IRS Issues Interim Guidance on Use of “Negative Additional Section 263A Costs”

May 13, 2007 — 1,812 views  
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The IRS released interim guidance on the use of negative additional Sec. 263A costs. The concept of “negative additional 263A costs” is best explained using depreciation as an example.

Sec. 471 requires a taxpayer to capitalize certain book costs to inventory (for example, depreciation on facilities and equipment used in the production process). Sec. 263A requires a taxpayer to treat certain additional costs (in excess of 471 costs) as inventoriable. “Additional Sec. 263A costs” are generally defined as those costs that were not capitalized immediately prior to the effective date of Sec. 263A. Additional Sec. 263A costs include tax depreciation in excess of book depreciation (if any). If a taxpayer continues to include book depreciation in accordance with Sec. 471, and if the book depreciation is greater than tax depreciation for the year, then it is possible that a taxpayer would over capitalize the amount of depreciation allocable to inventory costs.

Controversy has arisen recently as to whether taxpayers may be allowed to “remove” the excess book depreciation in the above situation by including a negative amount in their additional Sec. 263A costs and whether a taxpayer’s aggregate additional Sec. 263A costs may ever be a negative number. The inclusion of a negative number would occur if the taxpayer did not make an adjustment to its Sec. 471 costs in the above situation, but instead made an adjustment to its additional Sec. 263A costs.

In Notice 2007-29, the IRS and Treasury Department state that they are concerned that including negative amounts in additional Sec. 263A costs may result in “significant distortions” to taxable income. The Notice announces that the IRS is considering amendments to the regulations under Sec. 263A and requests comments. Additionally, the notice provides interim guidance that states that the IRS will not challenge the inclusion of negative amounts in computing additional Sec. 263A costs or the permissibility of aggregate negative additional Sec. 263A costs. The IRS also stated that it will not deny method change requests solely on the basis that the proposed method would include the use of a negative additional Sec. 263A cost as long as the taxpayer had already been including such negative amounts in its additional Sec. 263A costs. The IRS will not, however, allow taxpayers to change to a method that uses negative additional Sec. 263A costs if the taxpayer did not use such negative amounts before.

Grant Thornton LLP