(a) * * *

(6) * * *

(ii) [Reserved]. For further guidance, see §1.988-5T(a)(6)(ii).

* * * * *

(9) * * *

(iv) * * *

Example 11. [Reserved]. For further guidance, see §1.988-5T(a)(9)(iv).

Example 11.

* * * * *

Par. 3. Section 1.988-5T is added to read as follows:

(a) through (a)(6)(i) [Reserved]. For further guidance, see §1.988-5(a) through (a)(6)(i).

(ii) Legging out. With respect to a qualifying debt instrument and hedge that are properly identified as a qualified hedging transaction, “legging out” of integrated treatment under this paragraph (a) means that the taxpayer disposes of or otherwise terminates all or any portion of the qualifying debt instrument or the hedge prior to maturity of the qualified hedging transaction, or the taxpayer changes a material term of the qualifying debt instrument (for example, exercises an option to change the interest rate or index, or the maturity date) or the hedge (for example, changes the interest or exchange rates underlying the hedge, or the expiration date) prior to maturity of the qualified hedging transaction. A taxpayer that disposes of or terminates a qualified hedging transaction (that is, disposes of or terminates both the qualifying debt instrument and the hedge in their entirety on the same day) shall be considered to have disposed of or otherwise terminated the synthetic debt instrument rather than legging out. If a taxpayer legs out of integrated treatment, the following rules shall apply:

(A) The transaction will be treated as a qualified hedging transaction during the time the requirements of this paragraph (a) were satisfied.

(B) If all of the instruments comprising the hedge (each such instrument, a component) are disposed of or otherwise terminated, the qualifying debt instrument shall be treated as sold for its fair market value on the date the hedge is disposed of or otherwise terminated (the leg-out date), and any gain or loss (including gain or loss resulting from factors other than movements in exchange rates) from the identification date to the leg-out date is realized and recognized on the leg-out date. The spot rate on the leg-out date shall be used to determine exchange gain or loss on the debt instrument for the period beginning on the leg-out date and ending on the date such instrument matures or is disposed of or otherwise terminated. Proper adjustment must be made to reflect any gain or loss taken into account. The netting rule of §1.988-2(b)(8) shall apply.

(C) If a hedge has more than one component (and such components have been properly identified as being part of the qualified hedging transaction) and at least one but not all of the components that comprise the hedge has been disposed of or otherwise terminated, or if part of any component of the hedge has been terminated (whether a hedge consists of a single or multiple components), the date such component (or part thereof) is disposed of or terminated shall be considered the leg-out date and the qualifying debt instrument shall be treated as sold for its fair market value in accordance with the rules of paragraph (a)(6)(ii)(B) of this section on such leg-out date. In addition, all of the remaining components (or parts thereof) that have not been disposed of or otherwise terminated shall be treated as sold for their fair market value on the leg-out date, and any gain or loss from the identification date to the leg-out date is realized and recognized on the leg-out date. To the extent relevant, the spot rate on the leg-out date shall be used to determine exchange gain or loss on the remaining components (or parts thereof) for the period beginning on the leg-out date and ending on the date such components (or parts thereof) are disposed of or otherwise terminated.

(D) If the qualifying debt instrument is disposed of or otherwise terminated in whole or in part, the date of such disposition or termination shall be considered the leg-out date. Accordingly, the hedge (including all components making up the hedge in their entirety) that is part of the qualified hedging transaction shall be treated as sold for its fair market value on the leg-out date, and any gain or loss from the identification date to the leg-out date is realized and recognized on the leg-out date. To the extent relevant, the spot rate on the leg-out date shall be used to determine exchange gain or loss on the hedge (including all components thereof) for the period beginning on the leg-out date and ending on the date such hedge is disposed of or otherwise terminated.

(E) Except as provided in paragraph (a)(8)(iii) of this section (regarding identification by the Commissioner), the part of the qualified hedging transaction that has not been terminated (that is, the remaining debt instrument in its entirety even if partially hedged, or the remaining components of the hedge) cannot be part of a qualified hedging transaction for any period subsequent to the leg-out date.

(F) If a taxpayer legs out of a qualified hedging transaction and realizes a gain with respect to the disposed of or terminated debt instrument or hedge, then paragraph (a)(6)(ii)(B), (C), and (D) of this section, as appropriate, will not apply if during the period beginning 30 days before the leg-out date and ending 30 days after that date the taxpayer enters into another transaction that, taken together with any remaining components of the hedge, hedges at least 50 percent of the remaining currency flow with respect to the qualifying debt instrument that was part of the qualified hedging transaction or, if appropriate, an equivalent amount under the hedge (or any remaining components thereof) that was part of the qualified hedging transaction. Similarly, in a case in which a hedge has multiple components that are part of a qualified hedging transaction, if the taxpayer legs out of a qualified hedging transaction by terminating one such component or a part of one or more such components and realizes a gain with respect to the terminated component, components, or portions thereof, then paragraphs (a)(6)(ii)(B), (C), and (D) of this section, as appropriate, will not apply if the remaining components of the hedge (including parts thereof) by themselves hedge at least 50 percent of the remaining currency flow with respect to the qualifying debt instrument that was part of the qualified hedging transaction.

(a)(7) through (a)(9)(iv) Examples 10 [Reserved]. For further guidance, see §1.988-5(a)(7) through (a)(9)(iv) Example 10.

Example 11. (i) K is a U.S. corporation with the U.S. dollar as its functional currency. On January 1, 2013, K borrows 100 British pounds (£) for two years at a 10% rate of interest payable on December 31 of each year with no principal payment due until maturity on December 31, 2014. Assume that the spot rate on January 1, 2013, is £1=$1. On the same date, K enters into two swap contracts with an unrelated counterparty that economically results in the transformation of the fixed rate £100 borrowing to a floating rate dollar borrowing. The terms of the swaps are as follows:

(A) Swap #1, Currency swap. On January 1, 2013, K will exchange £100 for $100.

(1) On December 31 of both 2013 and 2014, K will exchange $8 for £10;

(2) On December 31, 2014, K will exchange $100 for £100.

(B) Swap #2, Interest rate swap. On December 31 of both 2013 and 2014, K will pay LIBOR times a notional principal amount of $100 and will receive 8% times the same $100 notional principal amount.

(ii) Assume that K properly identifies the pound borrowing and the swap contracts as a qualified hedging transaction as provided in paragraph (a)(8) of this section and that the other relevant requirements of paragraph (a) of this section are satisfied.

(iii) Assume also that on January 1, 2014, the spot exchange rate is £1:$2; the U.S. dollar LIBOR rate of interest is 9%; and the market value of K’s note in pounds has not changed. K terminates swap #2. K will incur a loss of ($.91) (the present value of $1) with respect to the termination of such swap on January 1, 2014. Pursuant to paragraph (a)(6)(ii)(C) of this section, K must treat swap #1 as having been sold for its fair market value on the leg-out date, which is the date swap #2 is terminated. K must realize and recognize gain of $100.92 [the present value of £110 discounted in pounds to equal £100 x $2 ($200) less the present value of $108 ($99.08)]. The loss inherent in the pound borrowing from January 1, 2013 to January 1, 2014 is realized and recognized on January 1, 2014. Such loss is exchange loss in the amount of $100 [the present value of £110 that was to be paid at the end of the year discounted at pound interest rates to equal £100 times the change in exchange rates: (£100 x $1, the spot rate on January 1, 2013) - (£100 x $2, the spot rate on January 1, 2014)]. Except as provided in paragraph (a)(8)(iii) of this section (regarding identification by the Commissioner), the pound borrowing and currency swap cannot be part of a qualified hedging transaction for any period subsequent to the leg-out date.

(iv) Assume the facts are the same as in paragraph (iii) of this section except that on January 1, 2014, the U.S. dollar LIBOR rate of interest is 7% rather than 9%. When K terminates swap #2, K will realize gain of $0.93 (the present value of $1) received with respect to the termination on January 1, 2014. Fifty percent or more of the remaining pound cash flow of the pound borrowing remains hedged after the termination of swap #2. Accordingly, under paragraph (a)(6)(ii)(F) of this section, paragraphs (a)(6)(ii)(B) and (C) of this section do not apply and the gain on swap #1 and the loss on the qualifying debt instrument is not taken into account. Thus, K will include in income $0.93 realized from termination of swap #2.

(a)(10) through (g) [Reserved]. For further guidance, see §1.988-5(a)(10) through (g).

(h) Effective/applicability date. This section applies to leg-outs that occur on or after September 6, 2012.

(i) Expiration date. This section expires on September 4, 2015.

Steven T. Miller,
Deputy Commissioner for
Services and Enforcement.

Approved August 17, 2012.

Mark J. Mazur,
Assistant Secretary
of the Treasury (Tax Policy).

* * * * *

* * * * *

(d) * * *

(2) Section 471 costs.

(i) In general.

(ii) Removal of costs from inventory.

(iii) Method changes.

(3) Additional section 263A costs.

(i) In general.

(ii) Negative amounts.

(A) In general.

(B) Exception for small taxpayers using the simplified production method.

(C) Exception for modified simplified production method and simplified resale method.

* * * * *

* * * * *

(c) Modified simplified production method.

(1) In general.

(2) Eligible property.

(3) Modified simplified production method without historic absorption ratio election.

(i) General allocation formula.

(A) In general.

(B) Allocable preproduction additional section 263A costs.

(C) Allocable production additional section 263A costs.

(D) Effect of allocation.

(E) Treatment of mixed service costs.

(ii) Definitions

(A) Preproduction absorption ratio.

(1) In general.

(2) Preproduction additional section 263A costs.

(3) Raw material costs.

(B) Production absorption ratio.

(1) In general.

(2) Production additional section 263A costs.

(3) Production section 471 costs.

(iii) LIFO taxpayers electing the modified simplified production method.

(A) In general.

(B) LIFO increment.

(1) In general.

(2) Combined absorption ratio defined.

(C) LIFO decrement.

(iv) De minimis rule for producers with total indirect costs of $200,000 or less.

(v) Examples.

(4) Modified simplified production method with historic absorption ratio election.

(i) In general.

(ii) General allocation formula.

(A) In general.

(B) Preproduction historic absorption ratio.

(C) Production historic absorption ratio.

(iii) LIFO taxpayers making the historic absorption ratio election.

(A) In general.

(B) Combined historic absorption ratio.

(C) Total allocable additional section 263A costs incurred during the test period.

(D) Total section 471 costs remaining on hand at year end during the test period.

(iv) Extension of qualifying period.

(v) Transition rule.

(vi) Examples.

(d) Additional simplified methods for producers.

(e) Cross reference.

(f) Change in method of accounting.

(1) In general.

(2) Scope limitations.

(3) Audit protection.

(4) Section 481(a) adjustment.

(5) Time for requesting change.

(g) Effective/applicability date.

Par. 3. Section 1.263A-1 is amended by:

1. Revising paragraphs (d)(2) and (d)(3).

2. Adding a sentence to the end of paragraph (m).

The addition and revisions read as follows:

* * * * *

(d) * * *

(2) Section 471 costs—(i) In general. Except as otherwise provided in paragraph (d)(2)(ii) of this section, for purposes of section 263A, a taxpayer’s section 471 costs are the costs, other than interest, that a taxpayer capitalizes to its inventory (or other eligible property) in its financial statements. Thus, although section 471 applies only to inventories, section 471 costs include any non-inventory costs, other than interest, that a taxpayer capitalizes or includes in acquisition or production costs in its financial statements. However, notwithstanding the last sentence of paragraph (g)(2) of this section, section 471 costs must include all direct costs of producing property and of acquiring property held for resale, whether or not a taxpayer capitalizes these costs to inventory or to other eligible property in its financial statements. See paragraph (e)(2) of this section for a description of direct production costs and direct costs of acquiring property held for resale.

(ii) Removal of costs from inventory. A taxpayer must reduce its section 471 costs by those costs that the taxpayer capitalizes to its inventory (or other eligible property) in its financial statements that may not be capitalized under either §1.263A-1(c)(2) or §1.263A-1(j)(2)(ii), and those period costs that the taxpayer capitalizes to its inventory (or other eligible property) in its financial statements that, under §1.263A-1(j)(2), the taxpayer chooses not to capitalize under section 263A (for example, section 179 costs). A taxpayer described in paragraph (d)(3)(ii)(B) or (d)(3)(ii)(C) of this section that may remove these costs from inventory by including them as negative amounts in additional section 263A costs instead may reduce its section 471 costs for these costs. A taxpayer that reduces its section 471 costs must use a reasonable method that approximates the manner in which the taxpayer originally capitalized the costs to its inventory (or other eligible property) in its financial statements.

(iii) Method changes. A taxpayer may change its method of accounting for determining section 471 costs only with the consent of the Commissioner as required under section 446(e) and the corresponding regulations. If a taxpayer is using the simplified production method described in §1.263A-2(b), the modified simplified production method described in §1.263A-2(c), or the simplified resale method described in §1.263A-3(d), and changes its financial reporting practices regarding the costs capitalized to its inventory (or other eligible property) in a manner that would change its section 471 costs under the general provisions of paragraph (d)(2)(i) of this section, then the taxpayer must secure the Commissioner’s consent prior to computing its taxable income under the new method of accounting for section 471 costs.

(3) Additional section 263A costs—(i) In general. Additional section 263A costs are defined as the costs, other than interest, that are not included in a taxpayer’s section 471 costs, but that are required to be capitalized under section 263A. Additional section 263A costs do not include the direct costs that are required to be included in a taxpayer’s section 471 costs under paragraph (d)(2)(i) of this section.

(ii) Negative amounts—(A) In general. Except as otherwise provided by regulations or other published guidance, see §601.601(d)(2), a taxpayer may not include negative amounts in additional section 263A costs.

(B) Exception for small taxpayers using the simplified production method. Paragraph (d)(3)(ii)(A) of this section does not apply to a taxpayer using the simplified production method under §1.263A-2(b) if the taxpayer’s (or its predecessors’) average annual gross receipts for the three previous taxable years (test period) do not exceed $10,000,000. The rules of §1.263A-3(b) apply for purposes of determining the amount of a taxpayer’s gross receipts and the test period.

(C) Exception for modified simplified production method and simplified resale method. In general, a taxpayer using the modified simplified production method under §1.263A-2(c) or the simplified resale method under §1.263A-3(d) may (but is not required to) remove as negative amounts under section 263A indirect costs that are included in the taxpayer’s section 471 costs but that are not required to be, or may not be, capitalized into inventory (or other eligible property) for federal income tax purposes. However, a taxpayer using the modified simplified production method or the simplified resale method may not use negative amounts to adjust additional section 263A costs for cash or trade discounts described in §1.471-3(b).

* * * * *

(m) * * * Paragraphs (d)(2) and (d)(3) of this section apply for taxable years ending on or after the date these regulations are published as final regulations in the Federal Register.

Par. 4. Section 1.263A-2 is amended by:

1. Redesignating paragraphs (c), (d), (e), and (f) as paragraphs (d), (e), (f), and (g).

2. Adding a new paragraph (c).

3. Revising newly designated paragraph (g).

The addition and revisions read as follows:

* * * * *

(c) Modified simplified production method—(1) In general. This paragraph (c) provides a modified simplified method for determining the additional section 263A costs properly allocable to ending inventories of property produced and other eligible property on hand at the end of the taxable year.

(2) Eligible property. For purposes of this paragraph (c), eligible property has the same meaning as in paragraph (b)(2) of this section.

(3) Modified simplified production method without historic absorption ratio election—(i) General allocation formula—(A) In general. Except as otherwise provided in paragraph (c)(3)(iv) of this section, a taxpayer may compute the total additional section 263A costs allocable to eligible property remaining on hand at the close of the taxable year under the modified simplified production method as follows:

Allocable preproduction additional section 263A costs + Allocable production additional section 263A costs.

(B) Allocable preproduction additional section 263A costs. The amount of preproduction additional section 263A costs allocable to ending inventory or to other eligible property on hand at the end of the taxable year is computed as follows:

Preproduction absorption ratio x raw material section 471 costs incurred during the taxable year and remaining on hand at year end.

(C) Allocable production additional section 263A costs. The amount of production additional section 263A costs allocable to ending inventory or to other eligible property on hand at the end of the taxable year is computed as follows:

Production absorption ratio x production section 471 costs incurred during the taxable year and remaining on hand at year end.

(D) Effect of allocation. The allocable preproduction additional section 263A costs and the allocable production additional section 263A costs are totaled to compute the additional section 263A costs, which are added to the taxpayer’s ending section 471 costs to determine the total section 263A costs that are capitalized. See, however, paragraph (c)(3)(iii) of this section for special rules for LIFO taxpayers. Except as otherwise provided in this section or in §1.263A-1 or §1.263A-3, additional section 263A costs that are allocated to inventories on hand at the close of the taxable year under the modified simplified production method are treated as inventory costs for all purposes of the Internal Revenue Code.

(E) Treatment of mixed service costs. A taxpayer must apportion capitalizable mixed service costs (the aggregate portion of mixed service costs that are properly allocable to the taxpayer’s production or resale activities as additional section 263A costs) between preproduction additional section 263A costs described in paragraph (c)(3)(ii)(A)(2) of this section and production additional section 263A costs described in paragraph (c)(3)(ii)(B)(2) of this section. Under the modified simplified production method, a taxpayer must allocate capitalizable mixed service costs to preproduction additional section 263A costs in proportion to the raw material costs in total section 471 costs. The taxpayer must include the capitalizable mixed service costs that are not allocated to preproduction additional section 263A costs in production additional section 263A costs.

(ii) Definitions—(A) Preproduction absorption ratio—(1) In general. Under the modified simplified production method, the preproduction absorption ratio is determined as follows:

(2) Preproduction additional section 263A costs. Preproduction additional section 263A costs are the sum of the additional section 263A costs (as defined in §1.263A-1(d)(3)) incurred during the current taxable year that are described in paragraph (a)(3)(ii) of this section to the extent the costs are not treated as section 471 costs and the allocable portion of capitalizable mixed service costs as described in paragraph (c)(3)(i)(E) of this section.

(3) Raw material costs. Raw material costs are defined as the direct costs of acquiring raw materials that a taxpayer purchases during its current taxable year. Raw material section 471 costs incurred during the taxable year and remaining on hand at year end include the raw material costs in work-in-process and finished goods as well as unprocessed raw materials.

(B) Production absorption ratio—(1) In general. Under the modified simplified production method, the production absorption ratio is determined as follows:

(2) Production additional section 263A costs. Production additional section 263A costs are the sum of all additional section 263A costs (as defined in §1.263A-1(d)(3)) incurred during the current taxable year that are not preproduction additional section 263A costs as described in this section and the allocable portion of capitalizable mixed service costs as described in paragraph (c)(3)(i)(E) of this section. For example, production additional section 263A costs include the additional section 263A costs that constitute post-production costs as defined in paragraph (a)(3)(iii) of this section.

(3) Production section 471 costs. Production section 471 costs are defined as the total section 471 costs that a taxpayer incurs during its current taxable year less the taxpayer’s raw material costs.

(iii) LIFO taxpayers electing the modified simplified production method—(A) In general. Under the modified simplified production method, a taxpayer using a LIFO method must calculate a particular year’s index (for example, under §1.472-8(e)) without regard to its additional section 263A costs. Similarly, a taxpayer that adjusts current-year costs by applicable indexes to determine whether there has been an inventory increment or decrement in the current year for a particular LIFO pool must disregard the additional section 263A costs in making that determination.

(B) LIFO increment—(1) In general. If a taxpayer determines there has been an inventory increment, the taxpayer must state the amount of the increment in current-year dollars (stated in terms of section 471 costs). The taxpayer then multiplies this amount by the combined absorption ratio, as defined in paragraph (c)(3)(iii)(B)(2) of this section. The resulting product is the additional section 263A costs that must be added to the taxpayer’s increment for the year stated in terms of section 471 costs.

(2) Combined absorption ratio defined. For purposes of this paragraph (c)(3)(iii), the numerator of the combined absorption ratio is the total additional section 263A costs allocable to eligible property remaining on hand at the close of the taxable year, as described in paragraph (c)(3)(i)(A) of this section. The denominator of the combined absorption ratio is the total section 471 costs remaining on hand at year end, as described in paragraph (b)(3)(ii)(B) of this section.

(C) LIFO decrement. If a taxpayer determines there has been an inventory decrement, the taxpayer must state the amount of the decrement in dollars for the particular year for which the LIFO decrement has occurred. The additional section 263A costs incurred in prior years that apply to the decrement are included in cost of goods sold. The taxpayer determines the additional section 263A costs that apply to the decrement by multiplying the additional section 263A costs allocated to the layer of the pool in which the decrement occurred by the ratio of the decrement (excluding additional section 263A costs) to the section 471 costs in the layer of that pool.

(iv) De minimis rule for producers with total indirect costs of $200,000 or less. Paragraph (b)(3)(iv) of this section, which provides that the additional section 263A costs allocable to eligible property remaining on hand at the close of the taxable year are deemed to be zero for producers with total indirect costs of $200,000 or less, applies to the modified simplified production method.

(v) Examples. The rules of this paragraph (c)(3) are illustrated by the following examples:

Example 1. FIFO inventory method. (i) Taxpayer P uses the first-in, first-out (FIFO) method of accounting for inventories and a calendar taxable year. P’s beginning inventory for 2010 is $2,500,000, including $2,000,000 of section 471 costs and $500,000 of additional section 263A costs.

(ii) During 2010, P incurs $10,000,000 of section 471 costs, including $4,000,000 of raw material costs (as defined in paragraph (c)(3)(ii)(A)(3) of this section) and $6,000,000 of production section 471 costs (as defined in paragraph (c)(3)(ii)(B)(3) of this section). P also incurs $1,060,000 of additional section 263A costs, including $340,000 of preproduction additional section 263A costs (as defined in paragraph (c)(3)(ii)(A)(2) of this section) and $720,000 of production additional section 263A costs (as defined in paragraph (c)(3)(ii)(B)(2) of this section).

(iii) At the end of 2010, P’s section 471 costs incurred during the taxable year remaining in ending inventory are $3,500,000, including $2,000,000 of raw materials section 471 costs and $1,500,000 of production section 471 costs.

(iv) P computes its preproduction absorption ratio for 2010 under paragraph (c)(3)(ii)(A) of this section as follows:

(v) P computes its production absorption ratio for 2010 under paragraph (c)(3)(ii)(B)(1) of this section as follows:

(vi) Under paragraph (c)(3)(i)(B) of this section, P computes its allocable preproduction additional section 263A costs by multiplying the preproduction absorption ratio by raw materials section 471 costs incurred during the taxable year and remaining in ending inventory (8.5 percent * $2,000,000 = $170,000).

(vii) Under paragraph (c)(3)(i)(C) of this section, P computes its allocable production additional section 263A costs by multiplying the production absorption ratio by production section 471 costs incurred during the taxable year and remaining in ending inventory at year end (12 percent * $1,500,000 = $180,000).

(viii) Under paragraph (c)(3)(i)(A) of this section, P computes its total additional section 263A costs allocable to ending inventory by adding its allocable preproduction additional section 263A costs to its allocable production additional section 263A costs ($170,000 + $180,000 = $350,000).

(ix) P adds the $350,000 additional section 263A costs to the $3,500,000 of section 471 costs remaining in its ending inventory to calculate its total ending inventory of $3,850,000. P includes the balance of P’s additional section 263A costs incurred during 2010, $710,000 ($1,060,000 less $350,000), in P’s cost of goods sold.

Example 2. LIFO inventory method. (i) The facts are the same as in Example 1, except that P uses the LIFO inventory method rather than the FIFO method. P’s 2010 LIFO increment is $1,500,000.

(ii) Under paragraph (c)(3)(iii)(B)(1) of this section, P determines the additional section 263A costs allocable to its 2010 LIFO increment by multiplying the increment by a combined absorption ratio. Under paragraph (c)(3)(iii)(B)(2) of this section, P computes the combined absorption ratio as follows:

(iii) P’s additional section 263A costs allocable to its 2010 increment are $150,000 (10 percent * $1,500,000). Under paragraph (c)(3)(iii)(B)(1) of this section, P adds the $150,000 additional section 263A costs to its $1,500,000 LIFO increment to determine a total 2010 LIFO increment of $1,650,000. P’s ending inventory is $4,150,000 (its beginning inventory of $2,500,000 plus the $1,650,000 increment). P includes the remaining $910,000 ($1,060,000 less $150,000) of additional section 263A costs incurred during 2010 in P’s cost of goods sold.

Example 3. Mixed service costs. (i) During 2010, Taxpayer R incurs $200,000 of capitalizable mixed service costs (within the meaning of paragraph (c)(3)(i)(E) of this section). R incurs $8,000,000 of section 471 costs, including $2,000,000 of raw material costs (as defined in paragraph (c)(3)(ii)(A)(3) of this section).

(ii) Under paragraph (c)(3)(i)(E) of this section, R allocates its mixed service costs to preproduction additional section 263A costs by computing the proportion of raw material costs in its section 471 costs and multiplying its mixed service costs by this percentage. The proportion of raw material costs in R’s section 471 costs is 25 percent ($2,000,000/$8,000,000). R allocates $50,000 (25 percent * $200,000) of mixed service costs to preproduction additional section 263A costs. R includes the remaining $150,000 ($200,000 less $50,000) of capitalizable mixed service costs as production additional section 263A costs.

(4) Modified simplified production method with historic absorption ratio election—(i) In general. Except as otherwise provided in this paragraph (c)(4), paragraph (b)(4) of this section applies to the historic absorption ratio election under the modified simplified production method.

(ii) General allocation formula—(A) In general. Except as provided in paragraph (c)(4)(iii) of this section (relating to LIFO taxpayers), a taxpayer making the historic absorption ratio election under the modified simplified production method uses a preproduction historic absorption ratio and a production historic absorption ratio in place of the actual preproduction absorption ratio and production absorption ratio under paragraph (c)(3)(ii) of this section. The preproduction and production historic absorption ratios are based on costs a taxpayer capitalizes during its test period.

(B) Preproduction historic absorption ratio. The preproduction historic absorption ratio is computed as follows:

(iii) LIFO taxpayers making the historic absorption ratio election—(A) In general. Instead of the combined absorption ratio under paragraph (c)(3)(iii)(B)(2) of this section, a LIFO taxpayer making the historic absorption ratio election under the modified simplified production method calculates a combined historic absorption ratio based on costs a taxpayer capitalizes during its test period.

(B) Combined historic absorption ratio. The combined historic absorption ratio is computed as follows:

(C) Total allocable additional section 263A costs incurred during the test period. Total allocable additional section 263A costs incurred during the test period are the sum of the total additional section 263A costs allocable to eligible property on hand at year end as described in paragraph (c)(3)(i)(A) of this section, for all years in the test period.

(D) Total section 471 costs remaining on hand at each year end of the test period. Total section 471 costs remaining on hand at each year end of the test period are the sum of the total section 471 costs remaining on hand at year end described in paragraph (b)(3)(ii)(B) of this section, for all taxable years in the test period.

(iv) Extension of qualifying period. In the first taxable year following the close of each qualifying period (for example, the sixth taxable year following the test period), a taxpayer must compute the actual absorption ratios under paragraph (c)(3) of this section (preproduction and production absorption ratios or, for LIFO taxpayers, the combined absorption ratio). If the actual combined absorption ratio or both the actual preproduction and production absorption ratios, as applicable, computed for this taxable year (the recomputation year) is within one-half of one percentage point (plus or minus) of the corresponding historic absorption ratio or ratios used in determining capitalizable costs for the qualifying period (the previous five taxable years), the qualifying period is extended to include the recomputation year and the following five taxable years, and the taxpayer must continue to use the historic absorption ratio or ratios throughout the extended qualifying period. If, however, the actual combined historic absorption ratio or either the actual preproduction absorption ratio or production absorption ratio, as applicable, is not within one-half of one percentage point (plus or minus) of the corresponding historic absorption ratio, the taxpayer must use the actual absorption ratio or ratios beginning with the recomputation year and throughout the updated test period. The taxpayer must resume using the historic absorption ratio or ratios based on the updated test period in the third taxable year following the recomputation year.

(v) Transition rule. [Reserved].

(vi) Examples. The provisions of this paragraph (c)(4) are illustrated by the following examples:

Example 1. FIFO inventory method. (i) Taxpayer S uses the FIFO method of accounting for inventories and a calendar taxable year, and in 2010 elects to use the modified simplified production method. In 2013, S makes the historic absorption ratio election. S identifies the following costs incurred during the test period:

In 2013, S incurs $10,000 of section 471 costs of which $1,000 raw material costs and $2,000 production 471 costs remain in ending inventory.

(ii) Under paragraph (c)(4)(ii)(B) of this section, in 2013 S computes the preproduction historic absorption ratio as follows:

(iii) Under paragraph (c)(4)(ii)(C) of this section, S computes the production historic absorption ratio as follows:

(iv) Under paragraph (c)(4)(ii)(A) of this section, S determines the preproduction additional section 263A costs allocable to its ending inventory for 2013 by multiplying its raw materials section 471 costs incurred during the 2013 taxable year and remaining in its ending inventory by its preproduction historic absorption ratio. S allocates $80 preproduction additional section 263A costs to its ending inventory ($1,000 * 8 percent).

(v) S determines the production additional section 263A costs allocable to its ending inventory for 2013 by multiplying its production section 471 costs incurred during the 2013 taxable year and remaining in its ending inventory by its production historic absorption ratio. S allocates $200 production additional section 263A costs to its ending inventory ($2,000 * 10 percent).

(vi) Under paragraph (c)(4)(ii) of this section, S’s total additional section 263A costs allocable to ending inventory in 2013 are $280, which is the sum of the allocable preproduction additional section 263A costs ($80) and the allocable production additional section 263A costs ($200). S’s ending inventory in 2013 is $3,280, which is the sum of S’s additional section 263A costs allocable to ending inventory and S’s section 471 costs remaining in ending inventory ($280 + $3,000). S includes the balance of S’s additional section 263A costs incurred during 2013 in S’s cost of goods sold.

Example 2. LIFO inventory method. (i) The facts are the same as in Example 1, except that S uses the LIFO inventory method rather than the FIFO method. S calculates additional section 263A costs incurred during the taxable year and allocable to ending inventory under paragraph (c)(3)(iii) of this section and identifies the following costs incurred during the test period:

In 2013, the LIFO value of S’s increment is $1,500.

(ii) Under paragraph (c)(4)(iii) of this section, S computes a combined historic absorption ratio as follows:

(iii) S’s additional section 263A costs allocable to its 2013 LIFO increment is $150 ($1,500 beginning LIFO increment * 10 percent combined historic absorption ratio). S adds the $150 to the $1,500 LIFO increment to determine a total 2013 LIFO increment of $1,650.

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(g) Effective/applicability date. Paragraphs (b)(2)(i)(D), and (f) of this section apply for taxable years ending on or after August 2, 2005. Paragraph (c) of this section applies for taxable years ending on or after the date these regulations are published as final regulations in the Federal Register.

Steven T. Miller,
Deputy Commissioner for
Services and Enforcement.

(a) * * *

(6) * * *

(ii) [The text of these proposed amendments to §1.988-5(a)(6)(ii) is the same as the text of §1.988-5T(a)(6)(ii) published elsewhere in this issue of the Bulletin.]

* * * * *

(9) * * *

(iv) * * *

* * * * *

Example 11 [The text of these proposed amendments to §1.988-5(a)(9)(iv) Example 11 is the same as the text of §1.988-5T(a)(9)(iv) Example 11 published elsewhere in this issue of the Bulletin.]

* * * * *

(h) [The text of these proposed amendments to §1.988-5(h) is the same as the text of §1.988-5T(h) published elsewhere in this issue of the Bulletin.]

Steven T. Miller,
Deputy Commissioner for
Services and Enforcement.