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Proposed regulations under Section 263A concerning distribution and handling costs.

On January 13, 1994, Tax Executives Institute submitted the following comments to the Internal Revenue Service concerning the treatment of certain distribution and handling costs for purposes of the uniform capitalization rules under section 263A of the Internal Revenue Code. The comments, which took the form of a letter from TEI President Ralph Weiland to Commissioner Margaret Richardson, were prepared under the aegis of the Institute's Federal Tax Committee, whose chair is Michael A. DeLuca of Household International, Inc. Rick Eckert of General Motors Corporation also contributed materially to the preparation of the comments.

On behalf of Tax Executives Institute, the following comments are submitted on the proposed regulations under section 263A of the Internal Revenue Code relating to the treatment of distribution and handling costs. The proposed regulations (IA-64-91) were published in the Federal Register on August 9, 1993 (58 Fed. Reg. 42263), and in the Internal Revenue Bulletin (1993-28 I.R.B. 54) on September 7, 1993. A public hearing was held on November 30, 1993. We believe that, consistent with legislative history of section 263A, the cost of filling orders and other related distribution activities--so-called "pick, pack, and ship" activities-- should not be allocated between inventory and cost of goods sold. Rather, they should be deducted when incurred.


Tax Executives Institute is the principal association of corporate tax executives in North America. Our approximately 4,700 members represent 2,400 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works--one that is administrable and with which taxpayers can comply.

We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations under section 263A, relating to the uniform capitalization of "handling" costs and a bright-line test providing an exception for deduction of "distribution" costs generally.


On March 30, and August 7, 1987, temporary regulations under section 263A were issued to provide guidance on the uniform capitalization (hereinafter UNICAP) rules enacted in the Tax Reform Act of 1986. The 1987 temporary regulations generally distinguish between "handling" and "distribution" costs, requiring capitalization of the former and permitting current deductions for the latter.(1) Thus, the distribution cost exception under the temporary UNICAP rules permits all costs incurred in delivering goods from storage to a customer to be deducted. The temporary regulations were made final in August 1993, except that additional proposed regulations were issued to substantially narrow the scope of costs qualifying as deductible distribution costs. The proposed regulations set forth a new test that attempts to distinguish the treatment of distribution costs based upon whether the costs are incurred inside or outside a storage facility (i.e., a warehouse), requiring capitalization of the inside costs and permitting deductions for the outside or "loading dock" costs. In the preamble to the proposed regulations, the new test was characterized as a "bright-line" for taxpayers.(2)

"Distribution" Includes "Pick, Pack, and Ship" Activities

The legislative history of the UNICAP rules clearly evidences Congress's intent that the cost of activities such as selling and marketing-- as well as distribution--are excepted from capitalization.(3) The explanation of the Act's exclusion of these costs from capitalization appears redundant because, by definition, distribution activities include marketing and selling.(4) The reason for the redundancy is plain, however, when the statutory scheme is considered in context. The intent of Congress in enacting section 263A was to ensure that the direct and indirect costs of producing, acquiring, or holding inventory-type property for sale or resale were capitalized.(5)

One commonly accepted demarcation of distribution activity from marketing or selling activities, though, is that physical distribution may be said to begin with a customer order.(6) Physical distribution activities are considered to be the tasks associated with fulfilling completed transactions.(7) Since order processing--including retrieving goods and readying them for shipment (so-called pick, pack, and ship activities)--is a distribution activity, the associated costs appear to fall within the congressional exclusion of such costs from the capitalization rules. In the absence of a specific statutory rule requiring capitalization of order-processing costs, the proposed regulations appear to distend the scope of the congressional target. Costs associated with order processing are clearly not incurred to produce, acquire, or hold inventory property. Such costs are incurred to fulfill a specific order and, thus, should be treated as deductible distribution costs.

The temporary regulations under section 263A permit taxpayers to deduct all costs incurred in delivering goods from storage to a customer. As a result, costs incurred in order processing, order picking, staging for shipment, and shipping to customers are treated as distribution activities and qualify for the distribution cost exception. TEI believes that the temporary rules draw the proper line between distribution and handling costs and should be made final. Furthermore, TEI does not believe the proposed bright-line test is supported by the legislative history of the UNICAP rules. If Treasury is to formulate an additional bright-line rule, it should be in the form of a safe harbor that recognizes that the cost of distribution activities--such as pick, pack, and ship expenses--are not to be capitalized.

Legislative History Does Not Support the Proposed Bright Line

The preamble cites the Conference Report in support of its assertion that distribution costs for activities that occur after customer orders are received but prior to physical loading at a shipping dock are properly capitalized. The Conference Report states that, in general, the indirect costs allocable to inventory includes "... handling, processing, assembly, repackaging and similar costs, including labor costs attributable to unloading goods (but not including labor costs attributable to loading of goods for final shipment to customers)."(8) Notwithstanding the assertion in the preamble, TEI submits that the parenthetical language of the Conference Report is ambiguous concerning the line to be drawn between handling and distribution costs. A large number of activities take place between the "unloading [of] goods" at a storage facility and the "loading of goods for final shipment." Moreover, in a footnote to the cited language, the conferees declared unambiguously that taxpayers may use "any reasonable method of apportioning labor costs between inventoriable and noninventoriable functions."(9) The footnote is clearly inconsistent with the preamble's assertion that Congress intended a bright-line test to distinguish the two types 'of costs. What seems clear is that the cost of distribution activities incurred after a sale should be excluded from the reach of the UNICAP capitalization rules regardless of whether the costs are incurred at the loading dock area.

The preamble cites the General Explanation of the 1986 Tax Act prepared by the staff of the Joint Committee on Taxation (hereinafter the "Blue Book") to support its redrawn bright-line test. The Blue Book explains that distribution expenses are not subject to capitalization averring that --

distribution expenses are intended to include only external distribution costs, that is, those costs incurred in transporting goods from the taxpayer's warehouse or retail outlet to the customer, or to the customer's agent, a common carrier, or some other intermediary. Distribution expenses do not include costs of moving inventory from a taxpayer's warehouse to its retail store or other internal transportation costs.(10)

The "loading dock" bright-line test in the proposed regulations is apparently based on the statement that "only external distribution costs" qualify for deductions. Hence, the Blue Book's explanation is interpreted literally as specifying the location where the distribution activity occurs. TEI suggests that the Blue Book's reference to "external" costs is better analyzed as an attempt to describe the nature of the activities performed rather than the physical location (i.e., inside or outside a warehouse) where the activity is performed. That is, "external" distribution costs are those costs incurred to ship goods from a facility to an unrelated customer rather than an "internal" cost of shipping to a related party (or alternative storage site.)

Proper Matching of Income and Expense Requires a Deduction

The preamble argues that section 263A is designed to match income and expense and, furthermore, that "expansion of the distribution costs exception would be contrary to this principle because gross income is not typically recognized from a sale of an item when an order is placed, but rather when the item is shipped, delivered, accepted, or when title to the item transfers...."(11) We are unpersuaded by this rationale for several reasons. First, section 263A was enacted to capitalize the costs of producing, acquiring, or holding, property. Costs are properly capitalized to inventory property held at year-end when the costs relate to one of these three types of activities. Pick and pack activities relate to moving the goods out of storage to a customer in response to an order. Second, the time between receipt of an order and its shipment to a customer may, in some cases, be so insignificant that the revenue is recognized upon receipt of the order. Third, since the goal of section 263A is to determine the cost of property on hand at the end of the taxpayer's year and where the lag between receipt of an order time its fulfillment is small, the amount of pick and pack costs attributable to inventory on hand at year-end is likely de minimis.

The Proposed Regulations Narrow the Distribution Costs Exception

The preamble avers that Treasury is concerned about expanding the distribution costs exception to the UNICAP rules. TEI believes that, to the contrary, the effect of the proposed regulations is to narrow sharply the exception from the treatment accorded distribution costs in the temporary regulations. The proposed regulations distinguish distribution costs as deductible or capital depending upon whether the expense is incurred inside or outside a storage facility. The temporary regulations, which taxpayers and IRS have employed for several years, require taxpayers to capitalize the cost of "handling" activities but permitted taxpayers to deduct all costs incurred in delivering goods from storage to a customer. In practice, "pick, pack, and ship" costs have, we believe, generally been deducted. The proposed narrowing of the distribution cost exception is unwarranted, given the established application of the temporary regulations and the lack of explicit support in the legislative history for the redrawn bright-line test.

Alternative Bright-Line Safe Harbor

Congress granted the Secretary of the Treasury broad discretion to issue simplified rules and procedures to implement the section 263A UNICAP capitalization rules. We understand that Treasury wishes to adopt a bright-line test to easily distinguish between distribution and handling costs. We recommend that Treasury devise a bright-line safe harbor rule that defines clearly what costs qualify for the distribution costs exception to capitalization. Such a safe harbor rule should recognize that labor costs incurred for distribution activities such as order processing, order picking, packing, staging for shipment, loading, and shipping to customers are deductible expenses. The safe harbor should also give effect to the primary function language of the Conference Report.(12) That is, the safe harbor should exclude from capitalization the costs of activities performed in an off-site storage and warehousing facility whose primary function is other than the storage or warehousing of goods.

TEI is pleased to have the opportunity to submit its views on the subject of the proposed regulations relating to the treatment of distribution costs. These comments were prepared under the aegis of TEI's Federal Tax Committee whose chair is Michael A. DeLuca. If you have any questions concerning these comments, please call either Mr. DeLuca of Household International Incorporated at (708) 564-6108 or Jeffery P. Rasmussen of the Institute's professional tax staff at (202) 638-5601.

1 T.D. 8131, 52 Fed. Reg. 10052, 1987-1 C.B. 98.

2 1993-28 I.R.B. 54.

3 H.R. Rep. No. 99-841, 99th Cong., 2nd Sess. II-305 (September 16, 1986), reprinted in 1986-3 C.B. (Vol. 4) 305. Hereinafter, citations to the Conference Report will be as such or as "Conf. Rep."

4 The American Heritage Dictionary 383 (1981).

5 See H.R. Rep. 99-426, 99th Cong., 1st. Sess. 615, 626 (1985); S. Rep. 99-313, 99th Cong., 2d. Sess. 141, 142 (1986) (emphasis added).

6 p. Kotler & G. Armstrong, Marketing-An Introduction, 332 (1st ed. 1987).

7 Id. at 334.

8 Conf. Rep. II-306.

9 Conf. Rep. II-306 n.5.

10 Staff of the Joint Comm. on Taxation, General Explanation of the Tax Reform Act of 1986 (H.R. 3838, 99th Cong., 2d Sess., Public Law 96-514), 100th Cong., 1st Sess. 510 n.61. (1987) (emphasis added).

11 1993-28 I.R.B. 54.

12 Conf. Rep. II-306 n.4A. The proposed regulations would require the capitalization of distribution costs incurred at any "dual-function" storage facility with respect to property sold from the facility that is not sold directly to customers in on-site retail sales. The proposed regulations thus transmute the "primary" function test for a storage facility contained in the legislative history to an allocation of costs between retail-level and storage activities.
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Author:Eckert, Rick
Publication:Tax Executive
Date:Jan 1, 1994
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