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:: Cost Segregation Audit Techniques Guide - Chapter 6.1 -
Uniform Capitalization
APPENDIX - CHAPTER 6.1 -
UNIFORM CAPITALIZATION
INTRODUCTION
The allocation
of project costs in cost
segregation studies for
self-constructed assets may be
impacted by the Uniform
Capitalization (UNICAP) rules of
IRC § 263A(a). In addition, the
interest capitalization rules of
IRC § 263A(f) may also apply. A
brief summary of these
provisions is presented below.
APPLICATION OF THE
CAPITALIZATION RULES UNDER IRC §
263A
The uniform
capitalization (UNICAP) rules
require the capitalization of
all direct costs and certain
indirect costs properly
allocable to real property and
tangible personal property
produced by the taxpayer. For
purposes of the uniform
capitalization rules, to
"produce" means to construct,
build, install, manufacture,
develop, improve, create, raise
or grow [§ 263A(g)(1); Treas.
Reg. § 1.263A-2(a)(1)(i)].
Self-constructed assets and
property built under contract
are treated as property
"produced" by the taxpayer and
the rules under IRC § 263A(a)
govern.
In addition, §
263A(f) requires the
capitalization of interest
expense when the taxpayer
produces certain property. The
interest capitalization rules
under Treas. Reg. § 1.263A-8
contain precise definitions of
designated property and include
inherently permanent structures
in the definition of real
property. In summary, all real
property and certain tangible
personal property are subject to
the interest capitalization
rules. Therefore, any change in
the allocation of costs between
real and tangible personal
property may have an impact on
the amount of capitalized
interest. Many taxpayers attempt
to exclude all § 1245 property
from interest capitalization
arguing that the § 1245 property
is tangible personal property
that does not meet the
classification thresholds of
Treas. Reg. § 1.263A-8(b)(1).
Most of the § 1245 property in
these situations are inherently
permanent structures (real
property) subject to interest
capitalization without any
restrictions.
The following
text summarizes the
capitalization rules of §
263A(a) and the interest
capitalization rules of §
263A(f). Further detail and
updates can be obtained from Jim
Peschl, § 263A Technical
Advisor, at (763) 549-1020 (James.F.Peschl@irs.gov);
or Barbara J. Martin, § 263A
(Inventory) Technical Advisor,
at (708) 503-3540 x205 (Barbara.J.Martin@irs.gov).
Capitalization of Costs under
IRC § 263A(a)
How does § 263A
identify the costs subject to
capitalization? As a threshold
requirement, one must determine
whether the costs would, but for
§ 263A, be otherwise deductible.
A cost that is not otherwise
deductible may not be allocated
to property produced or acquired
for resale.
In addition,
any cost required to be
capitalized under § 263A may not
be included in inventory or
charged to capital accounts or
basis any earlier than the
taxable year during which the
amount is incurred within the
meaning of § 1.446-1(c)(1)(ii).
What costs are
capitalized under § 263A? Except
as otherwise provided, direct
and indirect costs that directly
benefit or are incurred by
reason of the performance of
production or resale activities
must be capitalized to the
property produced or acquired
for resale. For a producer the
direct costs generally include
direct material and direct
labor. The regulations include
examples of indirect costs [see
§ 1.263A-1(e)(3)(ii)]. Examples
of indirect costs required to be
capitalized are:
-
bidding
costs
-
capitalizable service
costs (including
capitalizable mixed
service costs)
-
cost
recovery allowances
(however, remember
depletion is only
allocated to inventory
produced and sold during
the year)
-
engineering and design
-
employee benefit
expenses
-
handling costs
-
indirect labor costs
-
indirect material costs
-
insurance
-
interest (see special
rules under § 263A(f))
-
licensing and franchise
costs
-
officers' compensation
-
pension
and other related costs
-
purchasing costs
-
quality
control
-
rent
-
repairs
and maintenance
-
spoilage
-
storage
costs
-
taxes
-
tools
and equipment
-
utilities
Producers must
capitalize costs (other than
interest) whether incurred
before, during, or after the
production period of property.
Interest is only capitalized
during the production period of
property. Pre-production costs
are subject to capitalization if
the property is held for future
production or if it is
reasonably likely that the
property will be produced at a
future date. Thus, costs of
storing raw materials and
carrying costs of realty held
for development are required to
be capitalized. Some issues may
arise in determining the
taxpayer's intent and the
taxpayer’s change in intent.
Production period costs are
costs incurred beginning on the
date on which production of the
property begins and ending on
the date on which the property
is ready to be placed in service
or is ready to be held for sale.
Post-production costs are costs
incurred after the actual
production and may include costs
of storage, warehousing,
insurance, materials, and
handling.
Treas. Reg. §
1.263A-1(f) sets forth various
detailed or specific cost
allocation methods that a
taxpayer may use to allocate
direct and indirect costs to
property produced. Under §
1.263A-1(f) a taxpayer may use a
specific identification method,
burden rate method, standard
cost method, or any other
reasonable method to allocate
costs. In addition, in lieu of
these methods, producer
taxpayers may use the simplified
production method provided in §
1.263A-2(b).
Capitalization of Interest under
IRC § 263A(f)
Treas. Reg. §§
1.263A-8 through 1.263A-15
provides guidance with respect
to the capitalization of
interest under IRC § 263A(f).
These regulations are effective
for 1995 and after, or at
taxpayer's election, 1994. For
years prior to the final
regulations, Notice 88-99,
1988-2 C.B. 422, and temporary
regulations provide guidance
with respect to the
capitalization of interest.
Interest is
capitalized with respect to each
unit of designated property.
Interest is capitalized during
each computation period; the
amount of interest that is
capitalized is a function of two
components:
-
the
amount of accumulated
production expenditures;
and,
-
the
amount of outstanding
debt on each measurement
date.
In determining
the amount of outstanding debt,
traced debt is considered first.
The excess expenditure amount is
the amount (if any) by which the
accumulated production
expenditures exceed the amount
of traced debt. Interest on
non-traced debt, up to the
excess expenditure amount, must
be capitalized, based upon a
weighted average interest rate.
Designated
property is defined in IRC §
263A(f)(1) and Treas. Reg. §
1.263A-8(b)(1). In general,
§263A(f) applies to designated
property. Designated property is
any property that is produced
and that is:
-
real
property; or,
-
tangible personal
property that meets any
of the following
classification
thresholds:
-
Property with a
class life of 20
years or more that
is not inventory in
the hands of the
taxpayer or a
related person;
-
Property with an
estimated production
period exceeding 2
years; or
-
Property with an
estimated production
period exceeding 1
year and estimated
cost of production
exceeding
$1,000,000.
Note:
All real property is subject to
the rules of § 263A(f); the
classification thresholds only
apply to tangible personal
property.
The
classification thresholds are
applied individually to each
unit of property.
Treas. Reg. §
1.263A-8(c)(1) defines real
property. Real property includes
land, unsevered natural products
of land, buildings, and
inherently permanent structures.
Any interest in real property,
including fee ownership,
co-ownership, a leasehold, an
option, or a similar interest is
real property. Unsevered natural
products of land include growing
crops and plants (that have a
preproductive period in excess
of 2 years), mines, wells, and
other natural deposits. Real
property includes the structural
components of both buildings and
inherently permanent structures.
Inherently
permanent structures include
property that is affixed to real
property and that will
ordinarily remain affixed for an
indefinite period of time.
Examples are swimming pools,
roads, bridges, tunnels, paved
parking areas and other
pavements, special foundations,
wharves and docks, fences,
inherently permanent advertising
displays, inherently permanent
outdoor lighting facilities,
railroad tracks and signals,
telephone poles, power
generation and transmission
facilities, permanently
installed telecommunications
cables, broadcasting towers, oil
and gas pipelines, derricks and
storage equipment, grain storage
bins and silos. For purposes of
this section, affixation to real
property may be accomplished by
weight alone. [Treas. Reg. §
1.263A-8(c)(3)]
Property may
constitute an inherently
permanent structure even though
it is not classified as a
building for purposes of former
IRC§ 48(a)(1)(B) and Treas. Reg.
§ 1.48-1. Any property not
otherwise described in this
paragraph (c)(3) that
constitutes other tangible
property under the principles of
former IRC § 48(a)(1)(B) and
Treas. Reg. § 1.48-1(d) is
treated for the purposes of this
section as an inherently
permanent structure. [Treas.
Reg. § 1.263A-8(c)(3)]
A structure
that is property in the nature
of machinery or is essentially
an item of machinery or
equipment is not an inherently
permanent structure and is not
real property. In the case,
however, of a building or
inherently permanent structure
that includes property in the
nature of machinery as a
structural component, the
property in the nature of
machinery is real property. A
structure may be an inherently
permanent structure, and not
property in the nature of
machinery or essentially an item
of machinery, even if the
structure is necessary to
operate or use, supports, or is
otherwise associated with,
machinery. [Treas. Reg.
1.263A-8(c)(4)]
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