Interest capitalization under the sec. 263A(f) proposed regs.: 20 questions may help clarify complicated rules.

The Tax Reform Act of 1986 added the interest capitalization rules to the comprehensive uniform capitalization (UNICAP) rules of Sec. 263A. UNICAP generally requires the capitalization of all direct and indirect costs of producing property or acquiring property for resale. Under Sec. 263A(f), interest expense attributable to the cost of constructing an asset is not currently deductible; rather, it must be capitalized and added to the basis of the asset.

The IRS issued proposed regulations for determining the amount of interest required to be capitalized under Sec. 263A(f). These rules include some significant departures from Notice 88-99,(1) which provided interim guidance on the interest capitalization rules in advance of regulations.

The proposed regulations provide both favorable and unfavorable departures from the existing rules under Notice 88-99, but they will not become effective until the regulations are finalized. (At. press time, final regulations were not on any IRS immediate priority list.) Until then, the proposed rules will not be applied adversely to taxpayers who took a position consistent with a reasonable interpretation of the statute, legislative history and applicable administrative pronouncements, such as Notice 88-99.(2)

This article will analyze the complex proposed regulations using a question format. Since the proposed regulations do not include the related party and flowthrough entity rules, a discussion of those rules is beyond the scope of this article.

Questions 1, 2 and 3 discuss timing issues and when a taxpayer must capitalize interest, Questions 4 through 13 cover the avoided cost method in detail, and Questions 14 through 20 address special rules.

Designated Property and Timing Issues

* Question 1: When must a taxpayer capitalize interest?

Interest must be capitalized with respect to certain "designated property produced" by the taxpayer.(3) "Produce" is broadly defined to mean construct, build, install, manufacture, develop, improve, create, raise or grow,(4) and includes property produced for the taxpayer under contract.(5)

"Designated property" refers to the types of produced property subject to interest capitalization.(6) Designated property is defined as produced property that is any of the following:

* Real property.

* Tangible personal property with a class life of 20 years or more, but only if the property is produced for the taxpayer's own use.(7)

* Tangible personal property with an estimated production period exceeding two years.

* Tangible personal property with an estimated production period exceeding one year and an estimated cost of production exceeding $1 million.(8)

Real property includes land and "unsevered natural products of land," such as mines, wells and other natural deposits, and growing crops and plants (but only if the production period of the crops exceeds two years). Real property also includes buildings, tenant improvements to a building and "inherently permanent structures," which include property affixed to real property that will ordinarily remain affixed for an indefinite period of time.(9)

The definition of tangible personal property under Temp. Regs. Sec. 1.263A-1T(a)(5)(iii) is extremely broad, and includes films, sound recordings, video tapes, books, etc. The interest capitalization rules also apply to costs relating to copyrights, licenses, manuscripts and other items that may be treated as intangible for other Code purposes. Interest capitalization is required with regard to long-lived personal property only if the property is produced for self-use. Thus, long-lived tangible personal property that is inventory in the taxpayer's hands is not designated property unless the inventory has an estimated production period exceeding two years, or exceeding one year and an estimated cost exceeding $1 million.(10)

A de minimis rule excludes certain property that would otherwise be classified as designated property. Interest capitalization is not required if the property has a production period of three months or less and the total cost of production is 10,000 or less.(11)

Special rules apply to long-term contracts, defined in Sec. 460(f) as any contract for the manufacture, building, installation or construction of property not completed within the same tax year in which it was entered into. Generally, Sec. 263A(c)(4) provides that the uniform capitalization rules do not apply to any property produced by the taxpayer pursuant to a long-term contract. However, Sec. 460(c)(3)(A) provides that in the case of a long-term contract, interest must be allocated to the contract in the same manner as interest is allocated to property produced by the taxpayer under Sec. 263A(f). Guidance on the special rules applicable to property produced under a long-term contract within the meaning of Sec. 460(f) is expected to be contained in future Sec. 460 regulations.(12)

Flowchart I on pages 526-527 illustrates whether property is subject to interest capitalization. If the answer is no, the remaining analysis does not apply; if the answer is yes, the remaining questions discuss how to calculate interest to be capitalized.

* Question 2: How is capitalized interest treated?

Interest that must be capitalized under Sec. 263A is treated as a cost of the designated property and is recovered in accordance with the general UNICAP rules.(13) Interest that is capitalized with respect to the production of land or a land improvement is ordinarily added to the basis of related depreciable property; if there is no depreciable property, the capitalized interest is added to the basis of the improved land.(14)

* Question 3: When does the production period begin, when does it end, and when can it be suspended?

Interest capitalization is required only during the production period of the unit of property. Each unit has its own production period.(15)

Beginning of production period for real property: The production period of a unit of real property begins when any "physical production activity" is performed on the site of the unit of real property.(16) "Physical production activity" includes any physical activity that constitutes production.(17) The proposed regulations set forth a nonexclusive list of activities that constitute physical production:

* Clearing, grading or excavating of raw land.

* Demolishing a building or gutting a standing building.

* Engaging in the construction of infrastructure, such as roads, sewers, sidewalks, cables, wiring, etc.

* Undertaking structural, mechanical or electrical activities with respect to a building or other structure.

* Engaging in landscaping activities.(18) Activities that are not physical production activities include:

* Planning and design activities.

* Incidental repairs (e.g., repairing fences, repairing or repainting the walls of an existing structure).(19)

Beginning of production period for tangible personal property. The production period of a unit of tangible personal property begins when accumulated production expenditures (APEs) for the unit equal or exceed 5% of the total APEs for the unit.(20)

Capitalization can begin earlier for financial accounting purposes than for tax purposes. Financial Accounting Standards Board Statement No. 34 (FASB 34), Capitalization of Interest Cost, states that the capitalization period begins when three conditions are present:

1. Expenditures for the asset have been made.

2. Activities necessary to get the asset ready for its intended use are in progress. "Activities" encompasses more than physical activities. For example, the process of obtaining government permits can initiate the beginning of the production period.

3. Interest cost is being incurred.

Ending date for production period: The ending date for the production period depends on whether the property is produced for self-use or for sale. The production period for property produced for self-use ends when (1) the property is ready to be placed in service and (2) all production activities reasonably expected to be undertaken by or for the taxpayer are completed.(21) The production period for property produced for sale ends when (1) the property is ready to be held for sale and (2) all production activities reasonably expected to be undertaken by or for the taxpayer are completed.(22)

The Sec. 189 legislative history provides that the construction period ends on the date that the building or improvement is ready to be placed in service or is ready to be held for sale.(23) The proposed regulations incorporate this test, but add a second test: for the production period to end, all production activities reasonably expected to be undertaken by or for the taxpayer must be completed.(24) This test can extend the production period beyond the apparent intent of Congress for property covered by Sec. 189.

Under Prop. Regs. Sec. 1.263A(f)-5(d)(2), for property that is customarily aged (e.g., tobacco, wine or whiskey), the production period includes the aging period.

For financial accounting purposes, FASB 34 states that the capitalization period ends when the asset is substantially completed and ready for its intended use.

Suspension of production period: The production period is suspended if activities related to the production of the unit cease for 12 consecutive months.(25) Interest capitalization may be suspended beginning with the thirteenth month of the period in which production activities have ceased. The suspension period ends on the first day any production activities take place. At that time, the taxpayer must resume interest capitalization with respect to that unit.

For financial accounting purposes, FASB 34 states that if substantially all activities related to acquisition of the asset are suspended, interest capitalization ceases until activities are resumed.

Avoided Cost Method

* Question 4: What is the "avoided cost method"

The core of the interest capitalization rules is the concept of "avoided cost."(26) Under the avoided cost method, any interest must be capitalized that the taxpayer theoretically could have avoided if expenditures for production had been used to repay or reduce the taxpayer's outstanding debt.(27) It is irrelevant that the taxpayer might not have used the amounts expended for production to repay or reduce the debt; rather, the assumption is that the taxpayer's debt would have been repaid or reduced.(28) If the debt proceeds were actually used for purposes other than the production of designated property, the interest must still be capitalized.(29)

The legislative history indicates that the avoided cost method is based on rules similar to those applicable under former Sec. 189.(30) The legislative history of the amendments to former Sec. 189 directed the Treasury to issue regulations (which have never been issued) allocating interest to expenditures for real property during construction consistent with FASB 34.(31)

Under FASB 34, the objectives of interest capitalization are to (1) obtain a measure of acquisition cost that more closely reflects the enterprise's total investment in the asset and (2) charge a cost that relates to the acquisition cost of a resource that will benefit future periods against the revenues of the periods benefited. To accomplish these objectives, FASB 34 provides that the amount of interest to be capitalized is the portion of interest expense incurred during the construction period that could have been avoided if funds had not been expended for construction.

The avoided cost approach to interest capitalization set forth in the proposed regulations is consistent with the general approach taken in FASB 34.

* Question 5: What kind of debt is excluded from interest capitalization?

Before turning to the complex calculations for determining capitalized interest, it is useful to summarize the types of debt that enter into the computation. Interest is capitalized with respect to "eligible debt," which generally includes all of the taxpayer's debt for which interest is deductible.

Under Prop. Regs. Sec. 1.263A(f)-2(a)(4), eligible debt does not include:

* Debt bearing interest disallowed under Temp. Regs. Sec. 1.163-8T(m)(7)(ii).

* Debt, such as accounts payable, that bears no interest, unless the debt is traced debt (described below).

* Debt borrowed from a related party with an interest rate less than the applicable Federal rate under Sec. 1274 on the date of issuance.

* Debt bearing personal interest under Sec. 163(h)(2).

* Debt bearing qualified residence interest under Sec. 163(h)(3).(32)

* Debt incurred by an exempt organization under Sec. 501(a), unless such debt is directly attributed to an unrelated trade or business.

* Reserves, deferred tax liabilities and similar items not treated as debt for Federal income tax purposes.

* Current Federal and state income tax liabilities, deferred tax liabilities under Sec. 453A, hypothetical tax liabilities under Sec. 460 and similar items.

* Question 6: How does a taxpayer compute the interest to be capitalized?

The amount of interest to be capitalized is the interest incurred on outstanding debt up to APEs, generally defined as the cumulative direct and indirect costs required to be capitalized with respect to a "unit of property." (APEs and units of property are discussed in Questions 13 and 12, respectively.) Interest on other outstanding debt is capitalized with respect to APEs that exceed specifically traced debt, using a "weighted average interest rate." Generally, the computation is as follows:(33)

Step 1: Calculate the traced debt amount (see Question 8).

Step 2: Calculate "average excess expenditures":

The sum of APEs exceeding traced debt at each measurement date during the computation period/

The number of measurement dates in the

computation period (See Question 7 for computation period and measurement dates, and Question 9 for the definition of average excess expenditures.)

Step 3: Calculate the "weighted average interest rate":

Interest incurred on nontraced debt during the computation period/

Average nontraced debt for the

computation period

Step 4: Calculate the "excess expenditure amount" (step 2 x step 3).(34)

Step 5: Capitalize the sum of steps 1 and 4.

Step 6: Capitalize interest in the following sequence, but not in excess of the excess expenditure amount:(35)

* Interest on traced debt.

* Interest on nontraced debt.

* Interest incurred on borrowings from a related party.(36)

* For a partnership, certain guaranteed payments.

Flowchart II on page 530 summarizes the interest calculation and illustrates the relationship between APEs, traced debt and avoided cost debt.

The application of the avoided cost method outlined above is illustrated in Example 1 above.

* Question 7: In the formula (set out in Question 6), what are the "computation period" and "measurement dates"?

The "computation period" is the period of time over which the taxpayer makes the avoided cost calculation. A taxpayer may (but is not required to) use a computation period of a full tax year.(37) This is a significant departure from Notice 88-99, which required at least a monthly calculation. Taxpayers electing to use the tax year as the computation period must calculate a weighted average interest rate on nontraced debt for the entire tax year, and apply this rate to the average excess expenditures for the tax year. If the taxpayer uses a shorter computation period, all computation periods within the tax year must be the same length.(38)

On each "measurement date," the taxpayer must determine traced debt, average nontraced debt and average excess expenditures. if the tax year is used as the computation period, measurement dates must occur at least quarterly.(39)

Example 2: Corporation X, a calendar-year taxpayer, is engaged in the production of designated property. X adopts the tax year as the computation period and quarterly measurement dates. X must identify traced debt, APES and nontraced debt at each quarterly measurement date (March 31, June 30, September 30 and December 31). X must calculate average excess expenditures for each unit of designated property by adding the APES in excess of traced debt for each unit of designated property at each quarter end and dividing the sum by four. X must calculate average nontraced debt by adding the nontraced debt outstanding at the end of each quarter and dividing the sum by four.(40)

* Question 8: In Step 1 of the formula, what is the "traced debt amount"

The traced debt amount equals the total interest incurred on the traced debt during each measurement period.(41)

Example 3: Assume that, in Example 1, the production period began on January 20 (instead of january 1) and ended on December 10 (instead of December 31). The traced debt amount would not change, because the total interest incurred on the traced debt during each measurement period must be capitalized.

On each measurement date, the taxpayer must identify traced debt with respect to a unit of designated property. This means eligible debt the proceeds of which, on any measurement date, are allocated to APES under the allocation rules of Temp. Regs. Sec. 1.163-8T.(42) Under those rules, debt generally is allocated to a particular expenditure by tracing disbursements of the debt proceeds to the expenditure.

* Question 9: In Step 2 of the formula, what are the "average excess expenditures" For each unit of designated property, the taxpayer must compute average excess expenditures according to the formula.

Example 4: Corporation X, a calendar-year taxpayer, is engaged in the production of a single unit of designated property during 1993. X adopts the tax year as the computation period and quarterly measurement dates. The production period begins on Jan. 14, 1993, and ends on June 16, 1993.

                    3/31/93      6/30/93
Traced debt      $1,000,000   $1,000,000
APEs              1,400,000    1,600,000

APES exceeding

traced debt $400,000 $600,000

Based on these facts, average excess expenditures during 1993 are $250,000 [[$400,000 + $600,000 $0 + $0] / 4).(43)

* Question 10: In Step 3, what is the "weighted average interest rate"

The weighted average interest rate is the "interest incurred on nontraced debt" cluring the computation period, divided by the "average nontraced debt" for the computation period.(44)

"Nontraced debt" is all elligible debt (other than any debt treated as traced debt) on a measurement date.(45)

"Interest incurred on nontraced debt" includes the total interest incurred during the computation period on all eligible debt, minus the interest incurred during the computation period on traced debt.(46)

"Average nontraced debt" for the computation period is:(47) The sum of all nontraced debt outstanding on each measurement date during the computation period The number of measurement dates during the computation period

It is somewhat anomalous that the "interest incurred on nontraced debt" (the numerator of the weighted average interest rate) includes all interest incurred on nontraced debt during the computation period, even if the underlying nontraced debt is repaid between measurement dates, and is therefore excluded from the denominator of the weighted average interest rate. However, the taxpayer may elect to treat eligible debt repaid within the 15-day period immediately preceding a quarterly measurement date as outstanding on that measurement date.(48)

* Question 11: In Step 4, what is the "excess expenditure amount"

With respect to each unit, the excess expenditure amount is the amount that the taxpayer must capitalize. However, if the excess expenditure amount for all units of designated property for the computation period exceeds the total amount available for capitalization, the interest allocated to each unit of designated property is calculated as follows:(49)

                             Average excess expenditures
Interest    Total interest   for the unit

allocated = available for x

to a unit   capitalization   Sum of average excess
                             expenditures for all units

* Question 12: What is a "unit of property" One of the more vexing problems faced by the drafters of the interest capitalization rules was how to define a unit of property. This is important, because the production period and APES are determined on a unit-by-unit basis. The one-year and two-year tests for property eligibility purposes are also determined with respect to each unit of property.

Real property: A unit of real property includes any components of real property owned by the taxpayer(50) that are "functionally interdependent."(51) Components of real property are functionally interdependent if the placing in service of one component is dependent on the placing in service of the other component by the taxpayer. In the case of property produced for sale, components of real property are functionally interdependent if they are customarily sold as a single unit.(52)

One of the more controversial aspects of the proposed regulations is the manner in which "common features" are treated for interest capitalization purposes. Generally, a common feature includes any real property that benefits real property produced by, or for, the taxpayer and not separately held for the production of income.(53) Real estate developers often construct common features such as roads, sidewalks, tennis courts, parking garages, etc.

The proposed regulations depart from Notice 88-99 by providing that a unit of real property includes an allocable share of common features that are real property, even though these features do not meet the functional interdependence test.(54) Thus, when production begins on a common feature relative to a unit of property, such as streets and sidewalks, the production period for the entire unit begins and interest must be capitalized starting from that point. Further, if the benefited unit is completed, but the production of the common feature has not been completed, the production period is extended until the common feature is completed (unless the unit is sold or placed in service). This rule relating to common features is significant, because it accelerates the point at which the production period begins and delays the point at which the production period ends, thus increasing APES and increasing the amount of interest that must be capitalized.

Example 5: B, a real estate developer, owns a 10-acre tract on which he plans to build four houses on two-acre lots. On the remaining two acres, B plans to construct a perimeter road that will benefit the four houses. The road is not a separate unit, but instead is a common feature. Each house is a separate unit which also includes an allocable portion of the road.(55)

Tangible personal property. The proposed regulations apply the same functionally interdependent test described above to tangible personal property. The proposed regulations set forth the example of an aircraft manufacturer that sells completely assembled aircraft--the unit of property includes all components of the completed aircraft. But if the aircraft manufacturer also separately sells aircraft engines, those engines are each a single unit.(56)

* Question 13: What is included in "accumulated production expenditures" In calculating "average excess expenditures" (step 2 in the formula), the APES must be calculated at each measurement date. Refer to Example 1, in which Corporation X incurred $1 million of costs each quarter, so that the APES at each quarterly measurement date were $1 million, $2 million, $3 million and $4 million, respectively.

Prop. Regs. Sec. 1.263A(f)-4(a) defines APEs as the cumulative amount of direct and indirect costs described in Sec. 263A(a) required to be capitalized with respect to the unit of property, including interest capitalized in prior computation periods.

The adjusted basis of any asset used to produce the unit of property is included in APES.(57) For example, any machinery or equipment (e.g., cranes, bulldozers) used directly or indirectly to produce the unit are included in APEs. The test for includibility is whether the assets are used in a "reasonably proximate manner" for the production of the unit of property. The basis of such assets is included in APES only during the period of their use.(58)

Timing. Under Prop. Regs. Sec. 1.263A(f)-4(b)(1), costs are included in APES when they would otherwise have been taken into account under the taxpayer's method of accounting. Costs incurred and capitalized with respect to a unit of property prior to the beginning of the production period (e.g., raw land acquired for development) are included in APES beginning on the date the production period begins. (The production period is discussed in Question 3.) Any interest that is capitalized is included in APES immediately after the end of the computation period.

Example 6: Corporation Y, a calendar-year taxpayer, is engaged in the production of a single unit of designated property during 1993. Y adopts a tax year computation period and quarterly measurement dates. Y paid $1,000,000 for the land for the unit of property in 1992. Production starts on Mar. 1, 1993, and ends on Nov. 30, 1994. The $1,000,000 cost of the land is not included in APES until Mar. 1, 1993, when production begins. Any interest that must be capitalized for 1993 with respect to this unit of property is added to APES on Jan. 1, 1994.

Costs of raw materials, supplies, etc., become part of APES when they are incurred and dedicated to production of a unit of property. The term "dedicated" means the first date on which the raw materials, supplies or similar items are specifically associated with the production of any unit of property.(59)

Property produced under a contract: If a unit of property is produced under a contract, both the customer and the contractor are subject to the interest capitalization rules and, therefore, must calculate APEs.

The customer's APEs include any payments under the contract that represent part of the purchase price,(60) and any other costs incurred by the customer that must be capitalized. The cumulative amount of the customer's payments attributable to the unit of property reduces the contractor's APEs.(61)

Improvements: Any improvement of real property or tangible personal property that meets the eligibility tests for designated property constitutes the production of designated property.(62) For example, Prop. Regs. Sec. 1.263(A)(f)-1(e)(3)(ii) provides that the demolition, rehabilitation or preservation of a standing building is an improvement that constitutes the production of designated property.

Special Rules

* Question 14: How do the interest capitalization rules apply to deferred and contingent interest? The drafters of the interest capitalization regulations faced a major problem with respect to this issue. Specifically, if another Code section, e.g., Sec. 267, would apply to defer any interest that would otherwise apply during the computation period, how should the interest capitalization rules apply?

The proposed regulations place deferred interest at the end of the priority sequence. In accordance with Prop. Regs. Sec. 1.263A(f)-2(c)(1) and -2[c)(2), interest is capitalized in the following sequence: traced debt, nontraced debt, interest incurred on borrowings from i related party and partnership guaranteed payments. If, after applying this sequence, the amount of interest capitalized with respect to all units of designated property is less than the amount that would have been capitalized if a deferral provision did not apply, the deferred interest is capitalized only when it ultimately would be deducted.(63) Contingent interest is treated the same way.

Deferred interest that must be capitalized consists of two components: (1) interest incurred on traced debt deferred because of a deferral provision and (2) deferred interest under Prop. Regs. Sec. 1.263A(f)-2(c)(4) (interest incurred on nontraced debt, interest incurred on borrowings from a related party and partnership guaranteed payments). The sum of these two components is the "deferral amount."(64) The deferral amount is capitalized when the deferred interest would be deductible but for the application of Sec. 263A(f) (the capitalization year).(65)

What happens if the property, to which the previously deferred interest relates, is sold prior to the capitalization year? The deferred interest is not deducted until the capitalization year and then is treated as if recovered from the sale of the property.(66)

What happens if the property, to which the previously deferred interest relates, is held throughout the capitalization year? The adjusted basis and applicable recovery percentages for the unit of property are redetermined for the capitalization year and subsequent years.(67)

To avoid the complexities of accounting for deferred interest, taxpayers have an alternative: substitute capitalization. Instead of capitalizing deferred interest, a taxpayer may elect to capitalize costs that would otherwise be currently deductible (e.g., marketing, administration or other currently deductible costs). These costs are capitalized in the computation period in which the interest is incurred and deferred (the "deferral period").(68)

If the taxpayer has sufficient substitute costs to cover the deferral amount, any interest incurred and deferred in the deferral period is neither capitalized nor deducted in the deferral period. It is deducted in the appropriate later year without regard to Sec. 263A(f).(69)

However, if the taxpayer comes up short (i.e., available substitute costs are less than the deferral amount), the difference is a carryforward to succeeding computation periods. In any future computation period, the taxpayer must capitalize an amount of substitute costs equal to the carryforward.(70) Example 7 illustrates the treatment of deferred interest.

Example 7:71 Throughout 1993, X constructs a warehouse, which is placed in service in December 1993. X's average excess expenditures in 1993 are $1,000,000. Throughout 1993, X's only outstanding debt is nontraced debt of $900,000 and $1,200,000, bearing interest at 15% and 9%, respectively. Of the total interest incurred, $140,000 is deferred under Sec. 267(a)(3). This amount would be deductible in 1995 if Sec. 263A(f) did not apply. Assuming X does not elect the substitute capitalization method, the calculations are as follows: Step 1: Interest incurred on traced debt = $0 Step 2: Average excess expenditures = $1,000,000 Step 3: Weighted average interest rate =

($900,000 x 15%) + ($1,200,000 x 9%)/    $243,000 /
    $900,000 + $1,200,000              = $2,100,000 = 11.6%

Step 4: Excess expenditure amount = $1,000,000 x 11.6% = $116,000

Step 5: Of the $243,000 interest incurred during 1993, only $103,000 is available for capitalization, and the $140,000 balance is deferred pursuant to Sec. 267(a)(3). The deferral amount is calculated as follows:

$116,000 amount required to be capitalized

103,000 amount available for capitalization

$13,000 deferral amount Of the $116,000 to be capitalized, $103,000 is capitalized in 1993. The remaining $13,000 is capitalized in 1995 because it would be deducted in 1995 if Sec. 263A(f) did not apply.

* Question 15: How does the "simplified inventory method" work?

For taxpayers that must capitalize interest with respect to inventory, the calculations can be extraordinarily complex. The proposed regulations offer a simplified inventory method based on the taxpayer's inventory turnover rate. Under this method, the taxpayer capitalizes interest as an aggregate adjustment to ending inventory after applying all other capitalization provisions.(72)

Step 1:

(Beginning inventory +

Inverse inventory turnover = ending inventory)(73) / 2

Cost of goods sold

Step 2:

Total ending

Equal inventory segments = inventory value/

                           Inverse inventory
                           turnover rate

Step 3: Assign an age to each inventory segment, starting with a one-year age for the first segment and ending with the total number of inventory segments.

Step 4: Determine the weighted average interest rate (step 3 of the avoided cost calculation) by treating all eligible debt (other than debt traced to noninventory property) as nontraced debt.

Step 5: The interest rate in Step 4 is compounded annually by the number of years assigned to the particular segment to produce the "applicable interest factor" for that segment.

Step 6: Apply the applicable interest factor to each segment.

Step 7: Combine the amounts in step 6 to produce an "aggregate interest capitalization amount," which is added to ending inventory.

Step 8: If the amount determined in step 7 is greater than the amount determined in step 7 for the previous year, there is an increase in the aggregate interest capitalization amount. This is the "incremental capitalization amount." If the amount determined in step 7 is less than the amount determined in step 7 for the previous year, there is a decrease in the aggregate interest capitalization amount.

Example 8: X uses the FIFO inventory method and determines that its cost of goods sold for 1993 is $900. Beginning inventory for 1993 is $2,900, and ending inventory for 1993 is $3,000. X's weighted average interest rate (determined on an annual basis] for 1993 is 10%. The aggregate interest capitalized as of the end of 1992 was $600. The simplified method is applied as follows:

  1. Inverse inventory         ($2-,900 + $3,000) / 2
turnover rate        =           $900
                     = 3.28  = 3 (rounded to nearest
                                 whole number)

2. Equal inventory = $3,000/ = $1,000 segments 3 (Total ending inventory of $3,000 is divided into 3 segments of $1,000 each.

3. * One segment is treated as 1-year old inventory.

* One segment is treated as 2-year old inventory.

* One segment is treated as 3-year old inventory.

4. Weighted average interest rate = 10%

5. The applicable interest factor f or the 1 -year old inventory is not compounded. The applicable interest factor for the 2-year old inventory is compounded for one year. The applicable interest factor for the 3-year old inventory is compounded for two years. The interest factors are, therefore, calculated as follows:

* Interest factor for 1 -year property = 0.1

* Interest factor for 2-year property = 0.21 = ([1.[1.sup.2]- 1)

* Interest factor for 3-year property = 0.331 = ([[1.[1.sup.3]]- 1)

6. * Segment 1: $1,000 x 0.1 = $100

& * Segment 2:$1,000 x 0.21 = $210

7. * Segment 3: $1,000 x 0.331 = $331/

                                   $641 aggregate
                                   interest to be
                                   capitalized

Few taxpayers may actually elect the simplified inventory method, because its use could effect a significant overcapitalization of interest expense. This is because the interest assigned to a segment is determined on the basis of a full year of capitalization. Further, since the proposed regulations only address capitalizing interest into ending inventory, the implication is that no interest is included in cost of goods sold. Other than the simplified inventory method, the proposed regulations do not provide guidance on how to capitalize interest with respect to inventory. However, taxpayers will normally have to face this issue only when the production period exceeds two years, such as for products that are aged (e.g., wine, liquor and tobacco).

* Question 16: Does Sec. 263A(f) preempt any other Code sections? Sec. 263A(f) preempts the following Code sections:74

* Sec. 163(d), the investment interest limitation.

* Sec. 163(j), the limitation on interest paid to a

tax-exempt related person.

* Sec. 266, the election to capitalize carrying charges.

* Sec. 469, the limitation on passive losses.

* Sec. 86 1, the allocation of interest to U.S. sources.

Any interest capitalized under Sec. 263A(f) that would otherwise be described in these Code sections is not taken into account under those sections.

With respect to the sequencing of capitalization of interest (see step 6 in the formula), the proposed regulations specifically provide that interest described in Secs. 163(d), 163(j) and 469 is last in the capitalization sequence.(75)

* Question 17: Does GAAP affect the interest capitalization rules?

Taxpayers must capitalize interest under the avoided cost method set forth under Sec. 263A(f), and the regulations thereunder, without regard to any financial or regulatory accounting principles for interest capitalization.(76) To emphasize this point, the Service issued Rev. Rul. 90-40,(77) which provides that in determining the amount of interest expense required to be capitalized under former Sec. 189 and Sec. 263A(f), a taxpayer cannot reduce the interest expense required to be capitalized by the interest income earned from temporarily investing unexpended debt proceeds.

Financial and regulatory accounting principles are not relevant for purposes of determining the capitalization of interest for Federal income tax purposes. Taxpayers must capitalize interest under the avoided cost method set forth in Sec. 263A(f) and the regulations thereunder.

Rev. Rul. 90-40 dealt with FASB 34, which generally requires interest capitalization for financial statement purposes. However, Financial Accounting Standards Board Statement No. 62 (FASB 62), Capitalization of Interest Cost in Situations Involving Certain Tax-Exempt Borrowings and Certain Gifts and Grants, which amended FASB 34, provides a special rule for the capitalization of interest expense incurred on restricted tax-exempt borrowings. Generally, under FASB 62, a taxpayer must capitalize interest expense less any income earned on interest-bearing investments acquired with the proceeds of the tax-exempt borrowing. This special rule conflicts with the general avoided cost principles of Sec. 263A(f).

Rev. Rul. 90-40 states that the netting rule of FASB 62 cannot be used for tax purposes. The legislative history makes it clear that a taxpayer must use the Sec. 263A(f) avoided cost method, regardless of whether application of such method is required or permitted under financial or regulatory accounting principles.(78)

* Question 18: If any costs were incurred before the effective date of Sec. 263A(f), are such costs included in APES for a current year? With regard to noninventory property, if costs were incurred before the effective date of Sec. 263A(f), such costs may still be included in APES for a current year. Prop. Regs. Sec. 1.263A(f)-9(b)(2)(i) provides that costs incurred before the effective date of Sec. 263A(f) are included in APES with respect to noninventory property only to the extent such costs were required to be capitalized under Sec. 263 when incurred and would have been taken into account in determining the amount of interest required to be capitalized under former Sec. 189, or pursuant to a Sec. 266 election then in effect.

The proposed regulations also provide a rule for property acquired before 1987 that is used to produce designated property after 1986. The basis of such property is included in APES without regard to whether the basis would have been taken into account under former Sec. 189 or Sec. 266.79

* Question 19: Which changes in the interest capitalization computational procedures are considered accounting method changes requiring IRS consent?

A change in method of accounting includes a change in the overall plan of accounting for gross income or deductions, or a change in the treatment of any material item. A material item is any item that involves the proper time for the inclusion of the item in income or the taking of a deduction.80 Therefore, capitalizing interest in accordance with the proposed regulations is a method of accounting.

Generally, a taxpayer must secure IRS consent before changing a method of accounting for Federal income tax purposes.(8) However, Prop. Regs. Sec.

1.263A(f)-9(d) provides automatic consent for taxpayers to change to the methods required or permitted by the proposed regulations. These automatic changes may be effected for the first tax year that begins after the date the proposed regulations become final, or for an earlier year, provided all necessary amended returns are filed within a 120-day period after the date the proposed regulations

become final.(82) If the taxpayer has failed to comply with an interpretation of the statute that is reasonable in light of the legislative history and applicable administrative pronouncements, the automatic consent provisions will not apply. In such case, the taxpayer must secure IRS consent to change its method of accounting under Rev. Proc. 92-20.(83)

If a taxpayer is capitalizing interest in accordance with the proposed regulations, and wants to change to another method of capitalizing interest that is permissible under the proposed regulations, such change is normally a change in method of accounting requiring IRS permission. Specifically, the proposed regulations treat the following as changes in accounting method:

* A change in the selection of a computation period.(84)

* A change to or from the substitute capitalization method.(85)

* A change from or to the simplified inventory method.(86)

* The making or revocation of an election not to trace debt.(87)

The proposed regulations state that the following are not changes in accounting method:

* A change in the selection of measurement dates.88

* An election to treat any eligible debt repaid within the 15-day period immediately preceding a quarterly measurement date as outstanding as of that measurement date.(89)

* Question 20: Are there anti-abuse rules? In determining the manner in which it will comply with the interest capitalization rules, a taxpayer must keep in mind the general statutory purpose of Sec. 263A(f). Even if the taxpayer complies with the specific requirements of the regulations, the Service's trump card is Prop. Regs. Sec. 1.263A(f)-9(e), which provides that the interest capitalization rules must be applied by the taxpayer in a manner that is consistent with and reasonably carries out the purposes of Sec. 263A(f). Further, taxpayers may not use loans in lieu of advance payments, tax-exempt parties, loan restructurings at measurement dates, or obligations bearing an unreasonably low rate of interest to avoid the purposes of that section. The IRS has reserved the right to capitalize interest when such capitalization would reasonably carry out the purpose of Sec. 263A(f).

Conclusion

Congress believed that comprehensive rules governing the capitalization of the costs of producing, acquiring and holding property, including interest, would more accurately reflect income and make the tax system more neutral. While the proposed interest capitalization regulations generally accomplish this purpose, they are needlessly complicated.

Specifically, the de minimis rule should be changed. The three-month and $10,000 test is much too low. For example, if the interest rate was 10% and the full de minimis limits were used, only $250 would be capitalized. A more reasonable de minimis test would be three months and $250,000, because $250,000 is the ratable (three-month) equivalent of the statutory $1 million threshold for tangible personal property.

Another major simplification measure would be to allow taxpayers to elect to use the AFR (rather than being required to use the weighted average interest rate) as the capitalization rate.

Further, many small taxpayers will deem the proposed regulations unadministrable and will do rough justice. Practitioners, as well as IRS agents, who rarely need to use these complicated rules may also be so tempted. Because of their complexity, the rules may not be uniformly applied nationwide by IRS agents.

In passing Sec. 263A(f), Congress recognized the undue complexity. The General Explanation of the Tax Reform Act of 1986 stated that "regulations may adopt other simplifying methods and assumptions where, in the judgment of the Secretary of the Treasury, the costs and other burdens of literal compliance may outweigh the benefits."(90) Like her recent predecessors, IRS Commissioner Richardson has actively promoted tax simplification. In considering final interest capitalization regulations, the IRS should certainly be concerned about taxpayers capitalizing the proper amount of interest. But advancing simplification (which would likely result in increased voluntary compliance) should be a primary goal. (1) Notice 88-99, 1988-2 CB 422. (2) Prop. Regs. Sec. 1.263A(f)-9. (3) Prop. Regs. Sec. 1.263A(f)-1(a)(1). The interest capitalization rules are not as broad as the general UNICAP rules, because interest capitalization applies only to property "produced" by the taxpayer, and not to property purchased for resale. Therefore, retailers and wholesalers are generally excluded from these rules. (4) SCC. 263A(g) and Regs. Sec. 1.263A-2(a)(1)(i). (5) Prop. Regs. Sec. 1.263A(f)-1(e)(2). (6) Notice 88-99, note 1, referred to "qualified property." (7) Property is also produced for the taxpayer's own use if it is produced for the use of a related party (within the meaning of Sec. 707(b) or 267(b)). See Prop. Regs. Sec. 1.263A(f)-1(b)(1)(ii)(A). (8) Sec. 263A(f)(1)(B) and (f)(4)(A); Prop. Regs. Sec. 1.263A(f)-1(b). (9) Prop. Regs. Sec. 1.263A(f)-1(c). (10) Prop. Regs. Sec. 1.263A(f)-1(d)(2). (11) Prop. Regs. Sec. 1.263A(f)-1(b)(3)(iii). (12) See the preamble to the proposed regulations. (13) Regs. Secs. 1.263A-1(c) and -2(a). (14) Prop. Regs. Sec. 1.263A(f)-1(a)(2). (15) Prop. Regs. Sec. 1.263A(f)-5(c)(1). (16) Prop. Regs. Sec. 1.263A(f)-5(c)(2). (17) Prop. Regs. Sec. 1.263A(f)-5(e)(1). (18) Prop. Regs. Sec. 1.263A(f)-5(e)(2). (19) Prop. Regs. Sec. 1.263A(f)-5(f). (20) Prop. Regs. Sec. 1.263A(f)-5(c)(3). (21) Prop. Regs. Sec. 1.263A(f)-5(d)(1). (22) Id. (23) H. Rep. No. 97-760, 97th Cong., 2d Sess. 485 (1982) (hereinafter, the "Conference Report"). (24) Prop. Regs. Sec. 1.263A(f)-5(d)(2). (25) Prop. Regs. Sec. 1.263A(f)-5(g)(1). (26) Prop. Regs. Sec. 1.263A(f)-2. (27) Sec. 263A(f)(2)(A)(ii) and Prop. Regs. Sec. 1.263A(f)-2(a)(1). (28) Prop. Regs. Sec. 1.263A(f)-2(a)(1). (29) Id. (30) General Explanation of the Tax Reform Act of 1986, 99th Cong., 2d Sess. 511 (1987). (31) Conference Report, note 23, at 484. (32) This is the only exception to eligible debt specifically set forth in the Code. See Sec. 263A(f)(2)(B). (33) Prop. Regs. Sec. 1.263A(f)-2(a)(2). (34) Prop. Regs. Sec. 1.263A(f)-2(c)(1). (35) Prop. Regs. Sec. 1.263A(f)-2(c)(2). (36) Prop. Regs. Sec. 1.263A(f)-2(a)(4)(iii). (37) Prop. Regs. Sec. 1.263A(f)-2(e)(1). (38) Id. (39) Prop. Regs. Sec. 1.263A(f)-2(e)(2). (40) See Prop. Regs. Sec. 1.263A(f)-2(e)(3), Example 1. (42) Prop. Regs. See. 1.263A(f)-2(b)(1), (42) Prop. Regs. Sec. 1.263A(f)-2(b)(2). (43) See the example at Prop. Regs. Sec. 1.263A(f)-2(c)(5)(ii)(b). (44) Prop. Regs. Sec. 1.263A(f)-2(c)(5)(iii)(a). (45) Prop. Regs. Sec. 1.263A(f)-2(c)(5)(i)(A). (46) Prop. Regs. Sec. 1.263A(f)-2(c)(5)(iii)(B). (47) Prop. Regs. Sec. 1.263A(f)-2(c)(5)(iii)(C). (48) Prop. Regs. Sec. 1.263A(f)-2(f)(7). (49) Prop, Regs. Sec. 1.263A(f)-2(c)(7)(i). (50) "Taxpayer" also includes a related party (within the meaning of Sec. 267(b) or 707(b)). See Prop. Regs. Sec. 1.263A(f)-3(b)(1). (51) Prop. Regs. Sec. 1.263A(f)-3(b)(1). (52) Prop. Regs. Sec. 1.263A(f)-3(b)(21. (53) Prop. Regs. See. 1.263A(f)-3(b)(3)(i). (54) Id. (55) See Prop. Regs. Sec. 1.263A(f)-3(b)(6), Example 1. (56) Prop. Regs. Sec. 1.263A(f)-3(c). (57) Prop. Regs. Sec. 1.263A(f)-4(d). (58) Prop. Regs. Sec. 1.263A(f)-4(d)(1). (59) Prop. Regs. Sec. 1.263A(f)-4(b)(2). (60) Prop. Regs. Sec. 1.263A(f)-4(c)(1). (61) Prop. Regs. Sec. 1.263A(f)-4(c)(2). (62) Prop. Regs. Sec. 1.263A(f)-1(el(3)(i). (63) Prop. Regs. Sec. 1.263A(f)-2(c)(4). (64) Prop. Regs. Sec. 1.263A(f)-2(f)(2)(i). (65) Prop. Regs. Sec. 1.263A(f)-2(f)(2)(iii). (66) Id. (67) Id. (68) Prop. Regs. Sec. 1.263A(f)-2(f)(2)(iv), (69) Prop. Regs. Sec. 1.263A(f)-2(f)(2)(iv)(b). (70) Id. (71) See the examples at Prop. Regs. Sec. 1.263A(f)-2(f)(2)(v). (72) Prop. Regs. See. 1.263A(f)-2(f)(3). (73) Beginning and ending inventory amounts are determined using total current cost (not carrying value). (74) Prop. Regs. Sec. 1.263A(f)-2(f)(1)(i). (75) Id. (76) Prop. Regs. Sec. 1.263A(f)-2(f)(4). (77) Rev. Rul. 90-40, 1990-1 CB 52. (78) H. Rep. No. 99-841, 99th Cong., 2d Sess. II-309 (1986). (79) Prop. Regs. Sec. 1.263A(f)-9(b)(2)(ii). (80) Regs. Sec. 1.446-1(e)(2)(ii)(a). (81) Sec. 446(e) and Regs. Sec. 1.446-1(e). (82) See the preamble to the proposed regulations. (83) Rev. Proc. 92-20, 1992-1 CB 685. (84) Prop. Regs. Sec. 1.263A(f)-2(e)(1)(ii). (85) Prop. Regs. Sec. 1.263A(f)-2(f)(2)(iv)(C). (86) Prop. Regs. Sec. 1.263A(f)-2(f)(3)(iv). (87) Prop. Regs. Sec. 1.263A(f)-2(d)(1). (88) See the preamble to the proposed regulations. (89) Prop. Regs. Sec. 1.263A(f)-2(f)(7). (90) Note 30, at 510.