulations include this qualified settlement income in the definition of income from a fishing business. Qualified settlement income is limited to interest and punitive damages. The extent to which compensatory damages are treated as income from a fishing business is determined under the generally applicable rules of section 1301.

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, and because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking preceding these regulations were submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

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

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

Par. 2. Section 1.1301-1 is amended by revising the section heading and paragraphs (a), (b)(1), (b)(3), (c)(1), (d)(3)(ii), (d)(4), (e), (f)(2), (f)(4), and (g) to read as follows:

Par. 3. Section 1.1301-1T is removed.

Approved December 7, 2010.

This document contains amendments to the Income Tax Regulations (26 CFR Part 1) under section 6012 relating to the returns of income corporations are required to file. Section 6011 provides that persons liable for a tax imposed by Title 26 shall make a return when required by regulations prescribed by the Secretary of the Treasury according to the forms and regulations prescribed by the Secretary. Treasury Regulation §1.6011-1 requires every person liable for income tax to make the returns required by regulation. Section 6012 requires corporations subject to an income tax to make a return with respect to that tax. Treasury Regulation §1.6012-2 sets out the corporations that are required to file returns and the form those returns must take.

A proposed regulation under section 6012 (REG-119046-10, 2010-40 I.R.B. 415) was published in the Federal Register on September 9, 2010. Requirement of a Statement Disclosing Uncertain Tax Positions, 75 Fed. Reg. 54802 (proposed Sept. 9, 2010). The IRS received one written comment concerning the proposed regulation, and a public hearing regarding the proposed regulation was held on October 19, 2010. Neither of the two speakers at the public hearing had comments relating to the proposed regulation, although both organizations the speakers represented had previously submitted written comments concerning the draft Schedule UTP and instructions. Announcement 2010-30, 2010-19 I.R.B. 668. After considering the comments, the proposed regulation is adopted by this Treasury decision with one non-substantive change related to the effective date. While the proposed regulation applied to returns filed for tax years beginning after December 15, 2009 and ending after the date the regulations were published in the Federal Register, the final regulation applies to returns filed for tax years beginning on or after January 1, 2010.

This rule will authorize the IRS to require certain corporations, as set out in forms, publications, instructions, or other guidance, to provide information concerning uncertain tax positions concurrent with the filing of a return. On September 24, 2010, the IRS released Schedule UTP with accompanying instructions that explain how the IRS plans to implement the authority provided by this regulation. One commentator asked that the proposed regulation not be adopted because Schedule UTP would require the disclosure of privileged information. If the regulation is adopted, the commentator recommended it should state that taxpayer may assert any applicable privileges to providing information sought by Schedule UTP and that any disclosure of information on that schedule will not constitute a waiver of any applicable privilege.

The final regulation does not adopt this recommendation. The regulation addresses the IRS’s authority to require certain corporations to provide information concerning uncertain tax positions. The IRS has decided to require the filing of Schedule UTP based on its determination that the information about uncertain tax positions taken in a tax return required by the schedule is essential to achieving an effective and efficient self-assessment tax system. Provisions relating to the assertion of privilege are not included in this regulation, since it does not affect the existence of any applicable privileges taxpayers may have concerning information requested by a return or how they may assert those privileges.

It has been determined that this final rule is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required.

This regulation will only affect taxpayers that prepare or are required to issue audited financial statements. Small entities rarely prepare or are required to issue audited financial statements due to the expense involved. It is hereby certified that this regulation will not have a significant economic impact on a substantial number of small entities pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6). Accordingly, a regulatory flexibility analysis is not required. Pursuant to 5 U.S.C. 553(d)(3), it has been determined that there is good cause for the effective date of this final rule, which is less than 30 days after the date of publication.

Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding this regulation was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Paragraph 1. The authority citation for part 1 is amended by adding an entry in numerical order to read as follows:

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

Section 1.6012-2 is also issued under the authority of 26 U.S.C. 6011 and 6012.

Par. 2. Section 1.6012-2 is amended by adding paragraphs (a)(4) and (a)(5) to read as follows:

This document contains amendments to the Procedure and Administration Regulations (26 CFR Part 301) under section 6229(c)(2) and section 6501(e) of the Internal Revenue Code. On September 28, 2009, temporary regulations (T.D. 9466, 2009-43 I.R.B. 551) regarding the definition of an omission from gross income for purposes of the six-year period for assessment were published in the Federal Register (74 FR 49321). A notice of proposed rulemaking (REG-108045-08, 2009-43 I.R.B. 557) cross-referencing the temporary regulations was published in the Federal Register for the same day (74 FR 49354). One written comment was received from the public in response to the notice of proposed rulemaking. No public hearing was requested or held. After consideration of the comment, the proposed regulations are adopted as amended by this Treasury decision, and the corresponding temporary regulations are removed.

These final regulations amend the Procedure and Administration Regulations (26 CFR part 301) relating to sections 6229(c)(2) and 6501(e). In addition to the revisions set forth in the proposed regulations cross-referencing the temporary regulations, the final regulations reflect structural amendments to sections 6229(c)(2) and 6501(e) in the Hiring Incentives To Restore Employment Act (Public Law 111-147, 124 Stat. 112) to accommodate an additional threshold triggering the six-year period of limitations for omissions from gross income attributable to assets subject to certain reporting requirements, which is not otherwise addressed in these final regulations. The final regulations also clarify the effective/applicability date provisions in the section 6229(c)(2) and section 6501(e) regulations to eliminate a perceived ambiguity in the temporary regulations, that was brought to light by the Tax Court in Intermountain Insurance Service of Vail v. Commissioner, 134 T.C. No. 11 (2010), appeal docketed, No. 10-1204 (D.C. Cir.).

As explained in the preamble to the temporary regulations, the United States Courts of Appeals for the Ninth Circuit and the Federal Circuit construed section 6501(e)(1) in cases outside the trade-or-business context contrary to the interpretation provided in these final regulations, holding that an overstatement of basis does not constitute an “omission.” Bakersfield Energy Partners v. Commissioner, 568 F.3d 767 (9th Cir. 2009); Salman Ranch Ltd v. United States, 573 F.3d 1362 (Fed. Cir. 2009). Those courts relied on the Supreme Court’s opinion in Colony v. Commissioner, 357 U.S. 28 (1958), which dealt with an omission from gross income in the context of a trade or business under the predecessor of section 6501(e). The Treasury Department and the Internal Revenue Service disagree with those courts that the Supreme Court’s reading of the predecessor to section 6501(e) in Colony applies to sections 6501(e)(1) and 6229(c)(2), for the reasons set forth in the preamble to the temporary regulations.

After publication of the temporary regulations, the Tax Court declared the temporary regulations invalid, adhering to its prior opinion in Bakersfield Energy Partners v. Commissioner, 128 T.C. 207 (2007). Intermountain Insurance Service of Vail v. Commissioner, 134 T.C. No. 11 (2010), appeal docketed, No. 10-1204 (D.C. Cir.). In part, the Tax Court in Intermountain concluded that the Supreme Court’s opinion in Colony was the only permissible interpretation of the statutory language in question (“omits from gross income”). The Treasury Department and the Internal Revenue Service disagree with Intermountain. The Supreme Court stated in Colony that the statutory phrase “omits from gross income” is ambiguous, meaning that it is susceptible to more than one reasonable interpretation. The interpretation adopted by the Supreme Court in Colony represented that court’s interpretation of the phrase but not the only permissible interpretation of it. Under the authority of Nat’l Cable & Telecomms. Ass’n v. Brand X Internet Servs., 545 U.S. 967, 982-83 (2005), the Treasury Department and the Internal Revenue Service are permitted to adopt another reasonable interpretation of “omits from gross income,” particularly as it is used in a new statutory setting. See Hernandez-Carrera v. Carlson, 547 F.3d 1237 (10th Cir. 2008) (agencies are free to promulgate a reasonable construction of an ambiguous statute that contradicts any court’s interpretation, even the Supreme Court’s). The interpretation of the phrase “omits from gross income” as used in section 6501(e)(1) is currently pending before several United States Courts of Appeals.

Because these regulations are a clarification of the period of limitations provided in sections 6501(e)(1) and 6229(c)(2) and are consistent with the Secretary’s application of those provisions both with respect to a trade or business (that is, gross income means gross receipts), as well as outside of the trade-or-business context (that is, the section 61 definition of gross income applies), they are applicable to all cases with respect to which the period for assessing tax was open on or after September 24, 2009, the date the temporary regulations were filed with the Federal Register.

The sole written comment received in response to the notice of proposed rulemaking by cross-reference to the temporary regulations questioned the application of the regulations, characterizing them as retroactive, and recommended that they be applied only prospectively. The commentator stated that the temporary regulations apply with retroactive effect “in that taxable years which had closed are now reopened.” The Treasury Department and the Internal Revenue Service disagree with the characterization of the regulations as retroactive. The final regulations have been clarified to emphasize that they only apply to open tax years, and do not reopen closed tax years as suggested by the commentator.

The commentator also relied on the 1996 amendments to section 7805(b) to argue that retroactively effective Treasury regulations are impermissible, with limited exceptions. The 1996 amendments to section 7805(b), however, do not apply to the regulations under sections 6229(c)(2) and 6501(e)(1). That is because those amendments are only effective for regulations that relate to statutory provisions enacted on or after July 30, 1996. Taxpayer Bill of Rights 2 (Public Law 104-168, section 1101(a), 110 Stat. 1469). Since section 6229(c)(2) was enacted in 1982 and section 6501(e)(1)(A) was enacted in 1954 (and redesignated as subparagraph (B) as part of the HIRE Act in 2010), the 1996 amendments to section 7805(b) are inapplicable to the regulations. Prior to the 1996 amendments, section 7805(b) provided, “The Secretary may prescribe the extent, if any, to which any ruling or regulation, relating to the internal revenue laws, shall be applied without retroactive effect.” Although these regulations are not retroactive, a retroactive regulation interpreting sections 6229(c)(2) and 6501(e)(1) is expressly permitted by the applicable version of section 7805(b), which presumes regulations to apply retroactively unless otherwise provided.

The Tax Court’s majority in Intermountain erroneously interpreted the applicability provisions of the temporary and proposed regulations, which provided that the regulations applied to taxable years with respect to which “the applicable period for assessing tax did not expire before September 24, 2009.” The Internal Revenue Service will continue to adhere to the position that “the applicable period” of limitations is not the “general” three-year limitations period. The three-year limitations period is one of several limitations periods in the Internal Revenue Code, including the six-year limitations period under sections 6229(c)(2) and 6501(e)(1). The expiration of the three-year period does not “close” a taxable year if a longer period applies. Consistent with that position, the final regulations apply to taxable years with respect to which the six-year period for assessing tax under section 6229(c)(2) or 6501(e)(1) was open on or after September 24, 2009. This includes, but is not limited to, all taxable years (1) for which six years had not elapsed from the later of the date that a tax return was due or actually filed, (2) that are the subject of any case pending before any court of competent jurisdiction (including the United States Tax Court and Court of Federal Claims) in which a decision had not become final (within the meaning of section 7481) or (3) with respect to which the liability at issue had not become fixed pursuant to a closing agreement entered into under section 7121. The Internal Revenue Service’s position is consistent with the effective/applicability date provisions of these final regulations.

The final regulations are amended to reinstate estate, gift and excise tax provisions that were inadvertently removed by the temporary regulations.

It has been determined that these regulations are 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, and because these regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, the NPRM cross-referencing the temporary regulations preceding these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Paragraph 1. The authority citation for part 301 is amended by adding the entry in numerical order to read in part as follows:

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

Section 301.6229(c)(2)-1 is also issued under 26 U.S.C. 6230(k). * * *

Par. 2. Section 301.6229(c)(2)-1 is added to read as follows:

Par. 3. Section 6229(c)(2)-1T is removed.

Par. 4. Section 301.6501(e)-1 is added to read as follows:

Par. 5. Section 301.6501(e)-1T is removed.

Approved December 13, 2010.

Section 9008(a) imposes the fee on each covered entity engaged in the business of manufacturing or importing branded prescription drugs. Section 9008(d)(1) defines a covered entity as “any manufacturer or importer with gross receipts from branded prescription drug sales.” For purposes of section 9008(a), a manufacturer or importer is the person identified in the Labeler Code of the National Drug Code (NDC) for a branded prescription drug. The NDC is an identifier assigned by the Food and Drug Administration (FDA) to a branded prescription drug, as well as other drugs. The Labeler Code is the first five numeric characters of the NDC or the first six numeric characters when the available five-character code combinations are exhausted.

Section 9008(d)(2) provides a controlled group rule under which all persons treated as a single employer under section 52(a), 52(b), 414(m), or 414(o) of the Internal Revenue Code (Code) shall be treated as a single covered entity. For this purpose, a foreign entity subject to tax under section 881 is included within a controlled group under section 52(a) or 52(b). This controlled group rule will be applied as of the end of the day on December 31 of the sales year. All persons treated as a single employer under section 9008(d)(2) are jointly and severally liable for the fee. See section 9008(d)(3).

In the case of a controlled group that is treated as a single covered entity under section 9008(d)(2), the controlled group must identify a single person as the “designated entity” that may act for the controlled group with respect to the section 9008 fee. If the controlled group, without regard to foreign corporations included under section 9008(d)(2)(B), is also an affiliated group that filed a consolidated return for federal income tax purposes, the designated entity is the common parent of the affiliated group as identified on the tax return filed for the sales year. In all other situations, the controlled group must select a person as the designated entity on Form 8947, Report of Branded Prescription Drug Information ^[1] (discussed further below), which is signed by the designated entity under penalties of perjury, stating that all the manufacturers or importers of branded prescription drugs who are members of the covered entity have consented to the selection of the designated entity.

Section 9008(b) provides that the annual fee for each covered entity is calculated by determining the ratio of (i) the covered entity’s branded prescription drug sales taken into account during the preceding calendar year to (ii) the aggregate branded prescription drug sales taken into account for all covered entities during the same year, and applying this ratio to the applicable amount as specified in the statute. “Sales taken into account” means sales exclusive of certain orphan drugs and after application of the percentage adjustment table in section 9008(b)(2). Section 9008(b)(1) provides that the calculation of the fee in any given year is based on branded prescription drug sales in the immediately preceding calendar year.

Section 9008(b)(3) provides that the Secretary of the Treasury shall determine the amount of each covered entity’s fee. In determining that amount, the Secretary may rely on reports submitted by the Agencies and any other source of information. Section 9008(i) also provides the Secretary with regulatory authority to carry out the purposes of the statute.

The IRS and Treasury Department have determined that, although the DOD and VA are expected to have complete data on branded prescription drug sales for the calendar year immediately preceding the fee year within the time frame necessary to administer the fee, CMS is not expected to have comparable data because it cannot complete its data processing within the necessary time frame. Accordingly, the IRS and Treasury Department will calculate the fee based on the branded prescription drug sales data provided by the Agencies for the second calendar year preceding the fee year. Because the use of the second preceding year, rather than the immediately preceding year, as the sales year may affect the amount of the fee paid by any particular covered entity, the fee due in every year after 2011 will include an adjustment amount.

An adjustment amount will be calculated for each NDC and will be added or subtracted, as appropriate, to the fee otherwise payable by the covered entity responsible for the NDC in the fee year in which the adjustment is calculated. The adjustment amount added or subtracted to the amount payable in a fee year will reflect the difference between the fee determined for the NDC in the immediately prior fee year, using data from the second calendar year preceding that fee year, and what the fee for that NDC would have been for the immediately prior fee year using data from the calendar year immediately preceding that prior fee year. For example, the amount due from a covered entity in the 2012 fee year will include an adjustment amount for each NDC for which the covered entity is responsible in 2012 equal to the difference between the 2011 fee associated with that NDC using 2009 data, and what the 2011 fee for that NDC would have been using 2010 data.

To calculate the adjustment amount for an NDC, the IRS will first determine two ratios: one based on data from the second preceding calendar year; and the other based on data from the third preceding calendar year. In both cases, the numerator of the ratio is the sales taken into account for the particular NDC during the relevant calendar year, and the denominator of the ratio is aggregate branded prescription drug sales taken into account for all NDCs during the relevant calendar year. For each NDC, the IRS will then take the difference between the ratio using second preceding year data and the ratio using third preceding year data and multiply that amount by the applicable amount of the fee for the relevant fee year, as set forth in section 9008(b)(4), to determine an adjustment for the NDC. The adjustment amount for any particular NDC will then be added to, or subtracted from, as appropriate, the amount of the fee otherwise payable by the covered entity associated with the NDC for the fee year in which the adjustment amount is calculated.

For example, in 2012 the fee payable by each covered entity will consist of two components. First, the applicable amount for 2012 will be allocated to the covered entities based on sales data for 2010 (i.e., the second preceding calendar year). Second, an adjustment amount will be calculated in 2012 for each NDC with respect to the 2011 fee year, by multiplying (i) the difference between the sales ratio determined using 2010 data and the sales ratio determined using 2009 data by (ii) the applicable amount of the fee for 2011. The adjustment amount for each NDC will then be added to, or subtracted from, as appropriate, the fee otherwise payable in 2012 by the covered entity associated with the NDC for the 2012 fee year.

The adjustment amount is applied only with respect to the amount of the fee otherwise payable by the relevant covered entity in the year in which the adjustment is calculated, and is not a refund, credit, or recalculation of a fee payable by any covered entity in any preceding fee year. In any given fee year, the amount assessed by the IRS will be based on data provided to it by the Agencies. The IRS does not intend to recalculate either the fee allocations or the adjustment amounts based on data that becomes available after those amounts are assessed.

Annually, each covered entity should submit a Form 8947 and provide the information specified by the form and instructions. The designated entity for a covered entity described in section 9008(d)(2) submits a single form for the covered entity. A covered entity should submit a completed Form 8947 by December 15 of each year unless an alternative date is prescribed by the form or instructions. The Form 8947 information is return information subject to the confidentiality protections of section 6103. The IRS will take into account the rebate information in calculating a covered entity’s annual fee for 2011 only if the rebate information is reported in accordance with items 4 and 5 below on a timely filed Form 8947. Form 8947 is available at http://www.irs.gov.

Form 8947 solicits the following information from each covered entity:

1. For a single-person covered entity, the covered entity’s name, address, and employer identification number. For a covered entity described in section 9008(d)(2), the name, address, and employer identification number of the designated entity and each manufacturer or importer with gross receipts from the sale of branded prescription drugs to specified government programs (or sales due to coverage under the programs) that was included in the covered entity as of the end of the day on December 31 of the sales year.

Part I of Form 8947 instructions are revised by this notice to provide that each designated entity should list the name, address, and employer identification number of itself and each manufacturer or importer with gross receipts from the sale of branded prescription drugs to specified government programs (or sales due to coverage under the programs) that was included in the covered entity as of the end of the day on December 31 of the sales year.

2. All of the NDCs for branded prescription drugs in which the covered entity is identified in the labeler code as of the end of the day on December 31 of the sales year. For a covered entity described in section 9008(d)(2), this includes all NDCs in which a member of the covered entity is identified in the labeler code as of the end of the day on December 31 of the sales year.

3. The brand name and NDC for each orphan drug for which a credit was allowed for any taxable year under section 45C of the Code. For purposes of section 9008(e)(3), the credit was “allowed” for any particular drug if any person claimed the credit and there has not been a final assessment or a court order disallowing the full credit taken for the drug. In addition, even if the credit has been allowed, a covered entity must not report an NDC for an orphan drug for any sales year following the calendar year in which the FDA approved the drug for marketing for any indication other than the treatment of the rare disease or condition for which the section 45C credit was allowed.

4. The rebates for each NDC paid for the sales year by the covered entity to Medicare Part D plans with respect to sales occurring in that sales year. For this purpose, report rebates paid for drugs dispensed in the 2009 sales year if paid before Form 8947 is filed. This information is needed for the 2009 sales year because, at this time, CMS does not have rebate data on branded prescription drug sales by NDC. However, starting in 2011, CMS is planning to collect this rebate information by NDC for the 2010 and subsequent sales years. It is therefore possible that covered entities will not report this rebate information for years following 2009.

5. The state supplemental rebates for each NDC paid in the sales year by the covered entity with respect to sales under Medicaid occurring in that sales year. For this purpose, report rebates invoiced by states for drugs reimbursed by states in the 2009 sales year and paid before Form 8947 is filed. This information is needed because Medicaid data will not include state supplemental rebates.

The IRS will compile a list of branded prescription drugs by NDC using the data submitted on Forms 8947. Appropriate due diligence will be performed to check for potential oversights. For example, the IRS may use information published by the FDA identifying drugs for which applications were submitted under section 505(b) of the Federal Food, Drug, and Cosmetic Act. The IRS will provide the Agencies with the compiled list of branded prescription drugs.

For each year in which the fee is due, the Agencies will provide data to the IRS on the branded prescription drug sales during the sales year by Program and NDC. The calculation methodology for each Program, including any reasonable estimation techniques and assumptions that the Agencies expect to use, are described below.

1. Medicare Part D. Section 9008 requires CMS to report the product of the per-unit ingredient cost reported by Part D sponsors (net of any per-unit rebate or other price concessions) and the number of units for each branded prescription drug. CMS currently collects prescription level encounter data from Part D sponsors on the Prescription Drug Event (PDE) records. On the PDE records, Part D sponsors report the NDC, as well as the ingredient cost, dispensing fee, sales tax, and units. CMS will aggregate the ingredient cost reported in the “Ingredient Cost Paid” field and the units reported in the “Quantity Dispensed” field of the PDE records for Part D covered drugs. These amounts will be aggregated at the NDC level for each sales year. Only PDE data that Part D sponsors have submitted by the PDE submission deadline (within 6 months after the end of the sales year) and have been approved for inclusion in the Part D payment reconciliation will be included.

2. Medicare Part B. First, for Healthcare Common Procedure Coding System (HCPCS) codes that consist solely and exclusively of branded prescription drugs (as identified by their respective NDCs) manufactured by a single entity, CMS will provide the total Medicare-allowed charges for the HCPCS code for the appropriate sales year.

Second, for HCPCS codes consisting of a mixture of branded prescription drugs made by different manufacturers or a mixture of branded prescription and generic drugs, CMS will determine: (i) the total Medicare-allowed charges for the HCPCS code for the appropriate sales year; (ii) the entities engaged in manufacturing each NDC assigned to the HCPCS code; and (iii) those entities (if any) that are manufacturing branded prescription drugs. CMS will then: (i) estimate the amount of Medicare-allowed charges for each manufacturer by applying the utilization percentage attributed to each manufacturer as determined under the Medicare Part B Program using manufacturer reported Average Sales Price sales data; (ii) multiply that percentage by the Medicare-allowed charge for that HCPCS code; and (iii) assign the result to each manufacturer within that HCPCS code.

Third, for the remainder of HCPCS codes that consist of multiple branded prescription drugs (as identified by their respective NDCs) manufactured by multiple entities that cannot be reliably calculated using the two methods above, CMS will determine: (i) the total Medicare-allowed charges for the HCPCS code for the appropriate sales year; (ii) the entities engaged in manufacturing each NDC assigned to the HCPCS code; and (iii) those entities (if any) that are manufacturing branded prescription drugs. CMS will then: (i) estimate the amount of Medicare-allowed charges for each manufacturer by applying the utilization percentage attributed to each manufacturer as determined under the Medicare Part D Program; (ii) multiply that percentage by the Medicare-allowed charge for that HCPCS code; and (iii) assign the result to each manufacturer within that HCPCS code.

Thus, the amounts attributed to branded prescription drugs within the HCPCS code will be estimated. CMS will calculate the sum of these components to arrive at an estimate of Medicare Part B spending on branded prescription drugs for each manufacturer.

3. Medicaid. The branded prescription drug sales for Medicaid may be determined as the per-unit Average Manufacturer Price less the Unit Rebate Amounts (URA) that CMS calculates based on manufacturer-reported pricing data multiplied by the number of units reported billed by states to manufacturers. This data would be based on the data reported to Medicaid by covered entities and the states. CMS does not currently intend to reduce this calculation for state supplemental rebates.

4. Department of Veterans Affairs. VA will provide, by NDC, the total amount paid for each branded prescription drug procured by the VA for its beneficiaries. The basis of this information will be national procurement data reported by VA’s Pharmaceutical Prime Vendor to the VA Pharmacy Benefits Management Service and National Acquisition Center. This information will not include procurement data that resides exclusively at the individual medical treatment facility level.

5. Department of Defense. The DOD will provide, by Labeler Code, the manufacturer’s name, the NDC, brand name, and the amount paid (net of rebates) for each branded prescription drug procured by DOD. TRICARE Management Activity will provide, by Labeler Code, the manufacturer’s name, the NDC, brand name, and the amount paid (net of refunds or rebates) for each branded prescription drug procured by DOD through the TRICARE Retail Pharmacy Program.

After receiving data from the Agencies and information from the covered entities, the IRS will calculate each covered entity’s branded prescription drug sales for each Program by NDC. A covered entity’s branded prescription drug sales for each Program will equal (i) the sum of all the covered entity’s branded prescription drug sales reported by the Program, less (ii) the sum of all branded prescription drug sales reported by the Program for each NDC for which the covered entity has appropriately claimed the orphan drug exclusion, less (iii) the sum of rebates reported by the covered entity on Form 8947 for the sales year.

After calculating the branded prescription drug sales for each Program, the IRS will calculate each covered entity’s branded prescription drug sales taken into account for purposes of the ratio set forth in section 9008(b)(1). A covered entity’s branded prescription drug sales taken into account for purposes of section 9008(b)(1)(A) will equal the sum of the covered entity’s branded prescription drug sales for all Programs reduced by the appropriate percentages set forth in section 9008(b)(2). The IRS will then calculate the aggregate branded prescription drug sales of all covered entities taken into account for purposes of section 9008(b)(1)(B), which is the sum of all the covered entities branded prescription drug sales taken into account for purposes of section 9008(b)(1)(A).

To determine each covered entity’s fee, the IRS will divide each covered entity’s branded prescription drug sales taken into account for purposes of section 9008(b)(1)(A) by the aggregate branded prescription drug sales of all covered entities taken into account for purposes of section 9008(b)(1)(B) and multiply that fraction by the applicable amount for the appropriate year as set forth in section 9008(b)(4).

This document contains proposed amendments to 26 CFR part 1 relating to the allocation under section 263A of the Internal Revenue Code (Code) of certain sales-based royalties. Sales-based royalties are royalty costs that become due only upon the sale of property. Thus, the fact of the liability arises, and the royalty is incurred within the meaning of section 461, only upon sale.

This document also contains proposed amendments to 26 CFR part 1 relating to the determination of cost of goods in inventory under section 471 when a taxpayer receives a sales-based vendor allowance. Sales-based vendor allowances are allowances, discounts, or price rebates that a reseller receives, earns, or otherwise becomes entitled to based on the resale of a vendor’s merchandise to a third party.

Section 263A requires taxpayers to capitalize the direct costs and indirect costs that are properly allocable to (1) real or tangible personal property the taxpayer produces, and (2) real property or personal property described in section 1221(a)(1) that the taxpayer acquires for resale. Taxpayers must allocate costs required to be capitalized under section 263A to property produced or acquired for resale during the taxable year using a cost allocation method described in the regulations. A taxpayer generally determines whether the cost of goods is included in cost of goods sold or in ending inventory using a cost flow assumption (for example, first-in, first-out or last-in, first-out). However, as explained later in this preamble, a taxpayer may use a simplified method to allocate costs required to be capitalized under section 263A between cost of goods sold and ending inventory.

Section 1.263A-1(e)(3)(i) defines indirect costs as all costs other than direct material costs and direct labor costs (in the case of property produced) or acquisition costs (in the case of property acquired for resale). Indirect costs are properly allocable to property produced or acquired for resale when the costs directly benefit or are incurred by reason of the performance of production or resale activities.

Section 1.263A-1(e)(3)(ii) provides a non-exclusive list of indirect costs that must be capitalized to the extent they are properly allocable to property produced or property acquired for resale. These costs include licensing and franchise costs incurred in securing the contractual right to use a trademark, corporate plan, manufacturing procedure, special recipe, or other similar right associated with property produced or property acquired for resale. Section 1.263A-1(e)(3)(ii)(U). Thus, royalty costs, including sales-based royalty costs, incurred in securing the contractual right to use a trademark, corporate plan, manufacturing procedure, special recipe, or other similar right associated with property produced or property acquired for resale, are indirect costs that are properly allocable to the property produced or acquired for resale to the extent the costs directly benefit or are incurred by reason of production or resale activities. See, for example, Plastic Engineering & Technical Services, Inc. v. Commissioner, TC Memo. 2001-324; but see Robinson Knife Manufacturing Company, Inc. v. Commissioner, No. 09-1496-ag, 2010 WL 986532 (2d Cir. March 19, 2010).

Section 1.263A-1(f) provides various “facts-and-circumstances” cost allocation methods that taxpayers may use to allocate direct and indirect costs to units of property produced or acquired for resale. The facts-and-circumstances methods allocate costs based on a relationship between the costs incurred and the units of property produced or acquired for resale.

In lieu of a facts-and-circumstances allocation method, taxpayers may use the simplified methods provided in §1.263A-2(b) (the simplified production method) or §1.263A-3(d) (the simplified resale method) to allocate costs to eligible property produced or eligible property acquired for resale. The simplified methods differ from facts-and-circumstances methods in that they allocate a pool of capitalizable costs (additional section 263A costs) between ending inventory and cost of goods sold using a defined ratio rather than allocating specific costs to particular goods. Additional section 263A costs are defined in §1.263A-1(d)(3) as the costs, other than interest, that were not capitalized under the taxpayer’s method of accounting immediately prior to the effective date of section 263A, but that are required to be capitalized under section 263A. Under the simplified methods, taxpayers allocate additional section 263A costs between ending inventory and cost of goods sold using a formula that includes all additional section 263A costs incurred during the taxable year (including capitalizable sales-based royalties, if any).

Section 471 provides that inventories must be taken on the basis the Secretary prescribes as conforming to the best accounting practice in the trade or business and as most clearly reflecting income.

Section 1.471-2(c) permits merchants and manufacturers to value inventories at either (1) cost, or (2) cost or market, whichever is lower. Under §1.471-3(b), the cost of merchandise purchased by taxpayers in general is the invoice price less trade or other discounts.

Section 1.471-8 allows a retail merchant to use the retail inventory method to arrive at an approximate cost of goods in ending inventory. This cost is determined by multiplying the aggregate selling prices of the goods in ending inventory by the ratio of (1) the cost of the goods in beginning inventory plus the cost of goods purchased during the year, to (2) the retail selling prices of the goods in beginning inventory plus the retail selling prices of inventory purchased during the year, with proper adjustments to the selling prices for mark-ups and mark-downs. However, retail selling prices are not adjusted for temporary mark-downs. Rev. Rul. 79-115, 1979-1 C.B. 185, see §601.601(d)(2).

The proposed regulations clarify that sales-based royalties, like other royalties, may be capitalizable to property a taxpayer produces or acquires for resale, but also provide that sales-based royalties required to be capitalized are allocable only to property that a taxpayer has sold.

In Robinson Knife, the Court of Appeals for the Second Circuit held that royalties for the right to use certain trademarks in manufacturing kitchen tools were not allocable to the property produced because the taxpayer’s royalty payments were calculated as a percentage of net sales and were incurred only on the sale of the product. The court stated that the royalty costs were not incurred by reason of and did not directly benefit the performance of production activities, and therefore were not capitalizable under the section 263A regulations. The court reasoned that, although the licensing agreements may have directly benefited or been incurred by reason of production activities, the regulations did not require the capitalization of the royalty costs because the costs themselves did not directly benefit and were not incurred by reason of the performance of production activities.

The proposed regulations are consistent with the court’s conclusion that, because of their relationship to sales, sales-based royalties inherently should not be capitalized to ending inventory. Because sales-based royalties are not incurred (within the meaning of section 461) until a unit of property is sold, sales-based royalties are more directly related to units of property sold during the taxable year than to unsold units. Therefore, the proposed regulations provide that capitalizable sales-based royalties are properly allocable to units of property produced or acquired for resale that are sold, or deemed sold, during the taxable year.

However, Robinson Knife misconstrued the nature of costs required to be capitalized. Royalties are the costs associated with the right to use intellectual property such as copyrighted works or patented inventions. If the use of those rights directly benefits or is incurred by reason of production activities, then the cost of securing those rights do as well. The fact that the amount of sales-based royalties is determined by reference to the number of units of property a taxpayer sells or is calculated as a percentage of revenue from the sale of inventory affects when a taxpayer incurs (within the meaning of section 461) that amount, but does not change an otherwise capitalizable production or resale cost into a non-capitalizable cost. Therefore, the proposed regulations also clarify that an indirect cost may directly benefit or be incurred by reason of the performance of production or resale activities even if the costs are incurred only upon the sale of inventory. Sales-based royalties, like other costs that directly benefit or are incurred by reason of production or resale activities, are capitalizable licensing and franchise costs within the meaning of §1.263A-1(e)(3)(ii)(U).

The proposed regulations achieve a similar result to that in Robinson Knife, but rather than determining that sales-based royalty costs are inherently non-capitalizable, the proposed regulations provide that otherwise capitalizable sales-based royalty costs are properly allocable to property sold during the taxable year.

Under §1.471-3(b), the cost of merchandise a taxpayer purchases generally is the invoice price less trade or other discounts. A sales-based vendor allowance is an allowance, discount, or price rebate a taxpayer earns as a result of selling a vendor’s merchandise, typically at a temporarily reduced price. The taxpayer’s right to receive the sales-based vendor allowance depends on actual sales of the vendor’s products. The amount received directly relates to the specific merchandise the taxpayer sells and properly is treated as a reduction in the cost of that merchandise. Therefore, the proposed regulations clarify that a sales-based vendor allowance is an adjustment to the cost of the merchandise sold or deemed sold under the taxpayer’s cost flow assumption.

Sales-based royalties and sales-based vendor allowances are properly allocable to property sold during the taxable year. Therefore, it is inappropriate to treat sales-based royalties and sales-based vendor allowances as adjustments to the cost of goods in ending inventory. The proposed regulations provide that sales-based royalties and sales-based vendor allowances are allocable to the units of property sold or deemed sold under the taxpayer’s cost flow assumption and are not included in determining the inventory cost or value of goods on hand at the end of the taxable year under any inventory method.

Because the proposed regulations expressly allocate sales-based royalties and sales-based vendor allowances to property that has been sold or deemed sold, the proposed regulations revise the simplified production and simplified resale methods to remove costs such as capitalizable sales-based royalties and cost reductions such as sales-based vendor allowances, which are properly allocable to property that has been sold, from the formulas used to allocate additional section 263A costs to ending inventory. Taxpayers must continue to include capitalizable sales-based royalty costs in both the numerator and denominator of the production cost allocation ratio under §1.263A-1(h)(5) for purposes of determining capitalized mixed service costs under the simplified service cost method.

The proposed regulations do not modify the retail inventory method under §1.471-8 specifically. Section 1.471-3 and section 263A determine the cost of purchases for purposes of the retail inventory method, and the proposed regulations under §§1.263A-1 and 1.471-3 preclude a taxpayer from including sales-based royalties and sales-based vendor allowances in the cost of goods in the fraction used to determine the value of ending inventory under §1.471-8. Similarly, if the selling price markdown in a sales-based vendor allowance arrangement is temporary, the retail selling price component of the fraction is not adjusted.

These regulations are proposed to apply for taxable years ending on or after the date the regulations are published as final regulations in the Federal Register.

This notice of proposed rulemaking 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. Because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, this notice of proposed rulemaking has been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Before these proposed regulations are adopted as final regulations, consideration will be given to any written comments that are submitted timely to the IRS. Comments may be submitted electronically or via a signed original with eight (8) copies. The IRS and the Treasury Department request comments on the clarity of the proposed rules and how they can be made easier to understand. All comments will be available for public inspection and copying.

A public hearing will be scheduled if requested in writing by any person that timely submits comments. If a public hearing is scheduled, notice of the date, time, and place for the hearing will be published in the Federal Register.

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

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

Section 1.263A-1 also issued under 26 U.S.C. 263A.

Section 1.263A-2 also issued under 26 U.S.C. 263A.

Section 1.263A-3 also issued under 26 U.S.C. 263A. * * *

Section 1.471-3 also issued under 26 U.S.C. 471. * * *

Par. 2. Section 1.263A-0 is amended by adding new entries for §§1.263A-1(c)(5), 1.263A-1(k), 1.263A-1(l), 1.263A-2(b)(3)(ii)(C), 1.263A-2(e), 1.263A-2(f), 1.263A-3(d)(3)(i)(C)(3), and 1.263A-3(f) and revising the entry for §§1.263A-1(e)(3)(ii) in the table of contents to read as follows: