[Code of Federal Regulations]
[Title 26, Volume 1]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.263A-1]

[Page 467-484]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.263A-1  Uniform capitalization of costs.

    (a) Introduction--(1) In general. The regulations under Sec. Sec. 
1.263A-1 through 1.263A-6 provide guidance to taxpayers that are 
required to capitalize certain costs under section 263A. These 
regulations generally apply to all costs required to be capitalized 
under section 263A except for interest that must be capitalized under 
section 263A(f) and the regulations thereunder. Statutory or regulatory 
exceptions may provide that section 263A does not apply to certain 
activities or costs; however, those activities or costs may nevertheless 
be subject to capitalization requirements under other provisions of the 
Internal Revenue Code and regulations.
    (2) Effective dates. (i) In general, this section and Sec. Sec. 
1.263A-2 and 1.263A-3 apply to costs incurred in taxable years beginning 
after December 31, 1993. In the case of property that is inventory in 
the hands of the taxpayer, however, these sections are effective for 
taxable years beginning after December 31, 1993. Changes in methods of 
accounting necessary as a result of the rules in this section and 
Sec. Sec. 1.263A-2 and 1.263A-3 must be made under terms and conditions 
prescribed by the Commissioner. Under these terms and conditions, the 
principles of Sec. 1.263A-7 must be applied in revaluing inventory 
property.
    (ii) For taxable years beginning before January 1, 1994, taxpayers 
must take reasonable positions on their federal income tax returns when 
applying section 263A. For purposes of this paragraph (a)(2)(iii), a 
reasonable position is a position consistent with the temporary 
regulations, revenue rulings, revenue procedures, notices, and 
announcements concerning section 263A applicable in taxable years 
beginning before January 1, 1994. See Sec. 601.601(d)(2)(ii)(b) of this 
chapter.
    (3) General scope--(i) Property to which section 263A applies. 
Taxpayers subject to section 263A must capitalize all direct costs and 
certain indirect costs properly allocable to--
    (A) Real property and tangible personal property produced by the 
taxpayer; and
    (B) Real property and personal property described in section 
1221(1), which is acquired by the taxpayer for resale.
    (ii) Property produced. Taxpayers that produce real property and 
tangible personal property (producers) must capitalize all the direct 
costs of producing the property and the property's properly allocable 
share of indirect costs (described in paragraphs (e)(2)(i) and (3) of 
this section), regardless of whether the property is sold or used in the 
taxpayer's trade or business. See Sec. 1.263A-2 for rules relating to 
producers.
    (iii) Property acquired for resale. Retailers, wholesalers, and 
other taxpayers that acquire property described in section 1221(1) for 
resale (resellers) must capitalize the direct costs of acquiring the 
property and the property's properly allocable share of indirect costs 
(described in paragraphs (e)(2)(ii) and (3) of this section). See Sec. 
1.263A-3 for rules relating to resellers. See also section 
263A(b)(2)(B), which excepts from section 263A personal property 
acquired for resale by a small reseller.
    (iv) Inventories valued at market. Section 263A does not apply to 
inventories valued at market under either the market method or the lower 
of cost or market method if the market valuation used by the taxpayer 
generally equals the property's fair market value. For purposes of this 
paragraph (a)(3)(iv), the term fair market value means the price at 
which the taxpayer sells its inventory to its customers (e.g., as in the 
market value definition provided in Sec. 1.471-4(b)) less, if 
applicable, the direct cost of disposing of the inventory. However, 
section 263A does apply in determining the market value of any inventory 
for which market is determined with reference to replacement cost or 
reproduction cost. See Sec. Sec. 1.471-4 and 1.471-5.
    (v) Property produced in a farming business. Section 263A generally 
requires taxpayers engaged in a farming business to capitalize certain 
costs. See sections 263A(d) and 263A(e) and Sec. 1.263A-4 for rules 
relating to taxpayers engaged in a farming business.
    (vi) Creative property. Section 263A generally requires taxpayers 
engaged in the production and resale of creative property to capitalize 
certain costs.
    (vii) Property produced or property acquired for resale by foreign 
persons. Section 263A generally applies to foreign persons.

[[Page 468]]

    (b) Exceptions--(1) Small resellers. See section 263A(b)(2)(B) for 
the $10,000,000 gross receipts exception for small resellers of personal 
property. See Sec. 1.263A-3(b) for rules relating to this exception. 
See also the exception for small resellers with de minimis production 
activities in Sec. 1.263A-3(a)(2)(ii) and the exception for small 
resellers that have property produced under contract in Sec. 1.263A-
3(a)(3).
    (2) Long-term contracts. Except for certain home construction 
contracts described in section 460(e)(1), section 263A does not apply to 
any property produced by the taxpayer pursuant to a long-term contract 
as defined in section 460(f), regardless of whether the taxpayer uses an 
inventory method to account for such production.
    (3) Costs incurred in certain farming businesses. See section 
263A(d) for an exception for costs paid or incurred in certain farming 
businesses. See Sec. 1.263A-4 for specific rules relating to taxpayers 
engaged in the trade or business of farming.
    (4) Costs incurred in raising, harvesting, or growing timber. See 
section 263A(c)(5) for an exception for costs paid or incurred in 
raising, harvesting, or growing timber and certain ornamental trees. See 
Sec. 1.263A-4, however, for rules relating to taxpayers producing 
certain trees to which section 263A applies.
    (5) Qualified creative expenses. See section 263A(h) for an 
exception for qualified creative expenses paid or incurred by certain 
free-lance authors, photographers, and artists.
    (6) Certain not-for-profit activities. See section 263A(c)(1) for an 
exception for property produced by a taxpayer for use by the taxpayer 
other than in a trade or business or an activity conducted for profit. 
This exception does not apply, however, to property produced by an 
exempt organization in connection with its unrelated trade or business 
activities.
    (7) Intangible drilling and development costs. See section 
263A(c)(3) for an exception for intangible drilling and development 
costs. Additionally, section 263A does not apply to any amount allowable 
as a deduction under section 59(e) with respect to qualified 
expenditures under sections 263(c), 616(a), or 617(a).
    (8) Natural gas acquired for resale. Under this paragraph (b)(8), 
section 263A does not apply to any costs incurred by a taxpayer relating 
to natural gas acquired for resale to the extent such costs would 
otherwise be allocable to cushion gas.
    (i) Cushion gas. Cushion gas is the portion of gas stored in an 
underground storage facility or reservoir that is required to maintain 
the level of pressure necessary for operation of the facility. However, 
section 263A applies to costs incurred by a taxpayer relating to natural 
gas acquired for resale to the extent such costs are properly allocable 
to emergency gas.
    (ii) Emergency gas. Emergency gas is natural gas stored in an 
underground storage facility or reservoir for use during periods of 
unusually heavy customer demand.
    (9) Research and experimental expenditures. See section 263A(c)(2) 
for an exception for any research and experimental expenditure allowable 
as a deduction under section 174 or the regulations thereunder. 
Additionally, section 263A does not apply to any amount allowable as a 
deduction under section 59(e) with respect to qualified expenditures 
under section 174.
    (10) Certain property that is substantially constructed. Section 
263A does not apply to any property produced by a taxpayer for use in 
its trade or business if substantial construction occurred before March 
1, 1986.
    (i) For purposes of this section, substantial construction is deemed 
to have occurred if the lesser of--
    (A) 10 percent of the total estimated costs of construction; or
    (B) The greater of $10 million or 2 percent of the total estimated 
costs of construction, was incurred before March 1, 1986.
    (ii) For purposes of the provision in paragraph (b)(10)(i) of this 
section, the total estimated costs of construction shall be determined 
by reference to a reasonable estimate, on or before March 1, 1986, of 
such amount. Assume, for example, that on March 1, 1986, the estimated 
costs of constructing a facility were $150 million. Assume that before 
March 1, 1986, $12 million of construction costs had been incurred. 
Based on the above facts, substantial

[[Page 469]]

construction would be deemed to have occurred before March 1, 1986, 
because $12 million (the costs of construction incurred before such 
date) is greater than $10 million (the lesser of $15 million; or the 
greater of $10 million or $3 million). For purposes of this provision, 
construction costs are defined as those costs incurred after 
construction has commenced at the site of the property being constructed 
(unless the property will not be located on land and, therefore, the 
initial construction of the property must begin at a location other than 
the intended site). For example, in the case of a building, construction 
commences when work begins on the building, such as the excavation of 
the site, the pouring of pads for the building, or the driving of 
foundation pilings into the ground. Preliminary activities such as 
project engineering and architectural design do not constitute the 
commencement of construction, nor are such costs considered construction 
costs, for purposes of this paragraph (b)(10).
    (11) Certain property provided incident to services--(i) In general. 
Under this paragraph (b)(11), section 263A does not apply to property 
that is provided to a client (or customer) incident to the provision of 
services by the taxpayer if the property provided to the client is--
    (A) De minimis in amount; and
    (B) Not inventory in the hands of the service provider.
    (ii) Definition of services. For purposes of this paragraph (b)(11), 
services is defined with reference to its ordinary and accepted meaning 
under federal income tax principles. In determining whether a taxpayer 
is a bona-fide service provider under this paragraph (b)(11), the nature 
of the taxpayer's trade or business and the facts and circumstances 
surrounding the taxpayer's trade or business activities must be 
considered. Examples of taxpayers qualifying as service providers under 
this paragraph include taxpayers performing services in the fields of 
health, law, engineering, architecture, accounting, actuarial science, 
performing arts, or consulting.
    (iii) De minimis property provided incident to services. In 
determining whether property provided to a client by a service provider 
is de minimis in amount, all facts and circumstances, such as the nature 
of the taxpayer's trade or business and the volume of its service 
activities in the trade or business, must be considered. A significant 
factor in making this determination is the relationship between the 
acquisition or direct materials costs of the property that is provided 
to clients and the price that the taxpayer charges its clients for its 
services and the property. For purposes of this paragraph (b)(11), if 
the acquisition or direct materials cost of the property provided to a 
client incident to the services is less than or equal to five percent of 
the price charged to the client for the services and property, the 
property is de minimis. If the acquisition or direct materials cost of 
the property exceeds five percent of the price charged for the services 
and property, the property may be de minimis if additional facts and 
circumstances so indicate.
    (12) De minimis rule for certain producers with total indirect costs 
of $200,000 or less. See Sec. 1.263A-2(b)(3)(iv) for a de minimis rule 
that treats producers with total indirect costs of $200,000 or less as 
having no additional section 263A costs (as defined in paragraph (d)(3) 
of this section) for purposes of the simplified production method.
    (13) Exception for the origination of loans. For purposes of section 
263A(b)(2)(A), the origination of loans is not considered the 
acquisition of intangible property for resale. (But section 
263A(b)(2)(A) does include the acquisition by a taxpayer of pre-existing 
loans from other persons for resale.)
    (c) General operation of section 263A--(1) Allocations. Under 
section 263A, taxpayers must capitalize their direct costs and a 
properly allocable share of their indirect costs to property produced or 
property acquired for resale. In order to determine these capitalizable 
costs, taxpayers must allocate or apportion costs to various activities, 
including production or resale activities. After section 263A costs are 
allocated to the appropriate production or resale activities, these 
costs are generally allocated to the items of property produced or 
property acquired for resale during the taxable year and capitalized to 
the items that remain on hand at the end of the taxable year. See 
however, the simplified production

[[Page 470]]

method and the simplified resale method in Sec. Sec. 1.263A-2(b) and 
1.263A-3(d).
    (2) Otherwise deductible. (i) Any cost which (but for section 263A 
and the regulations thereunder) may not be taken into account in 
computing taxable income for any taxable year is not treated as a cost 
properly allocable to property produced or acquired for resale under 
section 263A and the regulations thereunder. Thus, for example, if a 
business meal deduction is limited by section 274(n) to 80 percent of 
the cost of the meal, the amount properly allocable to property produced 
or acquired for resale under section 263A is also limited to 80 percent 
of the cost of the meal.
    (ii) The amount of any cost required to be capitalized under section 
263A may not be included in inventory or charged to capital accounts or 
basis any earlier than the taxable year during which the amount is 
incurred within the meaning of Sec. 1.446-1(c)(1)(ii).
    (3) Capitalize. Capitalize means, in the case of property that is 
inventory in the hands of a taxpayer, to include in inventory costs and, 
in the case of other property, to charge to a capital account or basis.
    (4) Recovery of capitalized costs. Costs that are capitalized under 
section 263A are recovered through depreciation, amortization, cost of 
goods sold, or by an adjustment to basis at the time the property is 
used, sold, placed in service, or otherwise disposed of by the taxpayer. 
Cost recovery is determined by the applicable Internal Revenue Code and 
regulation provisions relating to the use, sale, or disposition of 
property.
    (d) Definitions--(1) Self-constructed assets. Self-constructed 
assets are assets produced by a taxpayer for use by the taxpayer in its 
trade or business. Self-constructed assets are subject to section 263A.
    (2) Section 471 costs--(i) In general. Except as otherwise provided 
in paragraphs (d)(2)(ii) and (iii) of this section, for purposes of the 
regulations under section 263A, a taxpayer's section 471 costs are the 
costs, other than interest, capitalized under its method of accounting 
immediately prior to the effective date of section 263A. Thus, although 
section 471 applies only to inventories, section 471 costs include any 
non-inventory costs, other than interest, capitalized or included in 
acquisition or production costs under the taxpayer's method of 
accounting immediately prior to the effective date of section 263A.
    (ii) New taxpayers. In the case of a new taxpayer, section 471 costs 
are those acquisition or production costs, other than interest, that 
would have been required to be capitalized by the taxpayer if the 
taxpayer had been in existence immediately prior to the effective date 
of section 263A.
    (iii) Method changes. If a taxpayer included a cost described in 
Sec. 1.471-11(c)(2)(iii) in its inventoriable costs immediately prior 
to the effective date of section 263A, that cost is included in the 
taxpayer's section 471 costs under paragraph (d)(2)(i) of this section. 
Except as provided in the following sentence, a change in the financial 
reporting practices of a taxpayer for costs described in Sec. 1.471-
11(c)(2)(iii) subsequent to the effective date of section 263A does not 
affect the classification of these costs as section 471 costs. A 
taxpayer may change its established methods of accounting used in 
determining section 471 costs only with the consent of the Commissioner 
as required under section 446(e) and the regulations thereunder.
    (3) Additional section 263A costs. Additional section 263A costs are 
defined as the costs, other than interest, that were not capitalized 
under the taxpayer's method of accounting immediately prior to the 
effective date of section 263A (adjusted as appropriate for any changes 
in methods of accounting for section 471 costs under paragraph 
(d)(2)(iii) of this section), but that are required to be capitalized 
under section 263A. For new taxpayers, additional section 263A costs are 
defined as the costs, other than interest, that the taxpayer must 
capitalize under section 263A, but which the taxpayer would not have 
been required to capitalize if the taxpayer had been in existence prior 
to the effective date of section 263A.
    (4) Section 263A costs. Section 263A costs are defined as the costs 
that a taxpayer must capitalize under section 263A. Thus, section 263A 
costs are the

[[Page 471]]

sum of a taxpayer's section 471 costs, its additional section 263A 
costs, and interest capitalizable under section 263A(f).
    (e) Types of costs subject to capitalization--(1) In general. 
Taxpayers subject to section 263A must capitalize all direct costs and 
certain indirect costs properly allocable to property produced or 
property acquired for resale. This paragraph (e) describes the types of 
costs subject to section 263A.
    (2) Direct costs--(i) Producers. Producers must capitalize direct 
material costs and direct labor costs.
    (A) Direct material costs include the costs of those materials that 
become an integral part of specific property produced and those 
materials that are consumed in the ordinary course of production and 
that can be identified or associated with particular units or groups of 
units of property produced.
    (B) Direct labor costs include the costs of labor that can be 
identified or associated with particular units or groups of units of 
specific property produced. For this purpose, labor encompasses full-
time and part-time employees, as well as contract employees and 
independent contractors. Direct labor costs include all elements of 
compensation other than employee benefit costs described in paragraph 
(e)(3)(ii)(D) of this section. Elements of direct labor costs include 
basic compensation, overtime pay, vacation pay, holiday pay, sick leave 
pay (other than payments pursuant to a wage continuation plan under 
section 105(d) as it existed prior to its repeal in 1983), shift 
differential, payroll taxes, and payments to a supplemental unemployment 
benefit plan.
    (ii) Resellers. Resellers must capitalize the acquisition costs of 
property acquired for resale. In the case of inventory, the acquisition 
cost is the cost described in Sec. 1.471-3(b).
    (3) Indirect costs--(i) In general. Indirect costs are defined as 
all costs other than direct material costs and direct labor costs (in 
the case of property produced) or acquisition costs (in the case of 
property acquired for resale). Taxpayers subject to section 263A must 
capitalize all indirect costs properly allocable to property produced or 
property acquired for resale. Indirect costs are properly allocable to 
property produced or property acquired for resale when the costs 
directly benefit or are incurred by reason of the performance of 
production or resale activities. Indirect costs may be allocable to both 
production and resale activities, as well as to other activities that 
are not subject to section 263A. Taxpayers subject to section 263A must 
make a reasonable allocation of indirect costs between production, 
resale, and other activities.
    (ii) Examples of indirect costs required to be capitalized. The 
following are examples of indirect costs that must be capitalized to the 
extent they are properly allocable to property produced or property 
acquired for resale:
    (A) Indirect labor costs. Indirect labor costs include all labor 
costs (including the elements of labor costs set forth in paragraph 
(e)(2)(i) of this section) that cannot be directly identified or 
associated with particular units or groups of units of specific property 
produced or property acquired for resale (e.g., factory labor that is 
not direct labor). As in the case of direct labor, indirect labor 
encompasses full-time and part-time employees, as well as contract 
employees and independent contractors.
    (B) Officers' compensation. Officers' compensation includes 
compensation paid to officers of the taxpayer.
    (C) Pension and other related costs. Pension and other related costs 
include contributions paid to or made under any stock bonus, pension, 
profit-sharing or annuity plan, or other plan deferring the receipt of 
compensation, whether or not the plan qualifies under section 401(a). 
Contributions to employee plans representing past services must be 
capitalized in the same manner (and in the same proportion to property 
currently being acquired or produced) as amounts contributed for current 
service.
    (D) Employee benefit expenses. Employee benefit expenses include all 
other employee benefit expenses (not described in paragraph 
(e)(3)(ii)(C) of this section) to the extent such expenses are otherwise 
allowable as deductions under chapter 1 of the Internal Revenue Code. 
These other employee benefit expenses include: worker's compensation; 
amounts otherwise deductible or allowable in reducing

[[Page 472]]

earnings and profits under section 404A; payments pursuant to a wage 
continuation plan under section 105(d) as it existed prior to its repeal 
in 1983; amounts includible in the gross income of employees under a 
method or arrangement of employer contributions or compensation that has 
the effect of a stock bonus, pension, profit-sharing or annuity plan, or 
other plan deferring receipt of compensation or providing deferred 
benefits; premiums on life and health insurance; and miscellaneous 
benefits provided for employees such as safety, medical treatment, 
recreational and eating facilities, membership dues, etc. Employee 
benefit expenses do not, however, include direct labor costs described 
in paragraph (e)(2)(i) of this section.
    (E) Indirect material costs. Indirect material costs include the 
cost of materials that are not an integral part of specific property 
produced and the cost of materials that are consumed in the ordinary 
course of performing production or resale activities that cannot be 
identified or associated with particular units or groups of units of 
property. Thus, for example, a cost described in Sec. 1.162-3, relating 
to the cost of a material or supply, is an indirect material cost.
    (F) Purchasing costs. Purchasing costs include costs attributable to 
purchasing activities. See Sec. 1.263A-3(c)(3) for a further discussion 
of purchasing costs.
    (G) Handling costs. Handling costs include costs attributable to 
processing, assembling, repackaging and transporting goods, and other 
similar activities. See Sec. 1.263A-3(c)(4) for a further discussion of 
handling costs.
    (H) Storage costs. Storage costs include the costs of carrying, 
storing, or warehousing property. See Sec. 1.263A-3(c)(5) for a further 
discussion of storage costs.
    (I) Cost recovery. Cost recovery includes depreciation, 
amortization, and cost recovery allowances on equipment and facilities 
(including depreciation or amortization of self-constructed assets or 
other previously produced or acquired property to which section 263A or 
section 263 applies).
    (J) Depletion. Depletion includes allowances for depletion, whether 
or not in excess of cost. Depletion is, however, only properly allocable 
to property that has been sold (i.e., for purposes of determining gain 
or loss on the sale of the property).
    (K) Rent. Rent includes the cost of renting or leasing equipment, 
facilities, or land.
    (L) Taxes. Taxes include those taxes (other than taxes described in 
paragraph (e)(3)(iii)(F) of this section) that are otherwise allowable 
as a deduction to the extent such taxes are attributable to labor, 
materials, supplies, equipment, land, or facilities used in production 
or resale activities.
    (M) Insurance. Insurance includes the cost of insurance on plant or 
facility, machinery, equipment, materials, property produced, or 
property acquired for resale.
    (N) Utilities. Utilities include the cost of electricity, gas, and 
water.
    (O) Repairs and maintenance. Repairs and maintenance include the 
cost of repairing and maintaining equipment or facilities.
    (P) Engineering and design costs. Engineering and design costs 
include pre-production costs, such as costs attributable to research, 
experimental, engineering, and design activities (to the extent that 
such amounts are not research and experimental expenditures as described 
in section 174 and the regulations thereunder).
    (Q) Spoilage. Spoilage includes the costs of rework labor, scrap, 
and spoilage.
    (R) Tools and equipment. Tools and equipment include the costs of 
tools and equipment which are not otherwise capitalized.
    (S) Quality control. Quality control includes the costs of quality 
control and inspection.
    (T) Bidding costs. Bidding costs are costs incurred in the 
solicitation of contracts (including contracts pertaining to property 
acquired for resale) ultimately awarded to the taxpayer. The taxpayer 
must defer all bidding costs paid or incurred in the solicitation of a 
particular contract until the contract is awarded. If the contract is 
awarded to the taxpayer, the bidding costs become part of the indirect 
costs allocated to the subject matter of the contract. If the contract 
is not awarded

[[Page 473]]

to the taxpayer, bidding costs are deductible in the taxable year that 
the contract is awarded to another party, or in the taxable year that 
the taxpayer is notified in writing that no contract will be awarded and 
that the contract (or a similar or related contract) will not be rebid, 
or in the taxable year that the taxpayer abandons its bid or proposal, 
whichever occurs first. Abandoning a bid does not include modifying, 
supplementing, or changing the original bid or proposal. If the taxpayer 
is awarded only part of the bid (for example, the taxpayer submitted one 
bid to build each of two different types of products, and the taxpayer 
was awarded a contract to build only one of the two types of products), 
the taxpayer shall deduct the portion of the bidding costs related to 
the portion of the bid not awarded to the taxpayer. In the case of a bid 
or proposal for a multi-unit contract, all bidding costs must be 
included in the costs allocated to the subject matter of the contract 
awarded to the taxpayer to produce or acquire for resale any of such 
units. For example, where the taxpayer submits one bid to produce three 
similar turbines and the taxpayer is awarded a contract to produce only 
two of the three turbines, all bidding costs must be included in the 
cost of the two turbines. For purposes of this paragraph (e)(3)(ii)(T), 
a contract means--
    (1) In the case of a specific unit of property, any agreement under 
which the taxpayer would produce or sell property to another party if 
the agreement is entered into before the taxpayer produces or acquires 
the specific unit of property to be delivered to the party under the 
agreement; and
    (2) In the case of fungible property, any agreement to the extent 
that, at the time the agreement is entered into, the taxpayer has on 
hand an insufficient quantity of completed fungible items of such 
property that may be used to satisfy the agreement (plus any other 
production or sales agreements of the taxpayer).
    (U) Licensing and franchise costs. Licensing and franchise costs 
include fees incurred in securing the contractual right to use a 
trademark, corporate plan, manufacturing procedure, special recipe, or 
other similar right associated with property produced or property 
acquired for resale. These costs include the otherwise deductible 
portion (e.g., amortization) of the initial fees incurred to obtain the 
license or franchise and any minimum annual payments and royalties that 
are incurred by a licensee or a franchisee.
    (V) Interest. Interest includes interest on debt incurred or 
continued during the production period to finance the production of real 
property or tangible personal property to which section 263A(f) applies.
    (W) Capitalizable service costs. Service costs that are required to 
be capitalized include capitalizable service costs and capitalizable 
mixed service costs as defined in paragraph (e)(4) of this section.
    (iii) Indirect costs not capitalized. The following indirect costs 
are not required to be capitalized under section 263A:
    (A) Selling and distribution costs. These costs are marketing, 
selling, advertising, and distribution costs.
    (B) Research and experimental expenditures. Research and 
experimental expenditures are expenditures described in section 174 and 
the regulations thereunder.
    (C) Section 179 costs. Section 179 costs are expenses for certain 
depreciable assets deductible at the election of the taxpayer under 
section 179 and the regulations thereunder.
    (D) Section 165 losses. Section 165 losses are losses under section 
165 and the regulations thereunder.
    (E) Cost recovery allowances on temporarily idle equipment and 
facilities--(1) In general. Cost recovery allowances on temporarily idle 
equipment and facilities include only depreciation, amortization, and 
cost recovery allowances on equipment and facilities that have been 
placed in service but are temporarily idle. Equipment and facilities are 
temporarily idle when a taxpayer takes them out of service for a finite 
period. However, equipment and facilities are not considered temporarily 
idle--
    (i) During worker breaks, non-working hours, or on regularly 
scheduled non-working days (such as holidays or weekends);

[[Page 474]]

    (ii) During normal interruptions in the operation of the equipment 
or facilities;
    (iii) When equipment is enroute to or located at a job site; or
    (iv) When under normal operating conditions, the equipment is used 
or operated only during certain shifts.
    (2) Examples. The provisions of this paragraph (e)(3)(iii)(E) are 
illustrated by the following examples:

    Example 1. Equipment operated only during certain shifts. Taxpayer A 
manufactures widgets. Although A's manufacturing facility operates 24 
hours each day in three shifts, A only operates its stamping machine 
during one shift each day. Because A only operates its stamping machine 
during certain shifts, A's stamping machine is not considered 
temporarily idle during the two shifts that it is not operated.
    Example 2. Facility shut down for retooling. Taxpayer B owns and 
operates a manufacturing facility. B closes its manufacturing facility 
for two weeks to retool its assembly line. B's manufacturing facility is 
considered temporarily idle during this two-week period.

    (F) Taxes assessed on the basis of income. Taxes assessed on the 
basis of income include only state, local, and foreign income taxes, and 
franchise taxes that are assessed on the taxpayer based on income.
    (G) Strike expenses. Strike expenses include only costs associated 
with hiring employees to replace striking personnel (but not wages of 
replacement personnel), costs of security, and legal fees associated 
with settling strikes.
    (H) Warranty and product liability costs. Warranty costs and product 
liability costs are costs incurred in fulfilling product warranty 
obligations for products that have been sold and costs incurred for 
product liability insurance.
    (I) On-site storage costs. On-site storage costs are storage and 
warehousing costs incurred by a taxpayer at an on-site storage facility, 
as defined in Sec. 1.263A-3(c)(5)(ii)(A), with respect to property 
produced or property acquired for resale.
    (J) Unsuccessful bidding expenses. Unsuccessful bidding costs are 
bidding expenses incurred in the solicitation of contracts not awarded 
to the taxpayer.
    (K) Deductible service costs. Service costs that are not required to 
be capitalized include deductible service costs and deductible mixed 
service costs as defined in paragraph (e)(4) of this section.
    (4) Service costs--(i) Introduction. This paragraph (e)(4) provides 
definitions and categories of service costs. Paragraph (g)(4) of this 
section provides specific rules for determining the amount of service 
costs allocable to property produced or property acquired for resale. In 
addition, paragraph (h) of this section provides a simplified method for 
determining the amount of service costs that must be capitalized.
    (A) Definition of service costs. Service costs are defined as a type 
of indirect costs (e.g., general and administrative costs) that can be 
identified specifically with a service department or function or that 
directly benefit or are incurred by reason of a service department or 
function.
    (B) Definition of service departments. Service departments are 
defined as administrative, service, or support departments that incur 
service costs. The facts and circumstances of the taxpayer's activities 
and business organization control whether a department is a service 
department. For example, service departments include personnel, 
accounting, data processing, security, legal, and other similar 
departments.
    (ii) Various service cost categories--(A) Capitalizable service 
costs. Capitalizable service costs are defined as service costs that 
directly benefit or are incurred by reason of the performance of the 
production or resale activities of the taxpayer. Therefore, these 
service costs are required to be capitalized under section 263A. 
Examples of service departments or functions that incur capitalizable 
service costs are provided in paragraph (e)(4)(iii) of this section.
    (B) Deductible service costs. Deductible service costs are defined 
as service costs that do not directly benefit or are not incurred by 
reason of the performance of the production or resale activities of the 
taxpayer, and therefore, are not required to be capitalized under 
section 263A. Deductible service costs generally include costs incurred 
by reason of the taxpayer's overall management or policy guidance 
functions. In addition, deductible service costs include costs incurred 
by reason of the

[[Page 475]]

marketing, selling, advertising, and distribution activities of the 
taxpayer. Examples of service departments or functions that incur 
deductible service costs are provided in paragraph (e)(4)(iv) of this 
section.
    (C) Mixed service costs. Mixed service costs are defined as service 
costs that are partially allocable to production or resale activities 
(capitalizable mixed service costs) and partially allocable to non-
production or non-resale activities (deductible mixed service costs). 
For example, a personnel department may incur costs to recruit factory 
workers, the costs of which are allocable to production activities, and 
it may incur costs to develop wage, salary, and benefit policies, the 
costs of which are allocable to non-production activities.
    (iii) Examples of capitalizable service costs. Costs incurred in the 
following departments or functions are generally allocated among 
production or resale activities:
    (A) The administration and coordination of production or resale 
activities (wherever performed in the business organization of the 
taxpayer).
    (B) Personnel operations, including the cost of recruiting, hiring, 
relocating, assigning, and maintaining personnel records or employees.
    (C) Purchasing operations, including purchasing materials and 
equipment, scheduling and coordinating delivery of materials and 
equipment to or from factories or job sites, and expediting and follow-
up.
    (D) Materials handling and warehousing and storage operations.
    (E) Accounting and data services operations, including, for example, 
cost accounting, accounts payable, disbursements, and payroll functions 
(but excluding accounts receivable and customer billing functions).
    (F) Data processing.
    (G) Security services.
    (H) Legal services.
    (iv) Examples of deductible service costs. Costs incurred in the 
following departments or functions are not generally allocated to 
production or resale activities:
    (A) Departments or functions responsible for overall management of 
the taxpayer or for setting overall policy for all of the taxpayer's 
activities or trades or businesses, such as the board of directors 
(including their immediate staff), and the chief executive, financial, 
accounting, and legal officers (including their immediate staff) of the 
taxpayer, provided that no substantial part of the cost of such 
departments or functions benefits a particular production or resale 
activity.
    (B) Strategic business planning.
    (C) General financial accounting.
    (D) General financial planning (including general budgeting) and 
financial management (including bank relations and cash management).
    (E) Personnel policy (such as establishing and managing personnel 
policy in general; developing wage, salary, and benefit policies; 
developing employee training programs unrelated to particular production 
or resale activities; negotiating with labor unions; and maintaining 
relations with retired workers).
    (F) Quality control policy.
    (G) Safety engineering policy.
    (H) Insurance or risk management policy (but not including bid or 
performance bonds or insurance related to activities associated with 
property produced or property acquired for resale).
    (I) Environmental management policy (except to the extent that the 
costs of any system or procedure benefits a particular production or 
resale activity).
    (J) General economic analysis and forecasting.
    (K) Internal audit.
    (L) Shareholder, public, and industrial relations.
    (M) Tax services.
    (N) Marketing, selling, or advertising.
    (f) Cost allocation methods--(1) Introduction. This paragraph (f) 
sets forth various detailed or specific (facts-and-circumstances) cost 
allocation methods that taxpayers may use to allocate direct and 
indirect costs to property produced and property acquired for resale. 
Paragraph (g) of this section provides general rules for applying these 
allocation methods to various categories of costs (i.e., direct 
materials, direct labor, and indirect costs, including service costs). 
In addition, in lieu of a facts-and-circumstances allocation

[[Page 476]]

method, taxpayers may use the simplified methods provided in Sec. Sec. 
1.263A-2(b) and 1.263A-3(d) to allocate direct and indirect costs to 
eligible property produced or eligible property acquired for resale; see 
those sections for definitions of eligible property. Paragraph (h) of 
this section provides a simplified method for determining the amount of 
mixed service costs required to be capitalized to eligible property. The 
methodology set forth in paragraph (h) of this section for mixed service 
costs may be used in conjunction with either a facts-and-circumstances 
or a simplified method of allocating costs to eligible property produced 
or eligible property acquired for resale.
    (2) Specific identification method. A specific identification method 
traces costs to a cost objective, such as a function, department, 
activity, or product, on the basis of a cause and effect or other 
reasonable relationship between the costs and the cost objective.
    (3) Burden rate and standard cost meth- ods--(i) Burden rate 
method--(A) In gen- eral. A burden rate method allocates an appropriate 
amount of indirect costs to property produced or property acquired for 
resale during a taxable year using predetermined rates that approximate 
the actual amount of indirect costs incurred by the taxpayer during the 
taxable year. Burden rates (such as ratios based on direct costs, hours, 
or similar items) may be developed by the taxpayer in accordance with 
acceptable accounting principles and applied in a reasonable manner. A 
taxpayer may allocate different indirect costs on the basis of different 
burden rates. Thus, for example, the taxpayer may use one burden rate 
for allocating the cost of rent and another burden rate for allocating 
the cost of utilities. Any periodic adjustment to a burden rate that 
merely reflects current operating conditions, such as increases in 
automation or changes in operation or prices, is not a change in method 
of accounting under section 446(e). A change, however, in the concept or 
base upon which such rates are developed, such as a change from basing 
the rates on direct labor hours to basing them on direct machine hours, 
is a change in method of accounting to which section 446(e) applies.
    (B) Development of burden rates. The following factors, among 
others, may be used in developing burden rates:
    (1) The selection of an appropriate level of activity and a period 
of time upon which to base the calculation of rates reflecting operating 
conditions for purposes of the unit costs being determined.
    (2) The selection of an appropriate statistical base, such as direct 
labor hours, direct labor dollars, machine hours, or a combination 
thereof, upon which to apply the overhead rate.
    (3) The appropriate budgeting, classification, and analysis of 
expenses (for example, the analysis of fixed versus variable costs).
    (C) Operation of the burden rate method. The purpose of the burden 
rate method is to allocate an appropriate amount of indirect costs to 
production or resale activities through the use of predetermined rates 
intended to approximate the actual amount of indirect costs incurred. 
Accordingly, the proper use of the burden rate method under this section 
requires that any net negative or net positive difference between the 
total predetermined amount of costs allocated to property and the total 
amount of indirect costs actually incurred and required to be allocated 
to such property (i.e., the under or over-applied burden) must be 
treated as an adjustment to the taxpayer's ending inventory or capital 
account (as the case may be) in the taxable year in which such 
difference arises. However, if such adjustment is not significant in 
amount in relation to the taxpayer's total indirect costs incurred with 
respect to production or resale activities for the year, such adjustment 
need not be allocated to the property produced or property acquired for 
resale unless such allocation is made in the taxpayer's financial 
reports. The taxpayer must treat both positive and negative adjustments 
consistently.
    (ii) Standard cost method--(A) In general. A standard cost method 
allocates an appropriate amount of direct and indirect costs to property 
produced by the taxpayer through the use of preestablished standard 
allowances,

[[Page 477]]

without reference to costs actually incurred during the taxable year. A 
taxpayer may use a standard cost method to allocate costs, provided 
variances are treated in accordance with the procedures prescribed in 
paragraph (f)(3)(ii)(B) of this section. Any periodic adjustment to 
standard costs that merely reflects current operating conditions, such 
as increases in automation or changes in operation or prices, is not a 
change in method of accounting under section 446(e). A change, however, 
in the concept or base upon which standard costs are developed is a 
change in method of accounting to which section 446(e) applies.
    (B) Treatment of variances. For purposes of this section, net 
positive overhead variance means the excess of total standard indirect 
costs over total actual indirect costs and net negative overhead 
variance means the excess of total actual indirect costs over total 
standard indirect costs. The proper use of a standard cost method 
requires that a taxpayer must reallocate to property a pro rata portion 
of any net negative or net positive overhead variances and any net 
negative or net positive direct cost variances. The taxpayer must 
apportion such variances to or among the property to which the costs are 
allocable. However, if such variances are not significant in amount 
relative to the taxpayer's total indirect costs incurred with respect to 
production and resale activities for the year, such variances need not 
be allocated to property produced or property acquired for resale unless 
such allocation is made in the taxpayer's financial reports. A taxpayer 
must treat both positive and negative variances consistently.
    (4) Reasonable allocation methods. A taxpayer may use the methods 
described in paragraph (f) (2) or (3) of this section if they are 
reasonable allocation methods within the meaning of this paragraph 
(f)(4). In addition, a taxpayer may use any other reasonable method to 
properly allocate direct and indirect costs among units of property 
produced or property acquired for resale during the taxable year. An 
allocation method is reasonable if, with respect to the taxpayer's 
production or resale activities taken as a whole--
    (i) The total costs actually capitalized during the taxable year do 
not differ significantly from the aggregate costs that would be properly 
capitalized using another permissible method described in this section 
or in Sec. Sec. 1.263A-2 and 1.263A-3, with appropriate consideration 
given to the volume and value of the taxpayer's production or resale 
activities, the availability of costing information, the time and cost 
of using various allocation methods, and the accuracy of the allocation 
method chosen as compared with other allocation methods;
    (ii) The allocation method is applied consistently by the taxpayer; 
and
    (iii) The allocation method is not used to circumvent the 
requirements of the simplified methods in this section or in Sec. 
1.263A-2, Sec. 1.263A-3, or the principles of section 263A.
    (g) Allocating categories of costs--(1) Direct materials. Direct 
material costs (as defined in paragraph (e)(2) of this section) incurred 
during the taxable year must be allocated to the property produced or 
property acquired for resale by the taxpayer using the taxpayer's d of 
accounting for materials (e.g., specific identification; first-in, 
first-out (FIFO); or last-in, first-out (LIFO)), or any other reasonable 
allocation method (as defined under the principles of paragraph (f)(4) 
of this section).
    (2) Direct labor. Direct labor costs (as defined in paragraph (e)(2) 
of this section) incurred during the taxable year are generally 
allocated to property produced or property acquired for resale using a 
specific identification method, standard cost method, or any other 
reasonable allocation method (as defined under the principles of 
paragraph (f)(4) of this section). All elements of compensation, other 
than basic compensation, may be grouped together and then allocated in 
proportion to the charge for basic compensation. Further, a taxpayer is 
not treated as using an erroneous method of accounting if direct labor 
costs are treated as indirect costs under the taxpayer's allocation 
method, provided such costs are capitalized to the extent required by 
paragraph (g)(3) of this section.
    (3) Indirect costs. Indirect costs (as defined in paragraph (e)(3) 
of this section)

[[Page 478]]

are generally allocated to intermediate cost objectives such as 
departments or activities prior to the allocation of such costs to 
property produced or property acquired for resale. Indirect costs are 
allocated using either a specific identification method, a standard cost 
method, a burden rate method, or any other reasonable allocation method 
(as defined under the principles of paragraph (f)(4) of this section).
    (4) Service costs--(i) In general. Service costs are a type of 
indirect costs that may be allocated using the same allocation methods 
available for allocating other indirect costs described in paragraph 
(g)(3) of this section. Generally, taxpayers that use a specific 
identification method or another reasonable allocation method must 
allocate service costs to particular departments or activities based on 
a factor or relationship that reasonably relates the service costs to 
the benefits received from the service departments or activities. For 
example, a reasonable factor for allocating legal services to particular 
departments or activities is the number of hours of legal services 
attributable to each department or activity. See paragraph (g)(4)(iv) of 
this section for other illustrations. Using reasonable factors or 
relationships, a taxpayer must allocate mixed service costs under a 
direct reallocation method described in paragraph (g)(4)(iii)(A) of this 
section, a step-allocation method described in paragraph (g)(4)(iii)(B) 
of this section, or any other reasonable allocation method (as defined 
under the principles of paragraph (f)(4) of this section).
    (ii) De minimis rule. For purposes of administrative convenience, if 
90 percent or more of a mixed service department's costs are deductible 
service costs, a taxpayer may elect not to allocate any portion of the 
service department's costs to property produced or property acquired for 
resale. For example, if 90 percent of the costs of an electing 
taxpayer's industrial relations department benefit the taxpayer's 
overall policy-making activities, the taxpayer is not required to 
allocate any portion of these costs to a production activity. Under this 
election, however, if 90 percent or more of a mixed service department's 
costs are capitalizable service costs, a taxpayer must allocate 100 
percent of the department's costs to the production or resale activity 
benefitted. For example, if 90 percent of the costs of an electing 
taxpayer's accounting department benefit the taxpayer's manufacturing 
activity, the taxpayer must allocate 100 percent of the costs of the 
accounting department to the manufacturing activity. An election under 
this paragraph (g)(4)(ii) applies to all of a taxpayer's mixed service 
departments and constitutes the adoption of a (or a change in) method of 
accounting under section 446 of the Internal Revenue Code.
    (iii) Methods for allocating mixed service costs--(A) Direct 
reallocation method. Under the direct reallocation method, the total 
costs (direct and indirect) of all mixed service departments are 
allocated only to departments or cost centers engaged in production or 
resale activities and then from those departments to particular 
activities. This direct reallocation method ignores benefits provided by 
one mixed service department to other mixed service departments, and 
also excludes other mixed service departments from the base used to make 
the allocation.
    (B) Step-allocation method. (1) Under a step-allocation method, a 
sequence of allocations is made by the taxpayer. First, the total costs 
of the mixed service departments that benefit the greatest number of 
other departments are allocated to--
    (i) Other mixed service departments;
    (ii) Departments that incur only deductible service costs; and
    (iii) Departments that exclusively engage in production or resale 
activities.
    (2) A taxpayer continues allocating mixed service costs in the 
manner described in paragraph (g)(4)(iii)(B)(1) of this section (i.e., 
from the service departments benefitting the greatest number of 
departments to the service departments benefitting the least number of 
departments) until all mixed service costs are allocated to the types of 
departments listed in this paragraph (g)(4)(iii). Thus, a step-
allocation method recognizes the benefits provided by one mixed service 
department to another mixed service department and

[[Page 479]]

also includes mixed service departments that have not yet been allocated 
in the base used to make the allocation.
    (C) Examples. The provisions of this paragraph (g)(4)(iii) are 
illustrated by the following examples:

    Example 1. Direct reallocation method. (i) Taxpayer E has the 
following five departments: the Assembling Department, the Painting 
Department, and the Finishing Department (production departments), and 
the Personnel Department and the Data Processing Department (mixed 
service departments). E allocates the Personnel Department's costs on 
the basis of total payroll costs and the Data Processing Department's 
costs on the basis of data processing hours.
    (ii) Under a direct reallocation method, E allocates the Personnel 
Department's costs directly to its Assembling, Painting, and Finishing 
Department, and not to its Data Processing department.

----------------------------------------------------------------------------------------------------------------
                                                          Total     Amount of
                      Department                          dept.      payroll    Allocation ratio      Amount
                                                          costs       costs                          allocated
----------------------------------------------------------------------------------------------------------------
Personnel............................................    $500,000     $50,000  .................  <$500,000