[Code of Federal Regulations]
[Title 26, Volume 6]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.460-6]

[Page 229-255]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.460-6  Look-back method.

    (a) In general--(1) Introduction. With respect to income from any 
long-term contract reported under the percentage of completion method, a 
taxpayer is required to pay or is entitled to receive interest under 
section 460(b) on the amount of tax liability that is deferred or 
accelerated as a result of overestimating or underestimating total 
contract price or contract costs. Under this look-back method, taxpayers 
are required to pay interest for any deferral of tax liability resulting 
from the underestimation of the total contract price or the 
overestimation of total contract costs. Conversely, if the total

[[Page 230]]

contract price is overestimated or the total contract costs are 
underestimated, taxpayers are entitled to receive interest for any 
resulting acceleration of tax liability. The computation of the amount 
of deferred or accelerated tax liability under the look-back method is 
hypothetical; application of the look-back method does not result in an 
adjustment to the taxpayer's tax liability as originally reported, as 
reported on an amended return, or as adjusted on examination. Thus, the 
look-back method does not correct for differences in tax liability that 
result from over- or under-estimation of contract price and costs and 
that are permanent because, for example, tax rates change during the 
term of the contract.
    (2) Overview. Paragraph (b) explains which situations require 
application of the look-back method to income from a long-term contract. 
Paragraph (c) explains the operation of the three computational steps 
for applying the look-back method. Paragraph (d) provides guidance 
concerning the simplified marginal impact method. Paragraph (e) provides 
an elective method to minimize the number of times the look-back method 
must be reapplied to a single long-term contract. Paragraph (f) 
describes the reporting requirements for the look-back method and the 
tax treatment of look-back interest. Paragraph (g) provides rules for 
applying the look-back method when there is a transaction that changes 
the taxpayer that reports income from a long-term contract prior to the 
completion of a contract. Paragraph (h) provides examples illustrating 
the three computational steps for applying the look-back method. 
Paragraph (j) of this section provides guidance concerning the election 
not to apply the look-back method in de minimis cases.
    (b) Scope of look-back method--(1) In general. The look-back method 
applies to any income from a long-term contract within the meaning of 
section 460(f) that is required to be reported under the percentage of 
completion method (as modified by section 460) for regular income tax 
purposes or for alternative minimum tax purposes. If a taxpayer uses the 
percentage of completion-capitalized cost method for long-term 
contracts, the look-back method applies for regular tax purposes only to 
the portion (40, 70, or 90 percent, whichever applies) of the income 
from the contract that is reported under the percentage of completion 
method. To the extent that the percentage-of-completion method is 
required to be used under Sec. 1.460-1(g) with respect to income and 
expenses that are attributable to activities that benefit a related 
party's long-term contract, the look-back method also applies to these 
amounts, even if those activities are not performed under a contract 
entered into directly by the taxpayer.
    (2) Exceptions from section 460. The look-back method generally does 
not apply to the regular taxable income from any long-term construction 
contract within the meaning of section 460(e)(4) that:
    (i) Is a home construction contract within the meaning of section 
460(e)(1)(A), or
    (ii) Is not a home construction contract but is estimated to be 
completed within a 2-year period by a taxpayer whose average annual 
gross receipts for the 3 tax years preceding the tax year the contract 
is entered into do not exceed $10,000,000 (as provided in section 
460(e)(1)(B)). These contracts are not subject to the look-back method 
for regular tax purposes, even if the taxpayer uses a version of the 
percentage of completion method permitted under Sec. 1.451-3, unless 
the taxpayer has properly changed its method of accounting for these 
contracts to the percentage of completion method as modified by section 
460(b). The look-back method, however, applies to the alternative 
minimum taxable income from a contract of this type, unless it is exempt 
from the required use of the percentage of completion method under 
section 56(a)(3).
    (3) De minimis exception. Notwithstanding that the percentage of 
completion method is otherwise required to be used, the look-back method 
does not apply to any long-term contract that:
    (i) Is completed within 2 years of the contract commencement date, 
and
    (ii) Has a gross contract price (as of the completion of the 
contract) that does not exceed the lesser of $1,000,000

[[Page 231]]

or 1 percent of the average annual gross receipts of the taxpayer for 
the 3 tax years preceding the tax year in which the contract is 
completed.

This de minimis exception is mandatory and, therefore, precludes 
application of the look-back method to any contract that meets the 
requirements of the exception. The de minimis exception applies for 
purposes of computing both regular taxable income and alternative 
minimum taxable income. Solely for this purpose, the determination of 
whether a long-term contract meets the gross receipts test for both 
alternative minimum tax and regular tax purposes is made based only on 
the taxpayer's regular taxable income.
    (4) Alternative minimum tax. For purposes of computing alternative 
minimum taxable income, section 56(a)(3) generally requires long-term 
contracts within the meaning of section 460(f) (generally without regard 
to the exceptions in section 460(e)) to be accounted for using only the 
percentage of completion method as defined in section 460(b), including 
the look-back method of section 460(b), with respect to tax years 
beginning after December 31, 1986. However, section 56(a)(3) (and thus 
the look-back method) does not apply to any long-term contract entered 
into after June 20, 1988, and before the beginning of the first tax year 
that begins after September 30, 1990, that meets the conditions of both 
section 460(e)(1)(A) and clauses (i) and (ii) of section 460(e)(1)(B), 
and does not apply to any long-term contract entered into in a tax year 
that begins after September 30, 1990, that meets the conditions of 
section 460(e)(1)(A). A taxpayer that applies the percentage of 
completion method (and thus the look-back method) to income from a long-
term contract only for purposes of determining alternative minimum 
taxable income, and not regular taxable income, must apply the look-back 
method to the alternative minimum taxable income in the year of contract 
completion and other filing years whether or not the taxpayer was liable 
for the alternative minimum tax for the filing year or for any prior 
year. Interest is computed under the look-back method to the extent that 
the taxpayer's total tax liability (including the alternative minimum 
tax liability) would have differed if the percentage of completion 
method had been applied using actual, rather than estimated, contract 
price and contract costs.
    (5) Effective date. The look-back method, including the de minimis 
exception, applies to long-term contracts entered into after February 
28, 1986. With respect to activities that are subject to section 460 
solely because they benefit a long-term contract of a related party, the 
look-back method generally applies only if the related party's long-term 
contract was entered into after June 20, 1988, unless a principal 
purpose of the related-party arrangement is to avoid the requirements of 
section 460.
    (c) Operation of the look-back method--(1) Overview--(i) In general. 
The amount of interest charged or credited to a taxpayer under the look-
back method is computed in three steps. This paragraph (c) describes the 
three steps for applying the look-back method. These steps are 
illustrated by the examples in paragraph (h). The first step is to 
hypothetically reapply the percentage of completion method to all long-
term contracts that are completed or adjusted in the current year (the 
``filing year''), using the actual, rather than estimated, total 
contract price and contract costs. Based on this reapplication, the 
taxpayer determines the amount of taxable income (and alternative 
minimum taxable income) that would have been reported for each year 
prior to the filing year that is affected by contracts completed or 
adjusted in the filing year if the actual, rather than estimated, total 
contract price and costs had been used in applying the percentage of 
completion method to these contracts, and to any other contracts 
completed or adjusted in a year preceding the filing year. If the 
percentage of completion method only applies to alternative minimum 
taxable income for contracts completed or adjusted in the filing year, 
only alternative minimum taxable income is recomputed in the first step. 
The second step is to compare what the tax liability would have been 
under the percentage of completion method (as reapplied in the first 
step) for each tax year for which the tax liability is affected by

[[Page 232]]

income from contracts completed or adjusted in the filing year (a 
``redetermination year'') with the most recent determination of tax 
liability for that year to produce a hypothetical underpayments or 
overpayment of tax. The third step is to apply the rate of interest on 
overpayments designated under section 6621 of the Code, compounded 
daily, to the hypothetical underpayment or overpayment of tax for each 
redetermination year to compute interest that runs, generally, from the 
due date (determined without regard to extensions) of the return for the 
redetermination year to the due date (determined without regard to 
extensions) of the return for the filing year. The net amount of 
interest computed under the third step is paid by or credited to the 
taxpayer for the filing year. Paragraph (d) provides a simplified 
marginal impact method that simplifies the second step--the computation 
of hypothetical underpayments or overpayments of tax liability for 
redetermination years--and, in some cases, the third step--the 
determination of the time period for computing interest.
    (ii) Post-completion revenue and expenses--(A) In general. Except as 
otherwise provided in section 460(b)(6) (see Sec. 1.460-6(j) for method 
of electing) or Sec. 1.460-6(e), a taxpayer must apply the look-back 
method to a long-term contract in the completion year and in any post-
completion year for which the taxpayer must adjust total contract price 
or total allocable contract costs, or both, under the PCM. Any year in 
which the look-back method must be reapplied is treated as a filing 
year. See Example (3) of paragraph (h)(4) for an illustration of how the 
look-back method is applied to post-completion adjustments.
    (B) Completion. A contract is considered to be completed for 
purposes of the look-back method in the year in which final completion 
and acceptance within the meaning of Sec. 1.460-1(c)(3) have occurred.
    (C) Discounting of contract price and contract cost adjustments 
subsequent to completion; election not to discount--(1) General rule. 
The amount of any post-completion adjustment to the total contract price 
or contract costs is discounted, solely for purposes of applying the 
look-back method, from its value at the time the amount is taken into 
account in computing taxable income to its value at the completion of 
the contract. The discount rate for this purpose is the Federal mid-term 
rate under section 1274(d) in effect at the time the amount is properly 
taken into account. For purposes of applying the look-back method for 
the completion year, no amounts are discounted, even if they are 
received after the completion year.
    (2) Election not to discount. Notwithstanding the general 
requirement to discount post-completion adjustments, a taxpayer may 
elect not to discount contract price and contract cost adjustments with 
respect to any contract. The election not to discount is to be made on a 
contract-by-contract basis and is binding with respect to all post-
completion adjustments that arise with respect to a contract for which 
an election has been made. An election not to discount with respect to 
any contract is made by stating that an election is being made on the 
taxpayer's timely filed Federal income tax return (determined with 
regard to extensions) for the first tax year after completion in which 
the taxpayer takes into account (i.e., includes in income or deducts) 
any adjustment to the contract price or contract costs. See Sec. 
301.9100-8 of this chapter.
    (3) Year-end discounting convention. In the absence of an election 
not to discount, any revisions to the contract price and contract costs 
must be discounted to their value as of the completion of the contract 
in reapplying the look-back method. For this purpose, the period of 
discounting is the period between the completion date of the contract 
and the date that any adjustment is taken into account in computing 
taxable income. Although taxpayers may use the period between the months 
in which these two events actually occur, in many cases, these dates may 
not be readily identifiable. Therefore, for administrative convenience, 
taxpayers are permitted to use the period between the end of the tax 
years in which these events occur as the period of discounting provided 
that the convention is used consistently

[[Page 233]]

with respect to all post-completion adjustments for all contracts of the 
taxpayer the adjustments to which are discounted. In that case, the 
taxpayer must use as the discount rate the Federal mid-term rate under 
section 1274(d) as of the end of the tax year in which any revision is 
taken into account in computing taxable income.
    (D) Revenue acceleration rule. Section 460(b)(1) imposes a special 
rule that requires a taxpayer to include in gross income, for the tax 
year immediately following the year of completion, any previously 
unreported portion of the total contract price (including amounts that 
the taxpayer expects to receive in the future) determined as of that 
year, even if the percentage of completion ratio is less than 100 
percent because the taxpayer expects to incur additional allocable 
contract costs in a later year. At the time any remaining portion of the 
contract price is includible in income under this rule, no offset 
against this income is permitted for estimated future contract costs. To 
achieve the requirement to report all remaining contract revenue without 
regard to additional estimated costs, a taxpayer must include only costs 
actually incurred through the end of the tax year in the denominator of 
the percentage of completion ratio in applying the percentage of 
completion method for any tax years after the year of completion. The 
look-back method also must be reapplied for the year immediately 
following the year of completion if any portion of the contract price is 
includible in income in that year by reason of section 460(b)(1). For 
purposes of reapplying the look-back method as a result of this 
inclusion in income, the taxpayer must only include in the denominator 
of the percentage of completion ratio the actual contract costs incurred 
as of the end of the year, even if the taxpayer reasonably expects to 
incur additional allocable contract costs. To the extent that costs are 
incurred in a subsequent tax year, the look-back method is reapplied in 
that year (or a later year if the delayed reapplication method is used), 
and the taxpayer is entitled to receive interest for the post-completion 
adjustment to contract costs. Because this reapplication occurs 
subsequent to the completion year, only the cumulative costs incurred as 
of the end of the reapplication year are includible in the denominator 
of the percentage of completion ratio.
    (2) Look-back Step One--(i) Hypothetical reallocation of income 
among prior tax years. For each filing year, a taxpayer must allocate 
total contract income among prior tax years, by hypothetically applying 
the percentage of completion method to all contracts that are completed 
or adjusted in the filing year using the rules of this paragraph (c)(2). 
The taxpayer must reallocate income from those contracts among all years 
preceding the filing year that are affected by those contracts using the 
total contract price and contract costs, as determined as of the end of 
the filing year (``actual contract price and costs''), rather than the 
estimated contract price and contract costs. The taxpayer then must 
determine the amount of taxable income and the amount of alternative 
minimum taxable income that would have been reported for each affected 
tax year preceding the filing year if the percentage of completion 
method had been applied on the basis of actual contract price and 
contract costs in reporting income from all contracts completed or 
adjusted in the filing year and in any preceding year. If the percentage 
of completion method only applies to alternative minimum taxable income 
from the contract, only alternative minimum taxable income is recomputed 
in the first step. For purposes of reallocating income (and costs if the 
10-percent year changes for a taxpayer using the 10-percent method of 
section 460(b)(5)) under the look-back method, the method of computing 
the percentage of completion ratio is the same method used to report 
income from the contract on the taxpayer's return. (Thus, an election to 
use the 10-percent method or the simplified cost-to-cost method is taken 
into account). See Example (1) of paragraph (h)(2) for an illustration 
of Step One.
    (ii) Treatment of estimated future costs in year of completion. If a 
taxpayer reasonably expects to incur additional allocable contract costs 
in a tax year subsequent to the year in which the

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contract is completed, the taxpayer includes the actual costs incurred 
as of the end of the completion year plus the additional allocable 
contract costs that are reasonably expected to be incurred (to the 
extent includible under the taxpayer's percentage of completion method) 
in the denominator of the percentage of completion ratio. The completion 
year is the only filing year for which the taxpayer may include 
additional estimated costs in the denominator of the percentage of 
completion ratio in applying the look-back method. If the look-back 
method is reapplied in any year after the completion year, only the 
cumulative costs incurred as of the end of the year of reapplication are 
includible in the denominator of the percentage of completion ratio in 
reapplying the look-back method.
    (iii) Interim reestimates not considered. The look-back method 
cannot be applied to a contract before it is completed. Accordingly, for 
purposes of applying Step One, the actual total contract price and 
contract costs are substituted for the previous estimates of total 
contract price and contract costs only with respect to contracts that 
have been completed in the filing year and in a tax year preceding the 
filing year. No adjustments are made under Step One for contracts that 
have not been completed prior to the end of the current filing year, 
even if, as of the end of this year, the estimated total contract price 
or contract costs for these uncompleted contracts is different from the 
estimated amount that was used during any tax year for which taxable 
income is recomputed with respect to completed contracts under the look-
back method for the current filing year.
    (iv) Tax years in which income is affected. In general, because 
income under the percentage of completion method is generally reported 
as costs are incurred, the taxable income and alternative minimum 
taxable income are recomputed only for each year in which allocable 
contract costs were incurred. However, there will be exceptions to this 
general rule. For example, a taxpayer may be required to cumulatively 
adjust the income from a contract in a year in which no allocable 
contract costs are incurred if the estimated total contract price or 
contract costs was revised in that year. However, in applying the look-
back method, no contract income is allocated to that year. Thus, there 
may be a difference between the amount of contract income originally 
reported for that year and the amount of contract income as reallocated. 
Similarly, because of the revenue acceleration rule of section 
460(b)(1), income may be reported in the year immediately following the 
completion year even though no costs were incurred during that year and, 
in applying the look-back method in that year or another year, if 
additional costs are incurred or the contract price is adjusted in a 
later year, no income is allocated to the year immediately following the 
completion year.
    (v) Costs incurred prior to contract execution; 10-percent method--
(A) General rule. The look-back method does not require allocation of 
contract income to tax years before the contract was entered into. Costs 
incurred prior to the year a contract is entered into are first taken 
into account in the numerator of the percentage of completion ratio in 
the year the contract is entered into. A taxpayer using the 10-percent 
method must also use the 10-percent method in applying the look-back 
method, using actual total contract costs to determine the 10-percent 
year. Thus, contract income is never reallocated to a year before the 
10-percent year as determined on the basis of actual contract costs. If 
the 10-percent year is earlier as a result of applying Step One of the 
look-back method, contract costs incurred up to and including the new 
10-percent year (as determined based on actual contract costs), are 
reallocated from the original 10-percent year to the new 10-percent, and 
costs incurred in later years but before the old 10-percent year are 
reallocated to those years. If the 10-percent year is later as a result 
of applying Step One of the look-back method, contract costs incurred up 
to and including the new 10-percent year are reallocated from all prior 
years to the new 10-percent year. This is the only case in which costs 
are reallocated under the look-back method.

[[Page 235]]

    (B) Example. The application of the look-back method by a taxpayer 
using the 10-percent method is illustrated by the following example:

    Example. Z elected to use the 10-percent method of section 460(b)(5) 
for reporting income under the percentage of completion method. Z 
entered into a contract in 1990 for a fixed price of $1,000x. During 
1990, Z incurred allocable contract costs of $80x and estimated that it 
would incur a total of $900x for the entire contract. Since $80x is less 
than 10 percent of total estimated contract costs, Z reported no revenue 
from the contract in 1990 and deferred the $80x of costs incurred. In 
1991, Z incurred an additional $620x of contract costs, and completed 
the contract. Accordingly, in its 1991 return, Z reported the entire 
contract price of $l,000x, and deducted the $620x of costs incurred in 
1991 and the $80x of costs incurred in 1990.
    Under section 460(b)(5), the 10-percent method applies both for 
reporting contract income and the look-back method. Under the look-back 
method, since the costs incurred in 1990 ($80x) exceed 10 percent of the 
actual total contract costs ($700x), Z is required to allocate $114x of 
contract revenue ($80x/$700xx$1,000x) and the $80x of costs incurred to 
1990. Thus, application of the 1ook-back method results in a net 
increase in taxable income for 1990 of $34x, solely for purposes of the 
look-back method.

    (vi) Amount treated as contract price--(A) General rule. The amount 
that is treated as total contract price for purposes of applying the 
percentage of completion method and reapplying the percentage of 
completion method under the look-back method under Step One includes all 
amounts that the taxpayer expects to receive from the customer. Thus, 
amounts are treated as part of the contract price as soon as it is 
reasonably estimated that they will be received, even if the all-events 
test has not yet been met.
    (B) Contingencies. Any amounts related to contingent rights or 
obligations, such as incentive fees or amounts in dispute, are not 
separated from the contract and accounted for under a non-long-term 
contract method of accounting, notwithstanding any provision in Sec. 
1.460-4(b)(4)(i), to the contrary. Instead, those amounts are treated as 
part of the total contract price in applying the look-back method. For 
example, if an incentive fee under a contract to manufacture a satellite 
is payable to the taxpayer after a specified period of successful 
performance, the incentive fee is includible in the total contract price 
at the time and to the extent that it can reasonably be predicted that 
the performance objectives will be met, . A portion of the contract 
price that is in dispute is included in the total contract price at the 
time and to the extent that the taxpayer can reasonably expect the 
dispute will be resolved in the taxpayer's favor (without regard to when 
the taxpayer receives payment for the amount in dispute or when the 
dispute is finally resolved).
    (C) Change orders. In applying the look-back method, a change order 
with respect to a contract is not treated as a separate contract unless 
the change order would be treated as a separate contract under the rules 
for severing and aggregating contracts provided in Sec. 1.460-1(e). 
Thus, if a change order is not treated as a separate contract, the 
contract price and contract costs attributable to the change order must 
be taken into account in allocating contract income to all tax years 
affected by the underlying contract.
    (3) Look-back Step Two: Computation of hypothetical overpayment or 
underpayment of tax--(i) In general. Step Two involves the computation 
of a hypothetical overpayment or underpayment of tax for each year in 
which the tax liability is affected by income from contracts that are 
completed or adjusted in the filing year (a ``redetermination year''). 
The application of Step Two depends on whether the taxpayer uses the 
simplified marginal impact method contained in paragraph (d) or the 
actual method described in this paragraph (c)(3). The remainder of this 
paragraph (c)(3) does not apply if a taxpayer uses the simplified 
marginal impact method.
    (ii) Redetermination of tax liability. Under the method described in 
this paragraph (c)(3) (the ``actual method''), a taxpayer, first, must 
determine what its regular and alternative minimum tax liability would 
have been for each redetermination year if the amounts of contract 
income allocated in Step One for all contracts completed or adjusted in 
the filing year and in any prior year were substituted for the amounts 
of contract income reported under the

[[Page 236]]

percentage of completion method on the taxpayer's original return (or as 
subsequently adjusted on examination, or by amended return). See Example 
(2) of paragraph (h)(3) for an illustration of Step Two.
    (iii) Hypothetical underpayment or overpayment. After redetermining 
the income tax liability for each tax year affected by the reallocation 
of contract income, the taxpayer then determines the amount, if any, of 
the hypothetical underpayment or overpayment of tax for each of these 
redetermination years. The hypothetical underpayment or overpayment for 
each affected year is the difference between the tax liability as 
redetermined under the look-back method for that year and the amount of 
tax liability determined as of the latest of the following:
    (A) The original return date;
    (B) The date of a subsequently amended or adjusted return (if, 
however, the amended return is due to a carryback described in section 
6611(f), see paragraph (c)(4)(iii)); or,
    (C) The last previous application of the look-back method (in which 
case, the previous hypothetical tax liability is used).
    (iv) Cumulative determination of tax liability. The redetermination 
of tax liability resulting from previous applications of the look-back 
method is cumulative. Thus, for example, in computing the amount of a 
hypothetical overpayment or underpayment of tax for a redetermination 
year, the current hypothetical tax liability is compared to the 
hypothetical tax liability for that year determined as of the last 
previous application of the look-back method.
    (v) Years affected by look-back only. A redetermination of income 
tax liability under Step Two is required for every tax year for which 
the tax liability would have been affected by a change in the amount of 
income or loss for any other year for which a redetermination is 
required. For example, if the allocation of contract income under Step 
One changed the amount of a net operating loss that was carried back to 
a year preceding the year the taxpayer entered into the contract, the 
tax liability for the earlier year must be redetermined.
    (vi) Definition of tax liability. For purposes of Step Two, the 
income tax liability must be redetermined by taking into account all 
applicable additions to tax, credits, and net operating loss carrybacks 
and carryovers. Thus, the tax, if any, imposed under section 55 
(relating to alternative minimum tax) must be taken into account. For 
example, if the taxpayer did not pay alternative minimum tax, but would 
have paid alternative minimum tax for that year if actual rather than 
estimated contract price and costs had been used in determining contract 
income for the year, the amount of any hypothetical overpayment or 
underpayment of tax must be determined by comparing the hypothetical 
total tax liability (including hypothetical alternative minimum tax 
liability) with the actual tax liability for that year. The effect of 
taking these items into account in applying the look-back method is 
illustrated in Examples (4) through (7) of paragraphs (h)(5) through 
(h)(8) below.
    (4) Look-back Step Three: Calculation of interest on underpayment or 
overpayment--(i) In general. After determining a hypothetical 
underpayment or overpayment of tax for each redetermination year, the 
taxpayer must determine the interest charged or credited on each of 
these amounts. Interest on the amount determined under Step Two is 
determined by applying the overpayment rate designated under section 
6621, compounded daily. In general, the time period over which interest 
is charged on hypothetical underpayments or credited on hypothetical 
overpayments begins at the due date (not including extensions) of the 
return for the redetermination year for which the hypothetical 
underpayment or overpayment determined in Step Two is computed. This 
time period generally ends on the earlier of:
    (A) The due date (not including extensions) of the return for the 
filing year, and
    (B) The date both
    (1) The income tax return for the filing year is filed, and
    (2) The tax for that year has been paid in full. If a taxpayer uses 
the simplified marginal impact method contained in paragraph (d), the 
remainder of this paragraph (c)(4) does not apply.

[[Page 237]]

    (ii) Changes in the amount of a loss or credit carryback or 
carryover. The time period for determining interest may be different in 
cases involving loss or credit carrybacks or carryovers in order to 
properly reflect the time period during which the taxpayer (in the case 
of an underpayment) or the Government (in the case of an overpayment) 
had the use of the amount determined to be a hypothetical underpayment 
or overpayment. Thus, if a reallocation of contract income under Step 
One results in an increase or decrease to a net operating loss carryback 
(but not a carryforward), the interest due or to be refunded must be 
computed on the increase or decrease in tax attributable to the change 
to the carryback only from the due date (not including extensions) of 
the return for the redetermination year that generated the carryback and 
not from the due date of the return for the redetermination year in 
which the carryback was absorbed. In the case of a change in the amount 
of a carryover as a result of applying the lookback method, interest is 
computed from the due date of the return for the year in which the 
carryover was absorbed. See Examples (8) and (9) of paragraph (h)(9) for 
an illustration of these rules.
    (iii) Changes in the amount of tax liability that generated a 
subsequent refund. If the amount of tax liability for a redetermination 
year (as reported on the taxpayer's original return, as subsequently 
adjusted on examination, as adjusted by amended return, or as 
redetermined by the last previous application of the look-back method) 
is decreased by the application of the look-back method, and any portion 
of the redetermination year tax liability was absorbed by a loss or 
credit carryback arising in a year subsequent to the redetermination 
year, the look-back method applies as follows to properly reflect the 
time period of the use of the tax overpayment. To the extent the amount 
of tax absorbed because of the carryback exceeds the total hypothetical 
tax liability for the year (as redetermined under the look-back method) 
the taxpayer is entitled to receive interest only until the due date 
(not including extensions) of the return for the year in which the 
carryback arose.

    Example. Upon the completion of a long-term contract in 1990, the 
taxpayer redetermines its tax liability for 1988 under the look-back 
method. This redetermination results in a hypothetical reduction of tax 
liability from $1,500x (actual liability originally reported) to $1,200x 
(hypothetical liability). In addition, the taxpayer had already received 
a refund of some or all of the actual 1988 tax by carrying back a net 
operating loss (NOL) that arose in 1989. The time period over which 
interest would be computed on the hypothetical overpayment of $300x for 
1988 would depend on the amount of the refund generated by the 
carryback, as illustrated by the following three alternative situations:
    (A) If the amount refunded because of the NOL is $1,500x: interest 
is credited to the taxpayer on the entire hypothetical overpayment of 
$300x from the due date of the 1988 return, when the hypothetical 
overpayment occurred, until the due date of the 1989 return, when the 
taxpayer received a refund for the entire amount of the 1988 tax, 
including the hypothetical overpayment.
    (B) If the amount refunded because of the NOL is $1,000x: interest 
is credited to the taxpayer on the entire amount of the hypothetical 
overpayment of $300x from the due date of the 1988 return, when the 
hypothetical overpayment occurred, until the due date of the 1990 
return. In this situation interest is credited until the due date of the 
return for the completion year of the contract, rather than the due date 
of the return for the year in which the carryback arose, because the 
amount refunded was less than the redetermined tax liability. Therefore, 
no portion of the hypothetical overpayment is treated as having been 
refunded to the taxpayer before the filing year.
    (C) If the amount refunded because of the NOL is $1,300x-: interest 
is credited to the taxpayer on $100x ($1,300x-$1,200x) from the due date 
of the 1988 return until the due date of the 1989 return because only 
this portion of the total hypothetical overpayment is treated as having 
been refunded to the taxpayer before the filing year. However, the 
taxpayer did not receive a refund for the remaining $200x of the 
overpayment at that time and, therefore, is credited with interest on 
$200x through the due date of the tax return for 1990, the filing year. 
See Examples (10) and (11) of paragraph (h)(9) for a further 
illustration of this rule.

    (d) Simplified marginal impact method--(1) Introduction. This 
paragraph (d) provides a simplified method for calculating look-back 
interest. Any taxpayer may elect this simplified marginal impact method, 
except that pass-

[[Page 238]]

through entities described in paragraph (d)(4) of this section are 
required to apply the simplified marginal impact method at the entity 
level with respect to domestic contracts and the owners of those 
entities do not apply the look-back method to those contracts. Under the 
simplified marginal impact method, a taxpayer calculates the 
hypothetical underpayments or overpayments of tax for a prior year based 
on an assumed marginal tax rate. A taxpayer electing to use the 
simplified marginal impact method must use the method for each long-term 
contract for which it reports income (except with respect to domestic 
contracts if the taxpayer is an owner in a widely held pass-through 
entity that is required to use the simplified marginal impact method at 
the entity level for those contracts).
    (2) Operation--(i) In general. Under the simplified marginal impact 
method, income from those contracts that are completed or adjusted in 
the filing year is first reallocated in accordance with the procedures 
of Step One contained in paragraph (c)(2) of this section. Step Two is 
modified in the following manner. The hypothetical underpayment or 
overpayment of tax for each year of the contract (a ``redetermination 
year'') is determined by multiplying the applicable regular tax rate (as 
defined in paragraph (d)(2)(iii)) by the increase or decrease in regular 
taxable income (or, if it produces a greater amount, by multiplying the 
applicable alternative minimum tax rate by the increase or decrease in 
alternative minimum taxable income, whether or not the taxpayer would 
have been subject to the alternative minimum tax) that results from 
reallocating income to the tax year under Step One. Generally, the 
product of the alternative minimum tax rate and the increase or decrease 
in alternative minimum taxable income will be the greater of the two 
amounts described in the preceding sentence only with respect to 
contracts for which a taxpayer uses the full percentage of completion 
method only for alternative minimum tax purposes and uses the completed 
contract method, or the percentage of completion-capitalized cost 
method, for regular tax purposes. Step Three is then applied. Interest 
is credited to the taxpayer on the net overpayment and is charged to the 
taxpayer on the net underpayment for each redetermination year from the 
due date (determined without regard to extensions) of the return for the 
redetermination year until the earlier of
    (A) The due date (determined without regard to extensions) of the 
return for the filing year, and
    (B) The first date by which both the return is filed and the tax is 
fully paid.
    (ii) Applicable tax rate. For purposes of determining hypothetical 
underpayments or overpayments of tax under the simplified marginal 
impact method, the applicable regular tax rate is the highest rate of 
tax in effect for the redetermination year under section 1 in the case 
of an individual and under section 11 in the case of a corporation. The 
applicable alternative minimum tax rate is the rate of tax in effect for 
the taxpayer under section 55(b)(1). The highest rate is determined 
without regard to the taxpayer's actual rate bracket and without regard 
to any additional surtax imposed for the purpose of phasing out multiple 
tax brackets or exemptions.
    (iii) Overpayment ceiling. The net hypothetical overpayment of tax 
for any redetermination year is limited to the taxpayer's total federal 
income tax liability for the redetermination year reduced by the 
cumulative amount of net hypothetical overpayments of tax for that 
redetermination year resulting from earlier applications of the look-
back method. If the reallocation of contract income results in a net 
overpayment of tax and this amount exceeds the actual tax liability (as 
of the filing year) for the redetermination year, as adjusted for past 
applications of the look-back method and taking into account net 
operating loss, capital loss, or credit carryovers and carrybacks to 
that year, the actual tax so adjusted is treated as the overpayment for 
the redetermination year. This overpayment ceiling does not apply when 
the simplified marginal impact method is applied at the entity level by 
a widely held pass-through entity in accordance with paragraph (d)(4) of 
this section.

[[Page 239]]

    (iv) Example. The application of the simplified marginal impact 
method is illustrated by the following example:

    Example. Corporation X, a calendar-year taxpayer, reports income 
from long-term contracts and elected the simplified marginal impact 
method when it filed its income tax return for 1989. X uses only the 
percentage of completion method for both regular taxable income and 
alternative minimum taxable income. X completed contracts A, B, and C in 
1989 and, therefore, was required to apply the look-back method in 1989. 
Income was actually reported for these contracts in 1987, 1988, and 
1989. X's applicable tax rate, as determined under section 11, for the 
redetermination years 1987 and 1988 was 40 percent and 34 percent, 
respectively. The amount of contract income originally reported and 
reallocated for contracts A, B, and C, and the net overpayments and 
underpayments for the redetermination years are as follows:

------------------------------------------------------------------------
                                                     1987        1988
------------------------------------------------------------------------
Contract A:
  Originally reported...........................    $5,000x     $4,000x
  Reallocated...................................     3,000x      5,000x
  Increase/(Decrease)...........................    (2,000x)     1,000x
Contract B:
  Originally reported...........................     6,000x      2,000x
  Reallocated...................................     7,000x      1,500x
  Increase/(Decrease)...........................     1,000x       (500x)
Contract C:
  Originally reported...........................     8,000x      5,000x
  Reallocated...................................     4,000x      7,000x
  Increase/(Decrease)...........................    (4,000x)     2,000x
Net Increase/(Decrease).........................    (5,000x)     2,500x
Tentative (Underpayment)/Overpayment:
    @ .40.......................................     2,000x   ..........
    @ .34.......................................  ..........      (850x)
Ceiling:
  Actual Tax Liability (After Carryovers and         1,500x        500x
   Carrybacks)..................................
Final (Underpayment)/Overpayment................     1,500x       (850x)
------------------------------------------------------------------------

    Under the simplified marginal impact method, X determined a 
tentative hypothetical net overpayment for 1987 and a net underpayment 
for 1988. X determined these amounts by first aggregating the difference 
for contracts A, B, and C between the amount of contract price 
originally reported and the amount of contract price as reallocated and, 
then, applying the highest regular tax rate to the aggregate decrease in 
income for 1987 and the aggregate increase in income for 1988.
    However, X's overpayment for 1987 is subject to a ceiling based on 
X's total tax liability. Because the tentative net overpayment of tax 
for 1987 exceeds the actual tax liability for that year after taking 
into account carryovers and carrybacks to that year, the final 
overpayment under the simplified marginal impact method is the amount of 
tax liability paid instead of the tentative net overpayment. Since 
application of the look-back method for 1988 results in a tentative 
underpayment of tax, it is not subject to a ceiling. If the look-back 
method is applied in 1991, the ceiling amount for 1987 will be zero and 
the ceiling amount for 1988 will be $1,350.
    X is entitled to receive interest on the hypothetical overpayment 
from March 15, 1988, to March 15, 1990. X is required to pay interest on 
the underpayment from March 15, 1989, to March 15, 1990.

    (3) Anti-abuse rule. If the simplified marginal impact method is 
used with respect to any long-term contract (including a contract of a 
widely held pass-through entity), the district director may recompute 
interest for the contract (including domestic contracts of widely held 
pass-through entities) under the look-back method using the actual 
method (and without regard to the simplified marginal impact method). 
The district director may make such a recomputation only if the amount 
of income originally reported with respect to the contract for any 
redetermination year exceeds the amount of income reallocated under the 
look-back method with respect to that contract for that year (using 
actual contract price and contract costs) by the lesser of $1,000,000 or 
20 percent of the amount of income as reallocated (i.e., based on actual 
contract price and contract costs) under the look-back method with 
respect to that contract for that year. In determining whether to 
exercise this authority upon examination of the Form 8697, the district 
director may take into account whether the taxpayer overreported income 
for a purpose of receiving interest under the look-back method on a 
hypothetical overpayment determined at the applicable tax rate. The 
district director also may take into account whether the taxpayer 
underreported income for the year in question with respect to other 
contracts. Notwithstanding the look-back method, the district director 
may require an adjustment to the tax liability for any open tax year if 
the taxpayer did not apply the percentage of completion method properly 
on its original return.
    (4) Application--(i) Required use by certain pass-through entities--
(A) General rule. The simplified marginal impact

[[Page 240]]

method is required to be used with respect to income reported from 
domestic contracts by a pass-through entity that is either a 
partnership, an S corporation, or a trust, and that is not closely held. 
With respect to contracts described in the preceding sentence, the 
simplified marginal impact method is applied by the pass-through entity 
at the entity level. For determining the amount of any hypothetical 
underpayment or overpayment, the applicable regular and alternative 
minimum tax rates, respectively, are generally the highest rates of tax 
in effect for corporations under section 11 and section 55 (b)(1). 
However, the applicable regular and alternative minimum tax rates are 
the highest rates of tax imposed on individuals under section 1 and 
section 55 (b)(1) if, at all times during the redetermination year 
involved (i.e., the year in which the hypothetical increase or decrease 
in income arises), more than 50 percent of the interests in the entity 
were held by individuals directly or through 1 or more pass-through 
entities.
    (B) Closely held. A pass-through entity is closely held if, at any 
time during any redetermination year, 50 percent of more (by value) of 
the beneficial interests in that entity are held (directly or 
indirectly) by or for 5 or fewer persons. For this purpose, the term 
``person'' has the same meaning as in section 7701(a)(1), except that a 
pass-through entity is not treated as a person. In addition, the 
constructive ownership rules of section 1563(e) apply by substituting 
the term ``beneficial interest'' for the term ``stock'' and by 
substituting the term ``pass-through entity'' for the term, 
``corporation'' used in that section, as appropriate, for purposes of 
determining whether a beneficial interest in a pass-through entity is 
indirectly owned by any person.
    (C) Examples. The following examples illustrate the application of 
the rules of paragraph (d)(4)(i):

    Example (1). P, a partnership, began a long-term contract on March 
1, 1986, and completed this contract in its tax year ending December 31, 
1989. P used the percentage of completion method for all contract 
income. Substantially all of the income from the contract arose from 
U.S. sources. At all times during all of the years for which income was 
required to be reported under the contract, exactly 25 percent of the 
value of P's interests was owned by Corporation M. The remaining 75 
percent of the value of P's interests was owned in equal shares by 15 
unrelated individuals, who are also unrelated to Corporation M. M's 
ownership of P represents less than 50 percent of the value of the 
beneficial interests in P, and, therefore, viewed alone, is insufficient 
to make P a closely held partnership. In addition, because no 4 of the 
individual owners together own 25 percent or more of the remaining value 
of P's beneficial interests, there is no group of 5 owners that together 
own, directly or indirectly, 50 percent or more by value of the 
beneficial interests in P. Therefore, P is not closely held pass-through 
entity.
    Because P is not a closely held pass-through entity, and because P 
completed the contract after the effective date of section 460(b)(4), P 
is required to use the simplified marginal impact method. Any interest 
computed under the look-back method will be paid to, or collected from, 
P, rather than its partners, and must be reported to each of the 
partners on Form 1065 as interest income or expense. Further, assume 
that, for the redetermination years, Corporation M is subject to 
alternative minimum tax at the rate of 20 percent and 3 of the 
individuals who own interests in P are subject to the highest marginal 
tax rate of 33 percent in 1988. Regardless of the actual marginal tax 
rates of its partners, P is required to determine the underpayment or 
overpayment of tax for each redetermination year at the entity level by 
applying a single rate to the increase or decrease in income resulting 
from the reallocation of contract income under the look-back method. 
Because more than 50 percent of the interests in P are held by 
individuals, P must use the highest rate specified in section 1 for each 
redetermination year. Thus, the rate applied by P is 50 percent for 
1986, 38.5 percent for 1987, and 28 percent for 1988.
    Example (2). Assume the same facts as in Example (1), except that 
one of the individuals, Individual I, who directly owns 5 percent of the 
value of the interests of P, also owns 100 percent of the stock of 
Corporation M. Section 1563(e)(4) of the Code provides that stock owned 
directly or indirectly by or for a corporation is considered to be owned 
by any person who owns 5 percent or more in value of its stock in that 
proportion which the value of the stock which that person so owns bears 
to the value of all the stock in that corporation. Because section 
460(b)(4)(C)(iii) and this paragraph (d)(4) provide that rules similar 
to the constructive ownership rules of section 1563(e) apply in 
determining whether a pass-through entity is closely held, all of M's 
interest in P is attributed to I because I owns 100 percent of the value 
of the stock in M. Accordingly, because I's direct 5 percent and 
constructive 25 percent ownership of P, plus the interests

[[Page 241]]

owned by any 4 other individual partners, equals 50 percent or more of 
the value of the beneficial interests of P, P is a closely held pass-
through entity within the meaning of section 460(b)(4)(C)(iii). 
Therefore, P cannot use the simplified marginal impact method at the 
entity level. Accordingly, each of the partners of P must separately 
apply the look-back method to their respective interests in the income 
and expenses attributable to the contract, but each partner may elect to 
use the simplified marginal impact method with respect to the partner's 
share of income from the contract.

    (D) Domestic contracts--(1) General rule. A domestic contract is any 
contract substantially all of the income of which is from sources in the 
United States. For this purpose, ``substantially all'' of the income 
from a long-term contract is considered to be from United States sources 
if 95 percent or more of the gross income from the contract is from 
sources within the United States as determined under the rules in 
sections 861 through 865.
    (2) Portion of contract income sourced. In determining whether 
substantially all of the gross income from a long-term contract is from 
United States sources, taxpayers must apply the allocation and 
apportionment principles of sections 861 through 865 only to the portion 
of the contract accounted for under the percentage of completion method. 
Under the percentage of completion method, gross income from a long-term 
contract includes all payments to be received under the contract (i.e., 
any amounts treated as contract price). Similarly, all costs taken into 
account in the computation of taxable income under the percentage of 
completion method are deducted from gross income rather than added to a 
cost of goods sold account that reduces gross income. Therefore, 
allocable contract costs are not considered in determining whether a 
long-term contract is a domestic contract or a foreign contract, even 
if, under the taxpayer's facts, the allocation of contract costs to any 
portion of a contract not accounted for under the percentage of 
completion method would affect the relative percentages of United States 
and foreign source gross income from the entire contract if this portion 
of the contract were taken into account in applying the 95-percent test.
    (E) Application to foreign contracts. If a widely held pass-through 
entity has some foreign contracts and some domestic contracts, the 
owners of the pass-through entity each apply the look-back method 
(using, if they elect, the simplified marginal impact method) to their 
respective share of the income and expense from foreign contracts. 
Moreover, in applying the look-back method to foreign contracts at the 
owner level, the owners do not take into account their share of 
increases or decreases in contract income resulting from the application 
of the simplified marginal impact method with respect to domestic 
contracts at the entity level.
    (F) Effective date. The simplified marginal impact method must be 
applied to pass-through entities described in paragraph (d)(4)(i) of 
this section with respect to domestic contracts completed or adjusted in 
tax years for which the due date of the return (determined with regard 
to extensions) of the pass-through entity is after November 9, 1988.
    (ii) Elective use--(A) General rule. As provided in paragraph 
(d)(4)(i) of this section, the simplified marginal impact method must be 
used by certain pass-through entities with respect to domestic 
contracts. C corporations, individuals, and owners of closely held pass-
through entities may elect the simplified marginal impact method. Owners 
of other pass-through entities may also elect the simplified marginal 
impact method with respect to all contracts other than those for which 
the simplified marginal impact method is required to be applied at the 
entity level. This rule applies to foreign contracts of widely held 
pass-through entities. In the case of an electing owner in a pass-
through entity, the simplified marginal impact method is applied at the 
owner level, instead of at the entity level, with respect to the owner's 
share of the long-term contract income and expense reported by the pass-
through entity.
    (B) Election requirements. A taxpayer elects the simplified marginal 
impact method by stating that the election is being made on a timely 
filed income tax return (determined with regard to extensions) for the 
first tax year the

[[Page 242]]

election is to apply. An election to use the simplified marginal impact 
method applies to all applications of the look-back method to all 
eligible long-term contracts for the tax year for which the election is 
made and for any subsequent tax year. The election may not be revoked 
without the consent of the Commissioner.
    (C) Consolidated group consistency rule. In the case of a 
consolidated group of corporations as defined in Sec. 1.1502-1(h), an 
election to use the simplified marginal impact method is made by the 
common parent of the group. The election is binding on all other 
affected members of the group (including members that join the group 
after the election is made with respect to all applications of the look-
back method after joining). If a member subsequently leaves the group, 
the election remains binding as to that member unless the Commissioner 
consents to a revocation of the election. If a corporation using the 
simplified marginal impact method joins a group that does not use the 
method, the election is automatically revoked with respect to all 
applications of the look-back method after it joins the group.
    (e) Delayed reapplication method--(1) In general. For purposes of 
reapplying the look-back method after the year of contract completion, a 
taxpayer may elect the delayed reapplication method to minimize the 
number of required reapplications of the look-back method. Under this 
method, the look-back method is reapplied after the year of completion 
of a contract (or after a subsequent application of the look-back 
method) only when the first one of the following conditions is met with 
respect to the contract:
    (i) The net undiscounted value of increases or decreases in the 
contract price occurring since the time of the last application of the 
look-back method exceeds the lesser of $1,000,000 or 10 percent of the 
total contract price as of that time,
    (ii) The net undiscounted value of increases or decreases in the 
contract costs occurring since the time of the last application of the 
look-back method exceeds the lesser of $1,000,000 or 10 percent of the 
total contract price as of that time,
    (iii) The taxpayer goes out of existence,
    (iv) The taxpayer reasonably believes the contract is finally 
settled and closed, or
    (v) Neither condition (e)(1) (i), (ii), (iii), nor (iv) above is met 
by the end of the fifth tax year that begins after the last previous 
application of the look-back method.
    (2) Time and manner of making election. An election to use the 
delayed reapplication method may be made for any filing year for which 
the due date of the return (determined with regard to extensions) is 
after June 12, 1990. The election is made by a statement to that effect 
on the taxpayer's timely filed Federal income tax return (determined 
with regard to extensions) for the first tax year the election is to be 
effective. An election to use the delayed reapplication method is 
binding with respect to all long-term contracts for which the look-back 
method would be reapplied without regard to the election in the year of 
election and any subsequent year unless the Commissioner consents to a 
revocation of the election. In the case of a consolidated group of 
corporations as defined in Sec. 1.1502-1(h), an election to use the 
delayed reapplication method is made by the common parent of the group. 
The election is binding on all other affected members of the group 
(including members that join the group after the election is made with 
respect to contracts adjusted after joining). If a member subsequently 
leaves the group, the election remains binding as to that member unless 
the Commissioner consents to a revocation of the election. If a 
corporation that has made the election joins a consolidated group that 
has not made the election, the election is treated as revoked with 
respect to contracts adjusted after joining.
    (3) Examples. The operation of this delayed reapplication method is 
illustrated by the following examples:

    Example (1). X completes a contract in 1987, and applies the look-
back method when its return for 1987 is filed. X properly uses $600,000 
as the actual contract price in applying the look-back method. In 1990, 
as a result of the settlement of a dispute with its customer, X 
redetermines total contract price to be $640,000, and includes $40,000 
in gross income. On its return for 1990, X states it is

[[Page 243]]

electing the delayed reapplication method. X is not required to reapply 
the look-back method at that time, because $40,000 does not exceed the 
lesser of $1,000,000 or 10 percent of the unadjusted contract price of 
$600,000, and 5 years have not passed since the last application of the 
look-back method.
    Example (2). Assume the same facts as in Example (1), except that at 
the end of 1992, the fifth year after completion of the contract, no 
other adjustments to contract price or contract costs have occurred. X 
is required to reapply the look-back method in 1992 and, accordingly, 
redetermine its tax liability for each redetermination year. After 
redetermining the underpayment of tax for those years, X must compute 
the amount of interest charged on the underpayments. Although 1992 is 
the filing year, interest is due on the amount of each underpayment 
resulting from the adjustment only from the due date of the return for 
each redetermination year to the due date of the return for 1990 because 
the tax liability for the adjustment was fully paid in 1990. However, 
from the due of the 1990 return until the due date of the 1992 return, 
when the look-back method is reapplied for the adjustment, interest is 
due on the amount of interest attributable to the underpayments.

    (f) Look-back reporting--(1) Procedure. The amount of any interest 
due from, or payable to, a taxpayer as a result of applying the look-
back method is computed on Form 8697 for any filing year. In general, 
the look-back method is applied by the taxpayer that reports income from 
a long-term contract. See paragraph (g) of this section to determine who 
is responsible for applying the look-back method when, prior to the 
completion of a long-term contract, there is a transaction that changes 
the taxpayer that reports income from the contract.
    (2) Treatment of interest on return--(i) General rule. The amount of 
interest required to be paid by a taxpayer is treated as an income tax 
under subtitle A, but only for purposes of subtitle F of the Code (other 
than sections 6654 and 6655), which addresses tax procedures and 
administration. Thus, a taxpayer that fails to pay the amount of 
interest due is subject to any applicable penalties under subtitle F, 
including, for example, an underpayment penalty under section 6651, and 
the taxpayer also is liable for underpayment interest under section 
6601. However, interest required to be paid under the look-back method 
is treated as interest expense for purposes of computing taxable income 
under subtitle A, even though it is treated as income tax liability for 
subtitle F purposes. Interest received under the look-back method is 
treated as taxable interest income for all purposes, and is not treated 
as a reduction in tax liability or a tax refund. The determination of 
whether or not interest computed under the look-back method is treated 
as tax is determined on a ``net'' basis for each filing year. Thus, if a 
taxpayer computes for the current filing year both hypothetical 
overpayments and hypothetical underpayments for prior years, the 
taxpayer has an increase in tax only if the interest computed on the 
underpayments for all those prior years exceeds the interest computed on 
the overpayments for all those prior years, for all contracts completed 
or adjusted for the year.
    (ii) Timing of look-back interest. For purposes of determining 
taxable income under subtitle A of the Code, any amount of interest 
payable to the taxpayer under the look-back method is includible in 
gross income as interest income in the tax year it is properly taken 
into account under the taxpayer's method of accounting for interest 
income. Any amount of interest required to be paid is taken into account 
as interest expense arising from an underpayment of income tax in the 
tax year it is properly taken into account under the taxpayer's method 
of accounting for interest expense. Thus, look-back interest required to 
be paid by an individual, or by a pass-through entity on behalf of an 
individual owner (or beneficiary) under the simplified marginal impact 
method, is personal interest and, therefore, is disallowed in accordance 
with Sec. 1.163-9T(b)(2). Interest determined at the entity level under 
the simplified marginal impact method is allocated among the owners (or 
beneficiaries) for reporting purposes in the same manner that interest 
income and interest expense are allocated to owners (or beneficiaries) 
and subject to the requirements of section 704 and any other applicable 
rules.
    (3) Statute of limitations and compounding of interest on look-back 
interest. For guidance on the statute of

[[Page 244]]

limitations applicable to the assessment and collection of look-back 
interest owed by a taxpayer, see sections 6501 and 6502. A taxpayer's 
claim for credit or refund of look-back interest previously paid by or 
collected from a taxpayer is a claim for credit or refund of an 
overpayment of tax and is subject to the statute of limitations provided 
in section 6511. A taxpayer's claim for look-back interest (or interest 
payable on look-back interest) that is not attributable to an amount 
previously paid by or collected from a taxpayer is a general, non-tax 
claim against the federal government. For guidance on the statute of 
limitations that applies to general, non-tax claims against the federal 
government, see 28 U.S.C. sections 2401 and 2501. For guidance 
applicable to the compounding of interest when the look-back interest is 
not paid, see sections 6601 to 6622.
    (g) Mid-contract change in taxpayer--(1) In general. The rules in 
this paragraph (g) apply if, as described in Sec. 1.460-4(k), prior to 
the completion of a long-term contract accounted for using the PCM or 
the PCCM by a taxpayer (old taxpayer), there is a transaction that makes 
another taxpayer (new taxpayer) responsible for accounting for income 
from the same contract. The rules governing constructive completion 
transactions are provided in paragraph (g)(2) of this section, while the 
rules governing step-in-the-shoes transactions are provided in paragraph 
(g)(3) of this section. For purposes of this paragraph, pre-transaction 
years are all taxable years of the old taxpayer in which the old 
taxpayer accounted for (or should have accounted for) gross receipts 
from the contract, and post-transaction years are all taxable years of 
the new taxpayer in which the new taxpayer accounted for (or should have 
accounted for) gross receipts from the contract.
    (2) Constructive completion transactions. In the case of a 
transaction described in Sec. 1.460-4(k)(2)(i) (constructive completion 
transaction), the look-back method is applied by the old taxpayer with 
respect to pre-transaction years upon the date of the transaction and, 
if the new taxpayer uses the PCM or the PCCM to account for the 
contract, by the new taxpayer with respect to post-transaction years 
upon completion of the contract. The contract price and allocable 
contract costs to be taken into account by the old taxpayer or the new 
taxpayer in applying the look-back method are described in Sec. 1.460-
4(k)(2).
    (3) Step-in-the-shoes transactions--(i) General rules. In the case 
of a transaction described in Sec. 1.460-4(k)(3)(i) (step-in-the-shoes 
transaction), the look-back method is not applied at the time of the 
transaction, but is instead applied for the first time when the contract 
is completed by the new taxpayer. Upon completion of the contract, the 
look-back method is applied by the new taxpayer with respect to both 
pre-transaction years and post-transaction years, taking into account 
all amounts reasonably expected to be received by either the old or new 
taxpayer and all allocable contract costs incurred during both periods 
as described in Sec. 1.460-4(k)(3). The new taxpayer is liable for 
filing the Form 8697 and for interest computed on hypothetical 
underpayments of tax, and is entitled to receive interest with respect 
to hypothetical overpayments of tax, for both pre- and post-transaction 
years. The old taxpayer will be secondarily liable for any interest 
required to be paid with respect to pre-transaction years reduced by any 
interest on pre-transaction overpayments.
    (ii) Application of look-back method to pre-transaction period--(A) 
Contract price. The actual contract price for pre-transaction taxable 
years must be determined by the new taxpayer without regard to any 
contract price adjustment described in paragraph (k)(3)(iv)(B)(1) of 
this section.
    (B) Method. The new taxpayer may apply the look-back method to each 
pre-transaction taxable year that is a redetermination year using the 
simplified marginal impact method described in paragraph (d) of this 
section (regardless of whether or not the old taxpayer would have 
actually used that method and without regard to the tax liability 
ceiling). But see paragraph (d)(4) of this section, which requires use 
of the simplified marginal impact method by certain pass-through 
entities.

[[Page 245]]

    (C) Interest accrual period. With respect to any hypothetical 
underpayment or overpayment of tax for a pre-transaction taxable year, 
interest accrues from the due date of the old taxpayer's tax return (not 
including extensions) for the taxable year of the underpayment or 
overpayment until the due date of the new taxpayer's return (not 
including extensions) for the completion year or the year of a post-
completion adjustment, whichever is applicable.
    (D) Information old taxpayer must provide. In order to help the new 
taxpayer to apply the look-back method with respect to pre-transaction 
taxable years, any old taxpayer that accounted for income from a long-
term contract under the PCM or PCCM for either regular or alternative 
minimum tax purposes is required to provide the information described in 
this paragraph to the new taxpayer by the due date (not including 
extensions) of the old taxpayer's income tax return for the first 
taxable year ending on or after a step-in-the-shoes transaction 
described in Sec. 1.460-4(k)(3)(i). The required information is as 
follows--
    (1) The portion of the contract reported by the old taxpayer under 
PCM for regular and alternative minimum tax purposes (i.e., whether the 
old taxpayer used PCM, the 40/60 PCCM method, or the 70/30 PCCM method);
    (2) Any submethods used in the application of PCM (e.g., the 
simplified cost-to-cost method or the 10-percent method);
    (3) The amount of total contract price reported by year;
    (4) The numerator and the denominator of the completion factor by 
year;
    (5) The due date (not including extensions) of the old taxpayer's 
income tax returns for each taxable year in which income was required to 
be reported;
    (6) Whether the old taxpayer was a corporate or a noncorporate 
taxpayer by year; and
    (7) Any other information required by the Commissioner by 
administrative pronouncement.
    (iii) Application of look-back method to post-transaction years. 
With respect to post-transaction taxable years, the new taxpayer must 
use the same look-back method it uses for other contracts (i.e., the 
simplified marginal impact method or the actual method) to determine the 
amount of any hypothetical overpayment or underpayment of tax and the 
time period for computing interest on these amounts.
    (iv) S corporation elections. Following the conversion of a C 
corporation into an S corporation, the look-back method is applied at 
the entity level with respect to contracts entered into prior to the 
conversion, notwithstanding section 460(b)(4)(B)(i).
    (4) Effective date. This paragraph (g) is applicable for 
transactions on or after May 15, 2002.
    (h) Examples--(1) Overview. This paragraph provides computational 
examples of the rules of this section. Except as otherwise noted, the 
examples involve calendar-year taxpayers and involve long-term contracts 
subject to section 460 that are accounted for using the percentage of 
completion method, rather than the percentage of completion-capitalized 
cost method. If the percentage of completion-capitalized cost method 
were used by a taxpayer described in the examples, the amounts of 
contract income and expenses shown in the examples would be reduced, for 
purposes of determining regular taxable income, to the appropriate 
fraction (40, 70, or 90 percent) of contract items accounted for under 
the percentage of completion method. Tens of thousands of dollars ($ 
00,000's) are omitted from the figures in the examples. The contracts 
described in the examples are assumed to be the taxpayers' only 
contracts that are subject to the look-back method of section 460. 
Except as otherwise stated, the examples assume that the taxpayer has no 
adjustments and preferences for purposes of section 55, so that 
alternative minimum taxable income is the same as taxable income, and no 
alternative minimum tax is imposed for the years involved. The examples 
assume that the taxpayer does not elect the 10-percent method, the 
simplified marginal impact method, or the delayed reapplication method.
    (2) Step One. The following example illustrates the application of 
paragraph (c)(2):

    Example (1). In 1989, W completes three long-term contracts, A, B, 
and C, entered

[[Page 246]]

into on January 1 of 1986, 1987, and 1988, respectively. For Contract A, 
W used the completed contract method of accounting. For Contract B, W 
used the percentage of completion-capitalized cost method of accounting, 
taking into account 60 percent of contract income under W's normal 
method of accounting, which was the completed contract method. For 
Contract C, W used the percentage of completion method of accounting. 
The total price for each contract was $1,000. In computing alternative 
minimum taxable income, W is required to use the percentage of 
completion method for Contracts B and C. W used regular tax costs for 
purposes of determining the degree of contract completion under the 
alternative minimum tax.
    Contract A is not taken into account for purposes of applying the 
look-back method, because it is subject to neither section 460 nor 
section 56(a)(3). Thus, even if W had used the percentage of completion 
method as permitted under Sec. 1.451-3, instead of the completed 
contract method, the look-back method would not be applicable because 
the Contract A was entered into before the effective date of section 
460.
    The actual costs allocated to Contracts B and C under section 460(c) 
and incurred in each year of the contract were as follows:

------------------------------------------------------------------------
                 Contract                    1987   1988   1989   Total
------------------------------------------------------------------------
B.........................................   $200   $400   $200     $800
C.........................................    100    300    400      800
------------------------------------------------------------------------

    In applying the look-back method, the first step is to allocate the 
contract price among tax years preceding and including the completion 
year. That allocation would produce the following amounts of gross 
income for purposes of the regular tax. Note that no income from 
Contract C is allocated to 1987, the year before the contract was 
entered into, even though contract costs were incurred in 1987:

----------------------------------------------------------------------------------------------------------------
              Contract                           1987                              1988                    1989
----------------------------------------------------------------------------------------------------------------
B..................................              $100                              $200                     $700
                                            (40%X$200/$800X$1000)          ((40%X$600/$800X$1000)-$100)  .......
C..................................                0                                500                      500
                                     ............................                     ($400/$800X$1000)  .......
----------------------------------------------------------------------------------------------------------------

    Because the percentage of completion-capitalized cost method may not 
be used for alternative minimum tax purposes, the allocation of contract 
income would produce the following amounts of gross income for purposes 
of computing alternative minimum taxable income:

----------------------------------------------------------------------------------------------------------------
                     Contract                               1987                       1988                1989
----------------------------------------------------------------------------------------------------------------
B.................................................          $250                       $500                 $250
                                                       ($200/$800X$1000)       (($600/$800X$1000)-$250)  .......
C.................................................            0                        500                   500
----------------------------------------------------------------------------------------------------------------

    (3) Step Two. The following example illustrates the application of 
paragraph (c)(3):

    Example (2). (i) X enters into two long-term contracts (D and E) in 
1988. X determines its tax liability for 1988 as follows:
    e=estimate
    a=amount originally reported (actual)
    h=hypothetical

------------------------------------------------------------------------
                                               1988
                                     ------------------------    Total
                                           D           E
------------------------------------------------------------------------
1988 contract costs.................    $3,000a     $2,000a   ..........
Total contract costs................     8,000e      8,000e   ..........
Total contract price................    10,000e     10,000e   ..........
1988 completion %...................      37.5e         25e   ..........
1988 gross income...................     3,750a      2,500a   ..........
Less, 1988 costs....................    (3,000a)    (2,000a)  ..........
                                     -------------
      1988 net contract income......       750a        500a     $1,250a
Other 1988 net income (loss)........  ..........  ..........    (2,000a)
                                     -------------
      Taxable income (NOL)..........  ..........  ..........      (750a)
                                     -------------
      Tax...........................  ..........  ..........         0a
Refund from NOL carryback fully       ..........  ..........       345a
 absorbed in 1985, at 46%...........
------------------------------------------------------------------------


[[Page 247]]

    (ii) X completes Contract D during 1989. X determines its taxable 
income for 1989 as follows:

------------------------------------------------------------------------
                                               1989
                                     ------------------------    Total
                                           D           E
------------------------------------------------------------------------
1989 contract costs.................    $3,000a          0a   ..........
Total contract costs................     6,000a     $9,000e   ..........
Total contract price................    10,000a     10,000e   ..........
1989 completion %...................       100a       22.2e   ..........
1989 gross income/(loss)............     6,250a      (278a)   ..........
Less, 1989 costs....................   (3,000a)          0a   ..........
                                     -------------
      1989 net contract income......     3,250a      (278a)      $2,972a
Other 1989 net income (loss)........  ..........  ..........          0a
                                     -------------
      Taxable income (NOL)..........  ..........  ..........      2,972a
Tax at 34%..........................  ..........  ..........      1,011a
------------------------------------------------------------------------

    (iii) For purposes of the look-back method, X must reallocate the 
actual total contract D price between 1988 and 1989 based on the actual 
total contract D costs. This results in the following hypothetical 
underpayment of tax for 1988 for purposes of the look-back method. Note 
that X does not reallocate the contract E price in applying the look-
back method in 1989 because contract E has not been completed, even 
though X's estimate of contract E costs has changed. The following 
computation is only for purposes of applying the look-back method, and 
does not result in the assessment of a tax deficiency.

------------------------------------------------------------------------
                                               1988
                                     ------------------------    Total
                                           D           E
------------------------------------------------------------------------
1988 contract costs.................    $3,000a     $2,000a   ..........
Total contract costs................     6,000a      8,000e   ..........
Total contract price................    10,000a     10,000e   ..........
1988 completion %...................        50a         25e   ..........
1988 gross income...................     5,000h      2,500a   ..........
Less, 1988 costs....................    (3,000a)    (2,000a)  ..........
                                     -------------
      1988 net contract income......     2,000h        500a     $2,500h
Other 1988 net income (loss)........  ..........  ..........    (2,000a)
                                     -------------
      Taxable income (NOL)..........  ..........  ..........       500h
Tax at 34%..........................  ..........  ..........       170h
Less, previously computed tax.......  ..........  ..........        -0a
Underpayment of 1988 tax............  ..........  ..........       170h
Underpayment of 1985 tax from NOL     ..........  ..........       345h
 carryback refund in 1988...........
                                     -------------
      Total underpayment of tax.....  ..........  ..........       515h
------------------------------------------------------------------------

    For purposes of any subsequent application of the look-back method 
for which 1989 is a redetermination year, because the reallocation of 
contract income and redetermination of tax liability are cumulative, X 
will use for 1989 the amount of contract D income and the amount of tax 
liability that would have been reported in 1989 if X had used actual 
contract costs instead of the amounts that were originally reported 
using the estimate of $8,000. Assuming no subsequent revisions (due to, 
for example, adjustments to contract D price and costs determined after 
the end of 1989), this amount would be determined as follows:

------------------------------------------------------------------------
                                               1989
                                     ------------------------    Total
                                           D           E
------------------------------------------------------------------------
1989 contract costs.................    $3,000a          0a   ..........
Total contract costs................     6,000a     $9,000e   ..........
Total contract price................    10,000a     10,000e   ..........
1989 completion %...................       100a       22.2e   ..........
1989 gross income...................     5,000h       (278a)  ..........

[[Page 248]]


Less, 1989 costs....................    (3,000a)         0a   ..........
                                     -------------
      1989 net contract income......     2,000h       (278a)     $1,722h
Other 1989 net income (loss)........  ..........  ..........          0a
                                     -------------
      Taxable income (NOL)..........  ..........  ..........      1,722h
Tax at 34%..........................  ..........  ..........        585h
------------------------------------------------------------------------

    (iv) X completes contract E during 1990. X determines its taxable 
income for 1990 as follows:

------------------------------------------------------------------------
                                               1990
                                     ------------------------    Total
                                           D           E
------------------------------------------------------------------------
1990 contract costs.................  ..........    $7,000a   ..........
Total contract costs................  ..........     9,000a   ..........
Total contract price................  ..........    10,000a   ..........
1990 completion %...................  ..........       100a   ..........
1990 gross income...................  ..........     7,778a   ..........
Less, 1990 costs....................  ..........    (7,000a)  ..........
                                     -------------
      1990 net contract income......  ..........       778a        $778a
Other 1990 net income (loss)........  ..........  ..........          0a
                                     -------------
      Taxable income (NOL)..........  ..........  ..........        778a
Tax at 34%..........................  ..........  ..........        265a
------------------------------------------------------------------------

    (v) For purposes of the look-back method, X must reallocate the 
actual total contract E price between the 1988, 1989, and 1990, based on 
the actual total contract E costs.

This results in the following hypothetical overpayment of tax for 1988. 
Note that X uses the amount of income for contract D determined in the 
last previous application of the look-back method, and not the amount of 
income actually reported:

------------------------------------------------------------------------
                                               1988
                                     ------------------------    Total
                                           D           E
------------------------------------------------------------------------
1988 contract costs.................    $3,000a     $2,000a   ..........
Total contract costs................    $6,000a     $9,000a   ..........
Total contract price................   $10,000a    $10,000a   ..........
1988 completion (%).................        50a       22.2a   ..........
1988 gross income...................    $5,000h     $2,222h   ..........
Less, 1988 costs....................   ($3,000a)   ($2,000a)  ..........
                                     -------------
      1988 net contract income......    $2,000h       $222h     $2,222h
Other 1988 net income (loss)........  ..........  ..........   ($2,000a)
                                     -------------
      Taxable income (NOL)..........  ..........  ..........      $222h
                                     -------------
      Tax at 34%....................  ..........  ..........       $75h
Less, previously computed tax (based  ..........  ..........      $170h
 on most recent application of the
 look-back method)..................
                                     -------------
      Overpayment of 1988 tax.......  ..........  ..........      ($95h)
------------------------------------------------------------------------

    In applying the look-back method to 1989, X again uses the amounts 
substituted as of the last previous application of the look-back method 
with respect to contract D. Thus, X computes its hypothetical 
underpayment for 1989 as follows:

[[Page 249]]



------------------------------------------------------------------------
                                               1989
                                     ------------------------    Total
                                           D           E
------------------------------------------------------------------------
1989 contract costs.................    $3,000a          0a   ..........
Total contract costs................    $6,000a     $9,000a   ..........
Total contract price................   $10,000a    $10,000a   ..........
1989 completion (%).................       100a       22.2a   ..........
1989 gross income...................    $5,000h         $0h   ..........
Less, 1989 costs....................   ($3,000a)       ($0a)  ..........
                                     -------------
      1989 net contract income......    $2,000h          0a     $2,000h
Other 1989 net income (loss)........  ..........  ..........       ($0a)
                                     -------------
Taxable income (NOL)................  ..........  ..........    $2,000h
Tax at 34%..........................  ..........  ..........      $680h
Less, previously computed tax.......  ..........  ..........      $585h
                                     -------------
      Underpayment of 1989 tax......  ..........  ..........       $95h
------------------------------------------------------------------------

    For purposes of any subsequent application of the look-back method 
for which 1990 is a redetermination year, X will use for 1990 the amount 
of Contract E income, and the amount of tax liability, that was 
originally reported in 1990 because X's estimate of the total contract 
costs from $8,000 to $9,000 did not change after 1989. Without regard to 
any subsequent revisions, these amounts are the same as in the table in 
paragraph (h)(3)(iv) above.

    (4) Post-completion adjustments. The following example illustrates 
the application of paragraph (c)(1)(ii):

    Example (3). The facts are the same as in Example (2). In 1991, X 
settles a lawsuit against its customer in Contract E. The customer pays 
X an additional $3,000, without interest, in 1991. Applying the Federal 
mid-term rate then in effect, this $3,000 has a discounted value at the 
time of contract completion in 1990 of $2,700. X is required to apply 
the look-back method for 1991 even though no contract was completed in 
1991. X must include the full $3,000 adjustment (which was not 
previously includible in total contract price) in gross income for 1991. 
X does not elect not to discount adjustments to the contract price or 
costs. Thus, X adjusts the contract price by the discounted amount of 
the adjustment and, therefore, uses $12,700 (not $13,000) for total 
Contract E price, rather than $10,000, which was used when the look-back 
method was first applied with respect to Contract E.
    For purposes of the look-back method, X must allocate the revised 
total Contract E price of $12,700 between 1988, 1989 and 1990 based on 
the actual total Contract E costs, and compare the resulting revised tax 
liability with the tax liability determined for the last previous 
application of the look-back method involving those years. This results 
in the following hypothetical underpayments of tax for purposes of the 
look-back method:
    r=revised

------------------------------------------------------------------------
                                               1988
                                    -------------------------    Total
                                          D           E
------------------------------------------------------------------------
1988 contract costs................     $3,000a     $2,000a   ..........
Total contract costs...............     $6,000a     $9,000a   ..........
Total contract price...............    $10,000a    $12,700r   ..........
1988 completion (%)................         50a       22.2a   ..........
1988 gross income..................     $5,000h    $2,822rh   ..........
Less, 1988 costs...................   ($3,000a)    ($2,000a)  ..........
                                    -------------
      1988 net contract income.....     $2,000h       822rh     $2,222rh
Other 1988 net income (loss).......  ..........  ...........   ($2,000a)
                                    -------------
      Taxable income...............  ..........  ...........      $822rh
      Tax at 34%...................  ..........  ...........      $279rh
Less, previously computed tax......  ..........  ...........        $75h
      Underpayment of 1988 tax.....  ..........  ...........      $204rh
------------------------------------------------------------------------

    No Contract E costs were incurred in 1989, and there is no 
hypothetical underpayment for 1989.
      
      

[[Page 250]]



------------------------------------------------------------------------
                                                    1990
                                  --------------------------------------
                                        D            E          Total
------------------------------------------------------------------------
1990 contract costs..............  ...........     $7,000a   ...........
Total contract costs.............  ...........     $9,000a   ...........
Total contract price.............  ...........    $12,700r   ...........
1990 completion (%)..............  ...........        100a   ...........
1990 gross income................  ...........    $9,878rh   ...........
Less 1990 costs..................  ...........    ($7,000a)  ...........
                                  --------------
      1990 net contract income...  ...........    $2,878rh     $2,878rh
Other 1990 net income (loss).....  ...........  ...........          0a
                                  --------------
Taxable income (NOL).............  ...........  ...........    $2,878rh
Tax at 34%.......................  ...........  ...........      $978rh
Less, previously computed tax....  ...........  ...........       $265h
                                  --------------
      Underpayment of 1990 tax...  ...........  ...........      $713rh
------------------------------------------------------------------------

    In 1992, X incurs an additional cost of $1,000 allocable to the 
contract, which was not previously includible in total contract costs. 
Applying the Federal mid-term rate then in effect, the $1,000 has a 
discounted value at the time of contract completion of $800. X deducts 
this additional $1,000 in expenses in 1992. Based on this increase to 
contract costs, X reapplies the look-back method, and determines the 
following hypothetical underpayments for 1988, 1989 and 1990 for 
purposes of the look-back method:

------------------------------------------------------------------------
                                             1988
                                  --------------------------    Total
                                        D            E
------------------------------------------------------------------------
1988 contract costs..............     $3,000a      $2,000a   ...........
Total contract costs.............     $6,000a      $9,800r   ...........
Total contract price.............    $10,000a     $12,700r   ...........
1988 completion (%)..............         50a        20.4r   ...........
1988 gross income................     $5,000h     $2,592rh   ...........
Less, 1988 costs.................    ($3,000a)    ($2,000a)  ...........
                                  --------------
      1988 net contract income...     $2,000h        592rh     $2,592rh
Other 1988 net income (loss).....  ...........  ...........    ($2,000a)
                                  --------------
      Taxable income (NOL).......  ...........  ...........      $592rh
Tax at 34%.......................  ...........  ...........      $201rh
Less, previously computed tax....  ...........  ...........      $279rh
                                  --------------
      Overpayment of 1988 tax....  ...........  ...........      ($78rh)
------------------------------------------------------------------------

    No Contract E costs were incured in 1989, and there is no 
hypothetical underpayment for 1989.

------------------------------------------------------------------------
                                              1990
                                   -------------------------    Total
                                         D           E
------------------------------------------------------------------------
1990 contract costs...............  ..........  ...........     $7,000a
Total contract costs..............  ..........      9,800r   ...........
Total contract price..............  ..........     12,700r   ...........
1990 completion (%)...............  ..........         92a   ...........
1990 gross income.................  ..........     9,071rh   ...........
Less, 1990 costs..................  ..........     (7,000a)  ...........
                                   -------------
1990 Net contract income..........  ..........     2,071rh     $2,071rh
Other 1990 net income (loss)......  ..........  ...........          0a
                                   -------------
      Taxable income (NOL)........  ..........  ...........     2,071rh
Tax at 34%........................  ..........  ...........       704rh
Less, previously computed tax.....  ..........  ...........       978rh
                                   -------------

[[Page 251]]


      Overpayment of 1990 tax.....  ..........  ...........      (274rh)
------------------------------------------------------------------------

    (5) Alternative minimum tax. The operation of the look-back method 
in the case of a taxpayer liable for the alternative minimum tax as 
provided in paragraph (c)(3)(vi) is illustrated by the following 
examples:

    Example (4). Y enters into a long-term contract in 1988 that is 
completed in 1989. Y used regular tax costs for purposes of determining 
the degree of contract completion under the alternative minimum tax.

    (i) Y determines its tax liability for 1988 as follows:

1988 contract costs........................................     $4,000a
Total contract costs.......................................     $8,000e
Total contract price.......................................    $20,000e
1988 completion (%)........................................         50e
1988 gross income..........................................    $10,000a
Less, 1988 contract costs..................................    ($4,000a
                                                            ------------
      1988 net contract income.............................     $6,000a
Other 1988 net income/(loss)...............................    ($3,400a)
Taxable income.............................................     $2,600a
Regular tax at 34%.........................................        884a
Adjustments and preferences to produce alternative minimum        $600a
 taxable income............................................
Alternative minimum taxable income.........................     $3,200a
Tentative minimum tax at 20%...............................        640a
Tax liability..............................................       $884a


    In 1989, Y determines the following amounts:

1989 contract costs..........................................    $6,000a
Total contract costs.........................................   $10,000a
Total contract price.........................................   $20,000a


    (ii) For purposes of applying the look-back method, Y redetermines 
its tax liability for 1988, which results in a hypothetical overpayment 
of tax. This hypothetical overpayment is determined by comparing Y's 
original regular tax liability for 1988 with the hypothetical total tax 
liability (including alternative minimum tax liability) for that year 
because Y would have paid the alternative minimum tax if Y had used its 
actual contract costs to report income:

1988 contract costs.........................................    $4,000a
Total contract costs........................................   $10,000a
Total contract price........................................   $20,000a
1988 completion(%)..........................................        40a
1988 gross income...........................................    $8,000h
less, 1988 contract costs...................................   ($4,000a)
1988 net contract income....................................    $4,000h
Other 1988 net income/(loss)................................   ($3,400a)
Taxable income..............................................      $600h
Regular tax at 34%..........................................      $204h
Adjustments and preferences to produce alternative minimum        $600a
 taxable income.............................................
Alternative minimum taxable income..........................    $1,200h
Tentative minimum tax at 20%................................       240h
Alternative minimum tax.....................................       $36h
Total tax liability.........................................      $240h
less, previously computed tax...............................      $884a
Underpayment/(overpayment)..................................     ($644h)


    (6) Credit carryovers. The operation of the look-back method in the 
case of credit carryovers as provided in paragraph (c)(3)(v) is 
illustrated by the following example:

    Example (5). Z enters into a contract in 1986 that is completed in 
1987. Z determines its tax liability for 1986 as follows:

1986 contract costs..........................................     $400a
Total contract costs.........................................   $1,000e
Total contract price.........................................   $2,000e
1986 completion (%)..........................................       40e
1986 gross income............................................     $800a
Less, 1986 costs.............................................    ($400a)
1986 net contract income.....................................     $400a
Other 1986 net income........................................       $0a
Taxable income...............................................     $400a
Tax at 46%...................................................     $184a
Unused tax credits carried forward from 1985 allowable in         $350a
 1986........................................................
Net tax due..................................................       $0a


    Z determines the following amounts for 1987:

1987 contract costs..........................................      $400a
Total contract price.........................................    $2,000a
Total contract costs.........................................      $800a


    If Z had used actual rather than estimated contract costs in 
determining gross income for 1986, Z would have reported tax liability 
of $276 (46%x$600) rather than $184. However, Z would have paid no 
additional tax for 1986 because its unused tax credits carried forward 
from 1985 would have been sufficient to offset this increased tax 
liability. Therefore, there is no hypothetical underpayment for 1986 for 
purposes of the look-back method. However, this hypothetical earlier use 
of the credit may increase the hypothetical tax liability for 1987 (or 
another subsequent year) for purposes of subsequent applications of the 
look-back method.


[[Page 252]]


    (7) Net operating losses. The operation of the look-back method in 
the case of net operating loss (``NOL'') carryovers as provided in 
paragraph (c)(3)(v) is illustrated by the following example:

    Example (6). A entered into a long-term contract in 1986, which was 
completed in 1987. A determined its tax liability for 1986 as follows:

1986 contract costs.........................................      $400a
Total contract costs........................................    $1,000e
Total contract price........................................    $2,000e
1986 completion (%).........................................        40e
1986 gross income...........................................      $800a
Less, 1986 costs............................................     ($400a)
1986 net contract income....................................      $400a
Other 1986 net income/(loss)................................   ($1,000a)
Taxable income/(NOL)........................................     ($600a)
Tax.........................................................        $0a


    A elected to carry this loss forward to 1987 pursuant to section 
172(b)(3)(C).
    For 1987, A determined the following amounts:

1987 contract costs...........................................     $400a
Total contract costs..........................................     $800a
Total contract price..........................................   $2,000a


    If actual rather than estimated contract costs had been used in 
determining gross income for 1986, A would have reported $1,000 of gross 
income from the contract rather than $800, and thus would have reported 
a loss of $400 rather than $600. However, since A would have paid no tax 
for 1986 regardless of whether actual or estimated contract costs had 
been used, A does not have an underpayment for 1986 for purposes of the 
look-back method. If A had, instead, carried back the 1986 NOL, and this 
NOL had been absorbed in the tax years 1983 through 1985, it would have 
resulted in refunds of tax for those years in 1986. When A applies the 
look-back method, a hypothetical underpayment of tax would have resulted 
for those years due to a hypothetical reduction in the amount that would 
have been refunded if income had been reported on the basis of actual 
contract costs. See Example (2)(iii).

    (8) Alternative minimum tax credit. The following example 
illustrates the application of the look-back method if affected by the 
alternative minimum tax credit as provided in paragraph (c)(3)(vi):
    (i) Example (4), above illustrates that the reallocation of contract 
income under the look-back method can result in a hypothetical 
underpayment or overpayment determined using the alternative minimum tax 
rate, even though the taxpayer actually paid only the regular tax for 
that year. However, application of the look-back method had no effect on 
the difference between the amount of alternative minimum taxable income 
and the amount of regular taxable income taken into account in that year 
because the taxpayer was required to use the percentage of completion 
method for both regular and alternative minimum tax purposes and used 
the same version of the percentage of completion method for both regular 
and alternative minimum tax purposes (i.e., the taxpayer had made an 
election to use regular tax costs in determining the percentage of 
completion for purposes of computing alternative minimum taxable 
income).
    (ii) The following example illustrates the application of the look-
back method in the case of a taxpayer that does not use the percentage 
of completion method of accounting for long-term contracts in computing 
taxable income for regular tax purposes and thus must make an adjustment 
to taxable income to determine alternative minimum taxable income. The 
example also shows how interest is computed under the look-back method 
when the taxpayer is entitled to a credit under section 53 for minimum 
tax paid because of this adjustment.

    Example (7). X is a taxpayer engaged in the construction of real 
property under contracts that are completed within a 24-month period and 
whose average annual gross receipts do not exceed $10,000,000. As 
permitted by section 460(e)(1)(B), X uses the completed contract method 
(``CCM'') for regular tax purposes. However, X is engaged in the 
construction of commercial real property and, therefore, is required to 
use the percentage of completion method (``PCM'') for alternative 
minimum tax (``AMT'') purposes.
    Assume that for 1988, 1989, and 1990, X has only one long-term 
contract, which is entered into in 1988 and completed in 1990. Assume 
further that X estimates gross income from the contract to be $2,000, 
total contract costs to be $1,000, and that the contract is 25 percent 
complete in 1988 and 75 percent complete in 1989. In 1990, the year of 
completion, the percentage of completion does not change but, upon 
completion, gross income from the contract is actually $3,000, instead 
of $2,000, and costs are actually $1,000.
    For 1988, 1989, and 1990, X's income and tax liability using 
estimated contract price and costs are as follows:

[[Page 253]]



------------------------------------------------------------------------
            Estimates                  1988         1989         1990
------------------------------------------------------------------------
Regular tax:
    Long-term:
        Contract-CCM.............           0            0       $2,000
        Other Income.............           0       $5,000            0
            Total Income.........           0       $5,000       $2,000
Tax @ 34%........................           0       $1,700         $680
AMT
    Gross Income.................        $500       $1,000       $1,500
    Deductions...................       $(250)       $(500)       $(250)
    Total long-term:
        Contract-PCM.............        $250         $500       $1,250
        Other Income.............           0       $5,000            0
            Total Income.........        $250       $5,500       $1,250
Tax @ 20%........................         $50       $1,100         $250
Tentative Minimum Tax............         $50       $1,100         $250
Regular Tax......................           0       $1,700         $680
Minimum Tax Credit...............           0         $(50)           0
    Net Tax Liability............         $50       $1,650         $680
------------------------------------------------------------------------

    When X files its tax return for 1990, X applies the look-back method 
to the contract. For 1988, 1989, and 1990, X's income and tax liability 
using actual contract price and costs are as follows:

------------------------------------------------------------------------
              Actual                   1988         1989         1990
------------------------------------------------------------------------
Regular tax:
    Long-term:
        Contract-CCM.............           0            0       $2,000
        Other Income.............           0       $5,000            0
            Total Income.........           0       $5,000       $2,000
Tax @ 34%........................           0       $1,700         $680
AMT
    Gross Income.................        $750       $1,500         $750
    Deductions...................       $(250)       $(500)       $(250)
    Total long-term:
        Contract-PCM.............        $500       $1,000         $500
        Other Income.............           0       $5,000            0
            Total Income.........        $500       $6,000         $500
Tax @ 20%........................        $100       $1,200         $100
Tentative Minimum Tax............        $100       $1,200         $100
Regular Tax......................           0       $1,700         $680
Minimum Tax Credit...............           0        $(100)           0
    Net Tax Liability............        $100       $1,600         $680
Underpayment.....................         $50   ...........  ...........
Overpayment......................  ...........         $50   ...........
------------------------------------------------------------------------

    As shown above, application of the look-back method results in a 
hypothetical underpayment of $50 for 1988 because X was subject to the 
alternative minimum tax for that year. Interest is charged to X on this 
$50 underpayment from the due date of X's 1988 return until the due date 
of X's 1990 return.
    In 1989, although X was required to compute alternative minimum 
taxable income using the percentage of completion method, X was not 
required to pay alternative minimum tax. Nevertheless, the look-back 
method must be applied to 1989 because use of actual rather than 
estimated contract price in computing alternative minimum taxable income 
for 1988 would have changed the amount of the alternative minimum tax 
credit carried to 1989. Interest is paid to X on the resulting $50 
overpayment from the due date of X's 1989 return until the due date of 
X's 1990 return.

    (9) Period for interest. The following Examples (8) through (11) 
illustrate how to determine the period for computing interest as 
provided in paragraph (c)(4):

    Example (8). The facts are the same as in Example (6), except that 
the contract is completed in 1988, and A determined the following 
amounts for 1987 and 1988:

For 1987:
  1987 contract costs.......................................          0
  Total contract costs......................................    $1,000e
  Total contract price......................................    $2,000e
  1987 completion (%).......................................       $40e
  1987 gross income.........................................         0a
  Less, 1987 costs..........................................         0a

[[Page 254]]


  Other 1987 net income.....................................      $600a
  Net operating loss carryforward from 1986.................     $(600a)
  Taxable income............................................         0a
  Tax.......................................................         0a
For 1988:
  1988 contract costs.......................................      $400a
  Total contract costs......................................      $800a
  Total contract price......................................    $2,000a


    If actual rather than estimated contract costs had been used in 
determining gross income for 1986, A would have reported $1,000 of gross 
income from the contract for 1986 rather than $800, and would have 
reported a net operating loss carryforward to 1987 of $400 rather than 
$600. Therefore, A would have reported taxable income of $200, and would 
have paid tax of $80 (i.e., $200x40%) for 1987. The due date for filing 
A's Federal income tax return for its 1988 taxable year is March 15. A 
obtains an extension and files its 1988 return on September 15, 1989. 
Under the look-back method, A is required to pay interest on the amount 
of this hypothetical underpayment ($80) computed from the due date 
(determined without regard to extensions) for A's return for 1987 (not 
1986, even though 1986 was the year in which the net operating loss 
arose) until March 15 (not September 15), the due date (without regard 
to extensions) of A's return for 1988. A is required to pay additional 
interest from March 15 until September 15 on the amount of interest 
outstanding as of March 15 with respect to the hypothetical underpayment 
of $80.
    Example (9). The facts are the same as in Example (6), except that A 
carries the net operating loss of $600 back to 1983 rather than forward 
to 1987, and receives a refund of $276 ($600 reduction in 1983 taxable 
income x 46% rate in effect in 1983). As in Example (6), if actual 
contract costs had been used, A would have reported a loss for 1986 of 
$400 rather than $600. Thus, A would have received a refund of 1983 tax 
of $184 ($400x46%) rather than $276. Under the look-back method A is 
required to pay interest on the difference in these two amounts ($92) 
computed from the due date (determined without regard to extensions) of 
A's return for 1986 (the year in which the carryback arose rather than 
1983, the year in which it was used) until the due date of A's return 
for 1988.
    Example (10). B enters into a long-term contract in 1986 that is 
completed in 1988. B determines its 1986 tax liability as follows:

1986 contract costs..........................................     $400a
Total contract costs.........................................   $1,000e
Total contract price.........................................   $2,000e
1986 completion (%)..........................................       40e
1986 gross income............................................     $800a
Less, 1986 costs.............................................    ($400a)
1986 net contract income.....................................     $400a
Other 1986 net income........................................   $2,000a
Taxable income...............................................   $2,400a
Tax at 46%...................................................   $1,104a
     B determines its tax liability for 1987 as follows:
1987 contract costs..........................................     $400a
Total contract costs.........................................   $1,600e
Total contract price.........................................   $2,000e
1987 completion (%)..........................................       50e
1987 gross income............................................     $200a
(=(50%x$2,000) $800 previously reported) less, 1987 costs....    ($400a)
1987 net contract income.....................................    ($200a)
Other 1987 net income/(loss).................................  ($2,200a)
Taxable income (NOL).........................................  ($2,400a)
Tax..........................................................        0a


    Assume that B had no taxable income in either 1984 or 1985, so that 
the entire amount of the $2,400 net operating loss is carried back to 
1986, and B receives a refund, with interest from the due date of B's 
1987 return, of the entire $1,104 in tax that it paid for 1986.
    In 1988, B determines the following amounts:

1988 contract costs...........................................     $800a
Total contract costs..........................................   $1,600a
Total contract price..........................................   $2,000a


    If B had used actual contract costs rather than estimated costs in 
determining its gross income for 1986, B would have had gross income 
from the contract of $500 rather than $800, and thus would have had 
taxable income of $2,100 rather than $2,400, and would have paid tax of 
$966 rather than $1,104. B is entitled to receive interest on the 
difference between these two amounts, the hypothetical overpayment of 
tax of $138. Interest is computed from the due date (without regard to 
extensions) of B's return for 1986 until the due date for B's return for 
1987. Interest stops running at this date, because B's hypothetical 
overpayment of tax ended when B filed its original 1987 return and 
received a refund for the carryback to 1986, and interest on this refund 
began to run only from the due date of B's 1987 return. See section 
6611(f).
    Example (11). C enters into a long-term contract in 1986, its first 
year in business, which is completed in 1988. C determines its tax 
liability for 1986 as follows:

1986 contract costs.........................................      $400a
Total contract costs........................................    $1,000e
Total contract price........................................    $2,000e
1986 completion (%).........................................        40e
1986 gross income...........................................      $800a
less, 1986 costs............................................     ($400a)
1986 net contract income....................................      $400a
Other 1986 net income.......................................    $2,000a
Taxable income (NOL)........................................    $2,400a
Tax at 46%..................................................    $1,104a


    C determines its tax liability for 1987 as follows:

1987 contract costs.........................................      $400a
Total contract costs........................................    $1,066e
Total contract price........................................    $2,000e
1987 completion (%).........................................        75e

[[Page 255]]


1987 gross income...........................................      $700a
Less, 1987 costs............................................     ($400a)
1987 net contract income....................................      $300a
Other 1987 net income.......................................   ($2,450a)
Taxable income (NOL)........................................   ($2,150a)
Tax.........................................................       $10a


    C carries back the net operating loss to 1986, and files an amended 
return for 1986, showing taxable income of $250, and receives a refund 
of $989 (46%x$2,150). Interest on this refund begins to run only as of 
the due date of C's 1987 return. See section 6611(f).
    In 1988, when the contract is completed, C determines the following 
amounts:

1988 contract costs.........................................      $800a
Total contract costs........................................    $1,600a
Total contract price........................................    $2,000a


    If C had used actual contract price and contract costs in 
determining gross income for 1986, it would have reported gross income 
from the contract of $500 rather than $800, taxable income of $2,100 
rather than $2,400, and tax liability of $966 rather than $1,104.
    If C had used actual contract price and contract costs in 
determining gross income for 1987, it would have reported gross income 
from the contract of $500 rather than $700, and would have reported a 
net operating loss of $2,350, rather than $2,150, which would have been 
carried back to 1986.
    Under the look-back method, C receives interest with respect to a 
total 1986 hypothetical overpayment of $138 ($1,104 minus $966). C is 
credited with interest on $23 of this amount only from the due date of 
C's 1986 return until the due date of C's 1987 tax return, because this 
portion of C's total hypothetical overpayment for 1986 was refunded to C 
with interest computed from the due date of C's 1987 return and, 
therefore, was no longer held by the government. However, because the 
remainder of the total hypothetical overpayment of $115 was not refunded 
to C, C is credited with interest on this amount from the due date of 
C's 1986 return until the due date of C's 1988 tax return.
    Under the look-back method, C receives no interest with respect to 
1987, because C had no tax liability for 1987 using either estimated or 
actual contract price and costs.

    (i) [Reserved]
    (j) Election not to apply look-back method in de minimis cases. 
Section 460(b)(6) provides taxpayers with an election not to apply the 
look-back method to long-term contracts in de minimis cases, effective 
for contracts completed in taxable years ending after August 5, 1997. To 
make an election, a taxpayer must attach a statement to its timely filed 
original federal income tax return (including extensions) for the 
taxable year the election is to become effective or to an amended return 
for that year, provided the amended return is filed on or before March 
31, 998. This statement must have the legend ``NOTIFICATION OF ELECTION 
UNDER SECTION 460(b)(6)''; provide the taxpayer's name and identifying 
number and the effective date of the election; and identify the trades 
or businesses that involve long-term contracts. An election applies to 
all long-term contracts completed during and after the taxable year for 
which the election is effective. An election may not be revoked without 
the Commissioner's consent. For taxpayers who elected to use the delayed 
reapplication method under paragraph (e) of this section, an election 
under this paragraph (j) automatically revokes the election to use the 
delayed reapplication method for contracts subject to section 460(b)(6). 
A consolidated group of corporations, as defined in Sec. 1.1502-1(h), 
is subject to consistency rules analogous to those in paragraph (e)(2) 
of this section and in paragraph (d)(4)(ii)(C) of this section 
(concerning election to use simplified marginal impact method).

[T.D. 8315, 55 FR 41670, Oct. 15, 1990, as amended by T.D. 8775, 63 FR 
36181, July 2, 1998; T.D. 8929, 66 FR 2240, Jan. 11, 2001; T.D. 8995, 67 
FR 34609, May 15, 2002]

                 taxable year for which deductions taken