SERVICE ISSUES GUIDANCE FOR TAXPAYERS WHO FAIL TO COMPLY WITH UNIFORM CAPITALIZATION RULES.

Notice 88-78

The purpose of this notice is to provide guidance and procedural information to taxpayers that fail to change their method of accounting in order to conform to the uniform capitalization rules in accordance with the effective date provisions of section 263A of the Internal Revenue Code. This notice also provides rules for the filing of amended returns by taxpayers that did not conform to the uniform capitalization rules in accordance with such effective date provisions.

I. BACKGROUND

Section 263A of the Code, enacted by the Tax Reform Act of 1986 (Pub. L. 99-514) (the "1986 Act"), provides uniform capitalization rules that apply to the production of property and the acquisition of property for resale. Proposed and temporary regulations interpreting section 263A were issued on March 30, 1987 (T.D. 8131, 1987-14 I.R.B. 8), and August 7, 1987 (T.D. 8148, 1987-39 I.R.B. 6). The temporary regulations will remain in effect until additional temporary or final regulations are published in the Federal Register.

In general, the uniform capitalization rules are effective for costs incurred after December 31, 1986, or, in the case of inventories, for taxable years beginning after December 31, 1986. Taxpayers that are required by section 263A of the Code to change their method of accounting may make such change in accordance with section 1.263A-lT(e) of the Income Tax Regulations. (See also Instructions for Form 3115 [Rev. November 1987], Application for Change in Accounting Method, and the instructions for the 1987 Form 1120, which require that a completed current Form 3115 be filed with the taxpayer's Federal income tax return in connection with the change in method of accounting under section 263A.) The change will generally be treated as an automatic change in accounting method, initiated by the taxpayer and approved by the Commissioner.

The preamble to the March 30, 1987, regulations under section 263A provides that:

The Internal Revenue Service intends to amend the general rules applicable to changes in methods of accounting to ensure that taxpayers failing to comply with the transitional provisions of section 263A of the Code will not receive more favorable treatment under the rules generally applicable to voluntary changes in methods of accounting.

1987-14 I.R.B. 8, 15. This notice amends the rules applicable to voluntary changes in methods of accounting, as envisioned in the preamble to T.D. 8131. It is anticipated that forthcoming changes in the regulations under section 263A of the Code will include such amended rules. Further, as provided in section 5.15 of Rev. Proc. 84-74, 1984-2 C.B. 736, the Commissioner imposes terms and conditions when consenting to changes in methods of accounting to make certain that taxable income is or will be clearly reflected, and to prevent taxpayers from receiving otherwise unavailable benefits that could arise in a change in method of accounting.

A taxpayer who fails to comply with the provisions of section 263A of the Code and the regulations thereunder with respect to the production or acquisition of inventory property for a taxable year that begins (or, pursuant to section 1.441-2(b)(1) of the regulations, is deemed to begin) after December 31, 1986, must secure the consent of the Commissioner before changing to a method that is in compliance with the provisions of section 263A. Similarly, a taxpayer who fails to comply with the provisions of section 263A and the regulations thereunder with respect to the production of non- inventory property after December 31, 1986, must secure the consent of the Commissioner before changing to a method that is in compliance with the provisions of section 263A.

II. CONDITIONS OF CONSENT -- TAXPAYERS FAILING TO MAKE CHANGE IN ACCORDANCE WITH THE EFFECTIVE DATE PROVISIONS OF SECTION 263A

Section 1.446-1(e)(3)(i) of the regulations provides that, generally, in order to secure the Commissioner's consent to a change of a taxpayer's method of accounting, the taxpayer must file an application on Form 3115, Application for Change in Accounting Method, with the Commissioner of Internal Revenue, Washington, D.C., within 180 days after the beginning of the taxable year in which the proposed change is to be made ("year of change").

Section 1.446-1(e)(3)(ii) of the regulations states that the Commissioner may prescribe administrative procedures, subject to such limitations, terms, and conditions as deemed necessary to obtain consent, to permit taxpayers to change their accounting practices or methods to an acceptable treatment consistent with applicable regulations. Limitations, terms and conditions, as may be prescribed in such administrative procedures by the Commissioner, shall include those necessary to prevent the omission or duplication of items includible in gross income or deductions.

Section 481(a) of the Code requires that those adjustments necessary to prevent amounts from being duplicated or omitted be taken into account when the taxpayer's taxable income is computed under a method of accounting different from the method used to compute taxable income for the preceding taxable year.

Rev. Proc. 84-74 contains procedures under section 1.446-1(e) of the regulations for obtaining the consent of the Commissioner to change a method of accounting for Federal income tax purposes. As stated in section 2.04 of Rev. Proc. 84-74, while the adjustment period is designed to ameliorate, at least in part, the otherwise distortive effect of the section 481(a) adjustment, the Service believes that, in order to further compliance with proper methods of accounting, situations exist when allowing an adjustment period of more than 1 year is not appropriate.

Accordingly, in the case of a taxpayer who fails to comply with the provisions of section 263A of the Code and the regulations thereunder with respect to costs incurred in the production or acquisition of inventory property for a taxable year that begins (or, is deemed to begin) after December 31, 1986, or with respect to costs incurred in the production of non-inventory property for a taxable year ending after December 31, 1986, an adjustment period of more than 1 year is not appropriate if the adjustment required under section 481(a) by the change in method of accounting to comply with the provisions of section 263A and the regulations thereunder increases taxable income (i.e., is a positive adjustment).

The entire adjustment required under section 481(a) of the Code as a result of a change in method of accounting to comply with section 263A and the regulations thereunder for a taxable year later than the first taxable year to which the taxpayer is subject to the provisions of section 263A and the regulations thereunder, if such adjustment is positive, shall be taken into account in the year of change. The following limitations shall also apply to such change in method of accounting:

(1) No part of any (consolidated or separate) net operating loss carryover available at the beginning of the year of change may be used as an offset against the positive section 481(a) adjustment taken into account in the year of change. That is, the net operating loss carryover available at the beginning of the year of change may be offset only against income (other than the section 481(a) adjustment) generated in the year of change. The positive section 481(a) adjustment attributable to the year of change may be offset against any net operating loss otherwise incurred in the year of change as well as against any future net operating loss carryback under section 172(b) of the Code.

(2) No part of any (consolidated or separate) credit carryover available at the beginning of the year of change may be used to reduce the Federal income tax liability resulting from, or attributable to, the inclusion in income of the positive section 481(a) adjustment in the year of change. This restriction does not apply to a credit arising in the year of change or to any future credit carrybacks to the year of change.

If the adjustment required under section 481(a) of the Code as a result of a change in method of accounting to comply with the provisions of section 263A and the regulations thereunder for a taxable year later than the first taxable year to which the taxpayer is subject to the provisions of section 263A and the regulations thereunder decreases taxable income (i.e., is a negative adjustment), the adjustment shall be taken into account over the appropriate period (not to exceed 6 taxable years) and under the limitations, terms, and conditions provided in Rev. Proc. 84-74 for negative adjustments from a change from a Category B method of accounting (as defined in section 6.03 of the revenue procedure).

In the case of property that is inventory in the hands of the taxpayer, the adjustment required under section 481(a) of the Code is the difference at the beginning of the year of change between the inventory as valued under the taxpayer's present method of determining costs and the inventory as revalued in accordance with section 263A of the Code and the regulations thereunder. In the case of property that is not inventory in the hands of the taxpayer, the section 481(a) adjustment is the difference at the beginning of the year of change between the basis of such property as determined under the taxpayer's present method and the basis redetermined by applying the provisions of section 263 (or other applicable provision) and the regulations thereunder to costs incurred before January 1, 1987, and section 263A and the regulations thereunder to costs incurred after December 31, 1986 (regardless of the taxpayer's taxable year) adjusted for allowable depreciation or accelerated cost recovery system deductions, if applicable.

III. AMENDED RETURNS PERMITTED

A taxpayer who fails to comply with section 263A of the Code and the regulations thereunder with respect to the production or acquisition of inventory property for its first taxable year that begins (or is deemed to begin) in 1987 is also hereby permitted to comply with the provisions of section 263A by filing an amended return for that year provided that (1) the taxpayer has not been contacted in any manner by a representative of the Service for the purpose of scheduling an examination of its federal income tax return for such first taxable year, and (2) the amended return is filed no later than the due date (determined with regard to extensions) of the taxpayer's income tax return for the second taxable year that begins (or is deemed to begin) after December 31, 1986.

A taxpayer who fails to comply with section 263A of the Code and the regulations thereunder with respect to the production of non- inventory property for its first taxable year ending after December 31, 1986, is permitted to comply with the provisions of section 263A by filing an amended return for that year provided that (1) the taxpayer has not been contacted in any manner by a representative of the Service for the purpose of scheduling an examination of its federal income tax return for such taxable year, and (2) the amended return is filed no later than the due date (determined with regard to extensions) of the taxpayers income tax return for the second taxable year ending after December 31, 1986.

The provisions of section 1.263A-1T(e) of the temporary regulations, relating to an automatic change in method of accounting, shall apply in effecting the change to comply with section 263A of the Code in an amended return filed pursuant to this notice.

In the case of property that is inventory in the hands of the taxpayer, a taxpayer filing an amended return for its first taxable year that begins (or is deemed to begin) in 1987, shall revalue its inventory on hand at the beginning of the taxable year in accordance with section 1.263A-1T(e) of the temporary regulations. The difference between the inventory as valued under its present method of determining cost and the revalued inventory will represent the amount of the adjustment to be taken into account under section 481(a) of the Code, in the manner specified in section 263A and the regulations thereunder. In the case of property that is not inventory in the hands of the taxpayer, the taxpayer shall apply the rules of section 263A to costs incurred after December 31, 1986 (regardless of when the taxpayer's taxable year ends in 1987) with no restatement of basis or capital account and no corresponding adjustment under section 481(a).

An election permitted by section 1.263A-1T(b)(5) (the "simplified production method"), section 1.263A-1T(b)(6) (the "simplified service cost method"), and section 1.263A-1T(d)(3) (the "simplified resale method") of the temporary regulations may not be changed in an amended return for the taxpayer's first taxable year that begins (or is deemed to begin) in 1987. Further, a method of allocating costs, as defined in section 1.263A-1T(a)(2), that is consistent with the provisions of section 263A of the Code and the regulations thereunder and that was used by the taxpayer in filing its return for the first taxable year ending after December 31, 1986, cannot not be changed in an amended return for that year. As provided under section 1.263A-1T of the temporary regulations, any such change in the taxpayer's use of a simplified method or a change in an allocation method is a change in method of accounting that requires the consent of the Commissioner and, thus, may not be made on an amended return.

IV. TAXPAYERS UNDER EXAMINATION

If a taxpayer whose method of determining costs incurred in the production or acquisition of inventory property violates the provisions of section 263A of the Code and the regulations thereunder has been contacted in any manner by a representative of the Service for the purpose of scheduling an examination of its federal income tax return for a taxable year beginning after December 31, 1986 (or, in the case of non-inventory property, taxable years ending after December 31, 1986), the change in method of accounting required to comply with the provisions of section 263A shall be made by the district director. In this situation, the entire positive adjustment required under section 481(a) to comply with section 263A and the regulations thereunder shall be taken into account in computing taxable income of the year of change and will be subject to the limitations set forth in II, above.

RELIANCE

This document serves as an "administrative pronouncement" as that term is described in section 1.6661-3(b)(2) of the Income Tax Regulations and may be relied upon to the same extent as a revenue ruling or revenue procedure.

DRAFTING INFORMATION

The principal authors of this notice are Paulette C. Galanko of the Legislation and Regulations Division and Ruth N. Bettinger of the Corporation Tax Division. For further information regarding this notice, contact Mrs. Bettinger at (202) 566-3638 (not a toll-free call).