SERVICE ISSUES GUIDANCE ON THE CAPITALIZATION OF INTEREST EXPENSE.

Notice 88-99

TABLE OF CONTENTS

I. Background.

I. BACKGROUND.

Section 263A of the Internal Revenue Code, enacted in 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 in a trade or business or an activity conducted for profit.

Section 263A(f)(1) of the Code requires the capitalization of interest under the uniform capitalization rules with respect to the production of certain types of property. Section 263A(f)(1) of the Code requires the capitalization of interest that is paid or incurred (sometimes hereafter referred to as "incurred") on debt that is allocable to the production expenditures of "qualified property". "Qualified property" is property that has (i) a long useful life (consisting of all real property, and all personal property with a class life of 20 years or more under section 168 of the Code that is produced for sale or for use in the taxpayer's trade or business); (ii) an estimated production period exceeding 2 years; or (iii) an estimated production period exceeding 1 year and a cost (excluding interest) exceeding $1,000,000.

For purposes of the interest capitalization rules, the production period of real property generally begins when physical activity is first performed upon the property (e.g., the grading or clearing of land, the excavation of foundations or lines for utilities, the performance of mechanical activities such as plumbing or electrical work upon a building that is being rehabilitated or improved, or any other work relating to the construction or improvement of real property). In the case of all other property, the production period begins on the date by which the cumulative amount of production expenditures that have been incurred (including planning and design costs) equals or exceeds 5 percent of the total estimated production expenditures (including planning and design costs) allocable to the property. In addition, the production period of property ends on the date that the property is ready to be placed in service or is ready to be held for sale.

Moreover, section 263A(f)(3) provides that the interest capitalization rules also apply to interest on debt allocable to property (e.g., equipment and facilities) which is used to produce qualified property. (Accord, S. Rep. No. 99-313, 99th Cong., 2d Sess. 144, n.44 (1986) ("Senate Report").)

Section 460 of the Code provides rules regarding the accounting for long-term contracts. Taxpayers using the percentage of completion-capitalized cost method under section 460 are required to capitalize direct and indirect costs allocable to such contracts, including interest, with respect to the portion of the contract taken into account under the taxpayers' "normal" method of accounting. Under section 460(c)(3) of the Code, interest costs are required to be capitalized with respect to production expenditures under a long- term contract in the manner provided in section 263A(f)of the Code, subject to certain modifications contained in sections 460(c)(3)(B) and (C). Moreover, the interest capitalization rules of section 460(c)(3) are applicable to all long-term contracts, including certain construction contracts described in section 460(e)(1) to which the provisions of section 460 do not generally apply.

For property produced under a long-term contract, section 460(c)(3)(B) provides that the production period shall begin on the later of: (1) the contract commencement date, or (2) in the case of a taxpayer using the accrual method as its normal method of accounting for long-term contracts (for purposes of the percentage of completion-capitalized cost method), the date by which the cumulative amount of production expenditures that have been incurred (including planning and design costs) equals or exceeds 5 percent of the total estimated production expenditures (including planning and design costs) allocable to the contract. The production period of property produced under a long-term contract ends on the completion date of the contract.

Section 263A(h) of the Code provides that the Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of section 263A, including regulations to prevent the use of related parties, pass-thru entities, or intermediaries to avoid the application of that section.

The provisions of section 263A of the Code (including the interest capitalization rules of section 263A(f)) are generally effective for costs incurred after December 31, 1986, in taxable years ending after such date. However, with respect to property that is inventory in the hands of the taxpayer, section 263A requires a change in method of accounting effective for taxable years beginning after December 31, 1986. Under this change in method of accounting, taxpayers are required to revalue all items or costs included in beginning inventory in the year of change (using the methods adopted by the taxpayer) as if the new capitalization rules of section 263A of the Code (including the interest capitalization rules of section 263A(f)) had been in effect during all prior periods. See section 1.263A-1T(e)(1) of the Income Tax Regulations. Thus, the change in method of accounting under section 263A with respect to inventories may require the inclusion in beginning inventory of interest that was expensed by the taxpayer during previous taxable years.

Section 263A (including the interest capitalization requirements of section 263A(f)) does not apply to any costs incurred for the construction of property for use by the taxpayer in its trade or business if substantial construction of the property had occurred before March 1, 1986. See section 1.263A-1T(a)(6)(v) of the regulations for the meaning of the term "substantial construction".

The provisions of section 460 of the Code (including the interest capitalization rules of sections 460(c)(3) and 263A(f)) apply to any long-term contract entered into after February 28, 1986, in taxable years ending after such date.

Except as provided to the contrary in this notice, interest capitalized with respect to the production of property under section 263A or 460 consists of interest on debt that is allocable to (i) property still on hand as of the end of the taxpayer's taxable year (thus increasing the basis of the taxpayer's property); as well as (ii) property that is sold or otherwise disposed of during the taxable year (thus increasing cost of goods sold, cost of sales, etc.).

Moreover, interest that is incurred by a taxpayer and hence subject to capitalization under section 263A or 460 consists of all amounts that are characterized as interest after the application of all relevant provisions of the Code, including sections 482, 483, 1272 1274, and 7872.

II. TRACING AND AVOIDED COST RULES.

(A) TRACED DEBT.

Section 263A(f)(2) of the Code requires that, in determining the amount of interest capitalized with respect to qualified property, interest on debt directly attributable to the property's production expenditures ("traced debt") shall be capitalized first. Traced debt shall be determined by applying the rules of section 1.163-8T of the regulations (relating to the allocation of debt to expenditures). Under those rules, debt generally is allocated to a particular expenditure by tracing disbursements of the debt proceeds to that expenditure. See section 1.163-8T(a)(3) of the regulations.

For purposes of these rules, traced debt includes only amounts of the taxpayer's "eligible debt" (defined herein) that are equal to or less than the property's accumulated production expenditures. To the extent that the taxpayer's eligible debt exceeds the property's accumulated production expenditures, the excess amount of the debt is not traced debt. Moreover, traced debt only consists of debt directly attributable to qualified property, i.e., property to which the interest capitalization rules of section 263A(f) of the Code apply. Traced debt does not include, for example, debt that is directly attributable to production activities to which the provisions of section 263A (but not section 263A(f)) apply. Interest on such debt, however, may be subject to capitalization with respect to the production of qualified property under the avoided costs rules of section II(B) of this notice.

Eligible debt is all debt of the taxpayer other than debt with respect to which the interest is (i) permanently nondeductible, i.e., not allowable as a deduction by reason of a disallowance provision within the meaning of section 1.163-8T(m)(7)(ii) of the regulations; (ii) personal interest within the meaning of section 163(h)(2) of the Code; or (iii) qualified residence interest within the meaning of section 163(h)(3) of the Code. In addition, eligible debt does not include debt incurred by an organization that is exempt from Federal income tax under section 501(a) of the Code, except to the extent that interest on such debt is directly connected with the organization's unrelated trade or business within the meaning of section 512 of the Code.

Moreover, eligible debt does not include debt between the taxpayer and related parties, or debt between related parties of the taxpayer, if the rate of interest on such debt is less than an adequate interest rate. (For purposes of the preceding sentence only, persons are related if their relationship is described in section 267(b) or 707(b) of the Code.) For purposes of this notice, the rate of interest on debt (after taking into account all provisions that apply to such debt, e.g., sections 482, 483, 1272, 1274, and 7872 of the Code) shall be considered less than an adequate interest rate if the effective rate of interest on such debt is less than the applicable Federal rate with respect to such debt (within the meaning of section 1274(d) of the Code), determined on the date such debt was issued. Thus, if certain exceptions contained in the provisions described in the preceding sentence result in an effective rate of interest that is less than the applicable Federal rate, such debt described in this paragraph shall not be eligible debt.

Eligible debt does, however, include intercompany debt between members of an affiliated group of corporations filing a consolidated return, if the rate of interest on the debt is equal to or greater than an adequate interest rate. Thus, the interest capitalization rules apply to interest incurred on such intercompany debt. Forthcoming regulations will require, however, that interest income on such intercompany debt must be currently taken into account by the lending member and may not be deferred by reason of the regulations under section 1502 of the Code (including, but not limited to, the regulations relating to deferred intercompany transactions), where the interest expense on such debt is capitalized by a member under section 263A or 460.

(B) AVOIDED COST DEBT.

After determining the amount of traced debt directly attributable to the property's production expenditures, section 263A(f)(2) of the Code then requires that any other eligible debt shall be assigned to any remaining production expenditures and that interest on such debt shall be capitalized, to the extent that the taxpayer's interest costs could have been reduced if such production expenditures had not been incurred ("avoided cost debt"). With respect to taxpayers producing more than one qualified property during the taxable year, avoided cost debt of the taxpayer shall be allocated pro-rata to the production expenditures of such properties, based on the ratio of each property's cost to the aggregate costs of all qualified properties under production.

As the legislative history to the 1986 Act provides, the determination of whether the taxpayer's interest costs could have been reduced if such production expenditures had not been incurred is made by assuming that the amounts expended for production had instead been used to repay the taxpayer's debt, thus reducing the principal balance of such debt and the interest costs thereon. Senate Report at 144. Thus, the avoided cost concept is applied using a mechanical formula that operates on the assumption that the amounts expended for production had instead been used to repay the taxpayer's debt. The operation of the avoided cost concept does not depend on whether, in fact, the taxpayer actually would have used the amounts otherwise expended for production to repay debt. Instead, the avoided cost method assumes that such repayment occurs, regardless of the taxpayer's subjective intentions and regardless of the particular facts and circumstances surrounding the taxpayer's operations. Furthermore, as the legislative history provides, the avoided cost concept applies under section 263A of the Code irrespective of whether its application is required, authorized, or considered appropriate under financial or regulatory accounting principles applicable to the taxpayer. 2 H. Rep. No. 99-841, 99th Cong., 2d Sess. II-309 (1986) ("Conference Report").

Thus, avoided cost debt consists of a pro-rata portion of all eligible debt of the taxpayer that is not traced to the production expenditures of qualified property, to the extent that the taxpayer's production expenditures exceed the amount of traced debt with respect to such production expenditures. (See also section VIII of this notice, which applies the avoided cost method to debt incurred by parties that are related to the taxpayer, and section XII of this notice, which applies such method to flow-through entities and their owners.)

III. EXAMPLES -- TRACING AND AVOIDED COST METHOD.

EXAMPLE (1). Assume that taxpayer B is engaged in the production of qualified property. B's production expenditures are $1,000,000; in addition, B has $400,000 of debt that is traced debt with respect to such production expenditures. B has an additional debt obligation of $1,200,000 which is eligible debt, bearing interest at a 10 percent annual rate. B is required to capitalize the interest incurred on the traced debt during the production period of the property. In addition, B is required to capitalize interest incurred on the avoided cost debt during such period, consisting of $600,000 of the $1,200,000 obligation, at a 10 percent annual interest rate. This $600,000 portion of that debt obligation is treated as avoided cost debt regardless of the particular financial or regulatory accounting treatment of such debt, and regardless of the purpose for which, or when in time, the debt obligation was initially incurred.

EXAMPLE (2). Assume the same facts as in Example (1), except that in addition to $400,000 of traced debt, B has remaining eligible debt of $1,800,000, consisting of three different debt obligations, debts 1, 2, and 3, with principal balances of $300,000 $600,000 and $900,000 respectively. The annual interest rates on debts 1, 2, and 3 are g, 12, and 15 percent, respectively. B has avoided cost debt of $600,000, consisting of a pro-rata portion of all of B's debt other than traced debt and ineligible debt. Thus B's avoided cost debt of $600,000 consists of $100,000 from debt 1 bearing an annual interest rate of 9 percent, $200,000 from debt 2 bearing an annual interest rate of 12 percent and $300,000 from debt 3 bearing an annual interest rate of 15 percent.

EXAMPLE (3). Assume the same facts as in Example (1), except that the remaining debt obligation of $1,200,000 bearing an annual interest rate of 10 percent was incurred to finance the purchase of taxable investment securities yielding an annual interest rate of 8 percent. Moreover, assume that under financial or regulatory accounting standards, B is allowed (or required) to capitalize only the "net" borrowing costs of 2 percent, calculated by subtracting the yield on the investment securities from the interest costs on the debt obligation. Notwithstanding the applicable financial or regulatory accounting standards, B is required, under section 263A(f)(2)(A), to capitalize interest with respect to the avoided cost debt, consisting of $600,000 of the remaining obligation, at a 10 percent annual interest rate. The avoided cost debt of $600,000 is capitalized at a 10 percent annual interest rate because if the amounts expended for production had been used instead to retire a portion of the remaining obligation, the reduction in interest cost from such retirement would have been equal to the rate of interest on such debt.

EXAMPLE (4). Assume the same facts as in Example (1), except that the remaining debt obligation of $1,200,000 was incurred to finance the purchase of tax-exempt securities and that, pursuant to section 265 of the Code, the interest expense on such debt is not deductible by B. B is not permitted to capitalize interest on this debt obligation under section 263A or 460, because the debt obligation is not eligible debt, i.e., interest on such debt is not allowed as a deduction by reason of a disallowance provision within the meaning of section 1.163- 8T(m)(7)(ii) of the regulations.

EXAMPLE (5). Assume the same facts as in Example (1), except that the remaining debt obligation of $1,200,000 bearing an annual interest rate of 10 percent would, in the absence of section 263A(f) and section 1.163-8T(m)(l)(iv) of the regulations, be allocated under the rules of section 1.163-8T of the regulations to an investment or passive activity expenditure. B is required to capitalize interest with respect to the avoided cost debt, consisting of $600,000 of the remaining obligation, at a 10 percent annual interest rate. But see 1.163- 8T(m)(6)(Example 3) of the regulations for guidance regarding the treatment of this debt if B ceases the production of property to which the interest capitalization rules apply.

EXAMPLE (6). Assume the same facts as in Example (1), except that in addition to producing qualified property to which the interest capitalization rules apply, B also produces tangible personal property subject to the provisions of section 263A which has an estimated production period of not more than one year and which does not have a long useful life ("non- qualified property"). Although the general capitalization rules of section 263A apply to the production of this non-qualified property, the interest capitalization rules of section 263A(f) do not apply to the production of such property. Assume further that the remaining debt obligation of $1,200,000 bearing an annual interest rate of 10 percent would, in the absence of section 263A(f) and section 1.163-8T(m)(l)(iv) of the regulations, be allocated, under the rules of section 1.163-8T of the regulations, to the production of the non-qualified property. B is nevertheless required to capitalize interest with respect to the avoided cost debt, consisting of $600,000 of the remaining obligation, at a 10 percent annual interest rate, into the cost of the qualified property. This debt is avoided cost debt because it is eligible debt, and because it is not traced debt (i.e., debt that is directly attributable to production expenditures with respect to qualified property).

EXAMPLE (7). Assume the same facts as in Example (1), except that B is a regulated enterprise. Under financial and regulatory accounting standards applicable to B, the remaining $600,000 of production costs is viewed as being financed by a "blend" of debt and equity which resembles B's overall capital structure used for ratemaking purposes. Notwithstanding the financial and regulatory accounting standards applicable to B's production, B is required under section 263A(f) to capitalize interest with respect to the avoided cost debt, consisting of $600,000 of the remaining obligation, at a 10 percent annual interest rate.

EXAMPLE (8). Assume the same facts as in Example (1), except that due to penalties on repaying any principal amounts o the remaining obligation of $1,200,000, B would not expect to repay any portion of the remaining obligation if the $600,000 of cash had not been expended for production activities. Notwithstanding the foregoing, under section 263A(f), B is required to capitalize interest with respect to the avoided cost debt, consisting of $600,000 of the remaining obligation, at a 10 percent annual interest rate.

IV. MECHANICS OF INTEREST CAPITALIZATION.

(A) IN GENERAL.

Sections 263A and 460 of the Code require the capitalization of interest incurred on traced or avoided cost debt during the production period of qualified property. Capitalized interest is treated as a cost of the property produced and is recovered (through cost of goods sold, an adjustment to basis, depreciation, amortization, etc.) at the time the property is sold, used, or otherwise disposed of under the rules applicable to such sale, use, or disposition.

In determining what constitutes traced or avoided cost debt, taxpayers shall include only debt that is treated as such for Federal income tax purposes. Taxpayers shall not, for example, include reserves, contingent liabilities not yet recognized for Federal income tax purposes (including liabilities with respect to which the "all-events test" has not been met or "economic performance,"" as defined in section 461(h) of the Code, has not yet occurred), "deferred taxes," and other similar items regardless of whether the reporting of such items is supported or required for financial or regulatory accounting purposes.

Although interest is required to be capitalized only during the production period, the capitalization of interest applies to all accumulated production expenditures required to be capitalized under section 263A or 460, including interest capitalized in prior taxable years during the production period as well as depreciation, amortization, and cost recovery allowances (collectively, "depreciation") on property used in the production of qualified property. The determination of accumulated production expenditures for purposes of these rules is made without regard to whether such expenditures are incurred during the production period of the property to which the costs relate. For example, accumulated expenditures with respect to which interest must be capitalized under section 263A or 460 include planning and design activities which generally are incurred before the production period of the property begins, as well as the costs of raw land and materials acquired before the production period begins. Although the costs of raw land are included in accumulated production expenditures that attract interest during the production period, interest capitalized with respect to the inclusion of raw land in such accumulated expenditures shall be capitalized as a cost of the improvements to the land (including, where appropriate, buildings) and not as a cost of the raw land itself. Furthermore, production expenditures include any costs incurred by a taxpayer with respect to qualified property produced by a third party under a contract with the taxpayer.

(B) PROPERTY USED TO PRODUCE QUALIFIED PROPERTY.

The interest capitalization rules of section 263A(f) require the capitalization of interest on debt allocable to all property, regardless of its nature, to the extent such property is used to produce qualified property. Thus, for example, if 75 percent of the operating hours of a bulldozer within a particular time period are spent in the construction of qualified property, then 75 percent of the bulldozer's adjusted basis (typically, the taxpayer's original basis less accumulated depreciation) would be included in production expenditures for that particular time period and would attract interest that would be capitalized as a cost of the qualified property. If the taxpayer then moved the bulldozer to another project and ceased to use it in producing the particular qualified property, the adjusted basis of the bulldozer would not be included in production expenditures for the qualified property beginning with the period the bulldozer was moved. (In contrast, depreciation charges with respect to the bulldozer would be permanently included in production expenditures with respect to the qualified property, to the extent the bulldozer was used to produce the qualified property during the periods for which the depreciation charges were computed.)

(C) DIRECT AND INDIRECT USE -- EQUIPMENT AND FACILITIES.

Section 263A requires the capitalization of all direct and indirect costs allocable to production or resale activities, including the costs of various service departments, as defined in section 1.263A-1T(b)(4)(ii) of the regulations. The costs of these service departments include depreciation of various properties ("equipment and facilities") used in those service departments. However, in calculating production expenditures attributable to qualified property under the interest capitalization rules of section 263A(f), taxpayers are required to include in production expenditures the adjusted bases of equipment and facilities only to the extent that such equipment and facilities are used in a reasonably proximate manner to produce the qualified property. Thus, for example, the adjusted bases of the following items shall be included in production expenditures: machinery directly used to produce qualified property or components thereof; assembly-line structures; structures used in the production process; buildings, leaseholds, and improvements thereon; and other similar types of property.

In contrast, the adjusted bases of equipment and facilities not used in a reasonably proximate manner to produce the qualified property may, if the taxpayer chooses, be excluded from the calculation of production expenditures under section 263A(f). Thus, for example, the adjusted bases of equipment and facilities used in various service departments (including buildings that house these service departments) may typically be excluded from production expenditures to the extent that such equipment and facilities are not used in a reasonably proximate manner to produce the qualified property. The adjusted bases of equipment and facilities in service departments performing the following functions may typically be excluded from production expenditures under this provision: administrative operations; personnel operations (i.e., recruiting, hiring, and maintaining personnel records of employees); purchasing operations; accounting and data services operations; data processing; security services; and legal departments.

The provisions of the preceding paragraph apply only to the adjusted bases (e.g., costs not yet depreciated) of certain assets used in producing property, and not to the treatment of depreciation charges on those assets themselves. Taxpayers are required to include in production expenditures all depreciation on all equipment and facilities allocable to production activities, including depreciation of various properties used in service departments as described in the preceding paragraph.

(D) REQUIREMENT OF CONSISTENT TREATMENT.

Taxpayers shall account for accumulated production expenditures and traced or avoided cost debt in a manner that is consistent with the method of accounting used by the taxpayer. For example, if a taxpayer is using an overall accrual method of accounting, then the computation of accumulated production expenditures is based on accrual method concepts and includes items incurred but not yet paid by the taxpayer (e.g., production expenditures for which the taxpayer has been billed by vendors, but which have not been paid by the taxpayer). Similarly, the computation by an overall accrual method taxpayer of traced or avoided cost debt is based on accrual method concepts and includes accounts payable, even though such debt may be non-interest bearing. (Thus, for example, an accrual basis taxpayer must include billed but unpaid production expenditures in the calculation of the total amount of accumulated production expenditures. Similarly, such a taxpayer would also include the accounts payable pertaining to those unpaid bills in the taxpayer's calculation of traced debt.)

Accounts payable, however, may not be included in traced or avoided cost debt if such inclusion would result in avoidance of the interest capitalization rules. For example, accounts payable may not be included in traced or avoided cost debt if such accounts payable were incurred by another person and subsequently transferred to the taxpayer, or if the taxpayer incurred the accounts payable for goods and services used by another person. In addition, accounts payable to related parties (and accounts payable between related parties) are treated as ineligible debt to the extent provided in section II(A) of this notice.

In contrast, a taxpayer using the cash method of accounting must use cash method concepts in computing accumulated production expenditures and, for example, would not include billed but unpaid items in computing accumulated production expenditures. Nor may such a taxpayer include accounts payable in the computation of traced or avoided cost debt.

V. DETERMINATION OF WHEN INTEREST IS PAID OR INCURRED.

Section 263A(f) requires the capitalization of interest that is "paid or incurred" during the production period. Thus, taxpayers using the cash method of accounting generally would capitalize interest that was paid during the production period, and taxpayers using an accrual method of accounting generally would capitalize interest that was incurred during the production period.

In order to prevent the avoidance of the interest capitalization rules (see section 263A(h)), forthcoming regulations will also require taxpayers using the cash method of accounting to capitalize any interest pertaining to traced or avoided cost debt if such interest (i) is unpaid as of the end of the property's production period, and (ii) was incurred during the production period. The adjustment required in the preceding sentence shall only apply to the amount by which such unpaid interest exceeds the amount of interest that was incurred on the traced and avoided cost debt during the last month of the production period. (In addition, such unpaid interest is subject to capitalization by a cash method taxpayer only at the time such interest is paid by the taxpayer.) Moreover, in determining when interest is incurred, the concepts of an accrual method of accounting shall apply. In addition, any cash method taxpayer making the adjustment required by this paragraph to the amount of capitalized interest may also, if the taxpayer so chooses, not capitalize any interest pertaining to traced or avoided cost debt if such interest (i) is paid during the property's production period, and (ii) was incurred before the beginning of the production period. However, the preceding sentence shall only apply to the amount by which such paid interest exceeds the amount of interest that was incurred on the traced and avoided cost debt during the last month immediately preceding the production period.

Of course, taxpayers using an accrual method of accounting are also required to capitalize all interest that is incurred on traced and avoided cost debt during the production period of the qualified property, regardless of when such interest is paid. (Hereafter in this notice, when describing interest as "incurred," such term shall include interest that is paid or incurred, as appropriate under the taxpayer's method of accounting, as modified by this section V.)

VI. METHODS TO BE USED.

Subject to the rules set forth in this notice, taxpayers may use any reasonable method, consistently applied, in calculating the amounts of traced or avoided cost debt, the interest on such debt, and the amount of accumulated production expenditures with respect to which interest must be capitalized. For example, taxpayers generally may utilize methods that involve the computation of daily, weekly, or monthly average debt balances, interest rates, or production expenditures of qualified property. However, a taxpayer may not use a method of making these calculations which involves computations that are made less frequently than on a monthly basis, unless the taxpayer can demonstrate that no significant difference in result occurs between the method it has chosen and a method which is based on monthly computations. Various examples used in this notice may assume, for purposes of illustration, that the taxpayer is making these computations on the basis of monthly averages.

For example, assume a calendar-year taxpayer is constructing a building and that the production period of such building begins on March 1, 1987. The production period ends 6 months later, on August 31, 1987. The accumulated production expenditures with respect to such building (including raw land) are as follows: March 1 - $1,000,000; April 1 - $1,100,000; May 1 - $1,300,000; June 1 - $1,600,000; July 1 - $2,000,000; July 31 - $2,500,000; and August 31 - $2,700,000. Under one method involving monthly balance computations, the average balance of production expenditures for March would be equal to $1,050,000 (i.e., $1,000,000 plus $1,100,000, divided by two). The average balances for the other months would be as follows: April - $1,200,000; May - $1,450,000; June - $1,800,000; July -82,250,000; and August - $2,600,000. Adding these monthly averages and dividing by six results in a monthly average for the entire six-month period of $1,725,000 (i.e., $1,050,000 plus $1,200,000 plus $1,450,000 plus $1,800,000 plus $2,250,000 plus $2,600,000, divided by six).

The taxpayer could then determine the monthly average of traced debt with respect to the building for the six-month period, using the same monthly convention as described above for production expenditures. Assume that the monthly average of traced debt for the six-month period is equal to $800,000 and that the weighted average interest rate on such debt is 12 percent. The taxpayer would then capitalize $48,000 of interest on traced debt with respect to the building (i.e., $800,000 multiplied by .12, multiplied by 6/12). A similar procedure would then be used to determine the interest on avoided cost debt subject to capitalization.

VII. ELECTION TO AVOID TRACING REQUIREMENT.

(A) IN GENERAL.

As previously provided in this notice, taxpayers capitalizing interest are first required to capitalize interest with respect to traced debt, with such debt being determined by applying the rules of section 1.163-8T of the regulations. If a taxpayer's production expenditures exceed the amount of traced debt, then such taxpayer is required to capitalize interest on avoided cost debt.

In order to avoid the potential administrative complexities of determining and accounting for the amount of all traced debt under section 1.163-8T of the regulations, a taxpayer may, subject to the conditions provided herein, elect to treat all of its traced debt as debt under the avoided cost method, regardless of the actual disbursement of debt proceeds to specific expenditures. The mechanics of the election may vary from year to year for a particular taxpayer, depending on that taxpayer's situation for such year, as discussed below.

(B) ELECTION WHERE EXPENDITURES EXCEED DEBT.

In the case where the electing taxpayer's production expenditures exceed the total aggregate amount of all the taxpayer's eligible debt (i.e., all traced and avoided cost debt), all otherwise traced debt shall be added to other eligible debt of the taxpayer, and the total sum of such debt shall be treated as avoided cost debt in determining the amount of interest which is capitalized by the taxpayer. In such a case, the taxpayer may avoid the tracing requirements of section 1.163-8T of the regulations with respect to all of its eligible debt.

(C) ELECTION WHERE DEBT EXCEEDS EXPENDITURES.

If the electing taxpayer's accumulated production expenditures are less than the total aggregate amount of all the taxpayer's eligible debt, then all of the taxpayer's eligible "trade or business debt" shall first be allocated with respect to the taxpayer's production expenditures and the amount of interest on such debt shall be capitalized by the taxpayer as if such debt were avoided cost debt. (If the taxpayer's eligible trade or business debt exceeds its production expenditures, then interest on a pro-rata portion of all such debt would be capitalized by the taxpayer as if such debt were avoided cost debt.) For purposes of this notice, "trade or business debt" is defined as eligible debt other than debt the interest on which is subject to the limitations of section 163(d) or 469 of the Code, determined under the allocation rules of section 1.163-8T of the regulations. If the taxpayer's total production expenditures exceed its trade or business debt, to the extent of such excess the taxpayer shall also allocate its remaining eligible debt that is not trade or business debt to such production expenditures on a pro-rata basis. In such a case, the taxpayer may avoid the tracing requirements of section 1.163-8T of the regulations with respect to all of its trade or business debt.

(D) ELECTION REQUIREMENTS.

Any election under this section VII must be made with respect to all of the electing taxpayer's traced debt. Taxpayers may automatically elect, as provided in this section VII, to avoid the tracing requirement of the interest capitalization rules for taxable years beginning in 1988 (or, if they choose, for taxable years beginning before 1988), regardless of the treatment of traced debt by such taxpayers for previous taxable years. For this purpose, such election is not treated as a change in method of accounting requiring the Commissioner's consent or the computation of an adjustment under section 481(a) of the Code. Except as otherwise provided in this paragraph (D), the election by a taxpayer previously subject to the interest capitalization rules of section 263A(f) to avoid the tracing requirements of the capitalization rules as provided in this section VII shall be treated as a method of accounting, with the consent of the Commissioner being required to change such method.

VIII. RELATED PARTY AVOIDED COST RULES.

The interest capitalization requirements (and avoided cost rules) of section 263A(f) apply in the case of parties related to the taxpayer producing qualified property to the extent provided herein. For purposes of the definition of a related party under this notice, real estate investment trusts, regulated investment companies, and real estate mortgage investment conduits shall be treated as C corporations.

(A) TAXABLE YEARS BEGINNING BEFORE JANUARY 1, 1988.

For taxable years of the producing taxpayer beginning before January 1, 1988, a person shall be related to the producing taxpayer if such person files a consolidated return (within the meaning of section 1501 of the Code) with the taxpayer. (But see section XII of this notice regarding the treatment of flow-through entities and their owners under the interest capitalization rules of section 263A(f)(2)(C) of the Code.)

(B) TAXABLE YEARS BEGINNING ON OR AFTER JANUARY 1, 1988.

For taxable years of the producing taxpayer beginning on or after January 1, 1988, a person shall be related to the producing taxpayer if such person and the taxpayer are members of the same parent-subsidiary controlled group of corporations as defined in section 1563(a)(1) of the Code (regardless of whether such persons would be treated as component members of such group under section 1563(b)) by applying all of the constructive ownership rules of section 1563(e) of the Code. A parent-subsidiary controlled group includes such a group contained within a combined group of corporations as defined in section 1563(a)(3) of the Code.

(C) CHANGES IN RELATED PARTIES.

Producing taxpayers and related parties shall take into account and make such adjustments as are necessary to reflect any changes from year to year in the definition of a "related party" under this notice, or any other changes in the actual composition of related parties with respect to a particular taxpayer. Notwithstanding this requirement, any changes necessary to take into account these factors shall not be considered as changes in method of accounting that require either the consent of the Commissioner or an adjustment under section 481(a) of the Code. If a person is subject to the rules of both this section VIIl and section XII (relating to flow-through entities) of this notice, section XII shall apply before the rules of this section VIII apply.

(D) ANTI-ABUSE RULE.

The related party avoided cost rules, generally applicable only to related parties described in paragraph (A) or (B) of this section VIII, shall also apply in any other case in which the producing taxpayer (including any person as defined in section 7701(a)(1) of the Code) and any person (or persons) engage in any transaction (including the incurring of debt or the financing of an entity's operations) with a principal purpose of avoiding the interest capitalization requirements of section 263A(f). Criteria that will be considered in determining whether a person and a producing taxpayer have engaged in such a transaction include, but are not limited to: (i) the existence of an actual or constructive transfer, directly or indirectly, of any amount or property (in the form of dividends, contributions to capital, returns of capital, etc.), by the person to the producing taxpayer; (ii) the capital structure (e.g., debt/equity ratio) of any person participating, directly or indirectly, in a transfer described in clause (i); (iii) the capital structure (e.g., debt/equity ratio) of the producing taxpayer; and (iv) the timing of a transfer described in clause (i) with respect to the production of qualified property by the taxpayer (e.g., whether the amounts transferred to the producing taxpayer were available to the taxpayer for purposes of financing production expenditures). Persons to which this section VIII(D) applies shall capitalize interest as required under the provisions of section IX(D) of this notice.

IX. METHODS OF CAPITALIZATION AND RECOVERY.

In the case of related parties to which the avoided cost rules apply (as described in section VIII (A) or (B) of this notice), the deferred asset method shall be used to comply with the interest capitalization requirements of section 263A(f) unless the substitute cost method is elected.

(A) DEFERRED ASSET METHOD.

(1) IN GENERAL.

Under the deferred asset method, the related party is required to capitalize interest equal to an amount that the producing taxpayer would have capitalized under section 263A or 460, using the avoided cost principles, had the producing taxpayer itself incurred the interest on the eligible debt of the related party ("related party avoided cost debt"). The requirements of the preceding sentence apply only to interest that is incurred (as modified by section V of this notice) by the related party during the production period of the qualified property by the producing taxpayer. Moreover, such requirements only apply to interest that is incurred by the related party during the period of time that such person and the taxpayer are related.

In applying the deferred asset method to interest incurred by related parties, the taxpayer producing the qualified property first must allocate the taxpayer's traced and avoided cost debt to the taxpayer's accumulated production expenditures. The interest incurred by related parties is subject to these rules only if the taxpayer's accumulated production expenditures exceed the total amount of its traced and avoided cost debt (such excess amount shall be referred to as "remaining production expenditures"). Similarly, interest on the eligible debt of related parties that is capitalized with respect to the taxpayer's remaining production expenditures shall only include interest on eligible debt that has not been allocated by the related party with respect to its own production expenditures of qualified property for the taxable year. Moreover, for purposes of this rule, the related party shall apply the interest capitalization rules to its own production expenditures first in time, before determining the amount of its related party avoided cost debt.

Generally, a related party shall capitalize interest incurred during the related party's taxable year only with respect to qualified property held by the producing taxpayer as of the end of the related party's taxable year in issue. However, interest incurred by the related party shall be capitalized with respect to the qualified property produced by the taxpayer during the related party's taxable year, even though the producing taxpayer has sold or transferred the property before the end of the related party's taxable year if, after such sale or transfer, a person related to the related party still holds the property as of the end of the related party's taxable year. (For purposes of the preceding sentence, two persons shall be related if their relationship is described in section 267(b) or 707(b) of the Code.) In such a situation, the related party shall capitalize interest with respect to the qualified property as if the property were still held by the producing taxpayer. (For examples illustrating the principles of this paragraph, see section XII(B)(l) of this notice, concerning the deferred asset method and flow-through entities.)

With respect to producing taxpayers that are required to change their method of accounting for inventory property under section 263A, under the deferred asset method, the portion of the adjustment under section 481(a) relating to the interest capitalized on related party avoided cost debt shall be taken into account by the related party and included in the related party's income. Generally, such portion of the adjustment under section 481(a) shall be taken into account by the related party in the same manner and at the same time that the producing taxpayer is required to take the adjustment under section 481(a) into account with respect to such inventory property.

(2) RECOVERY OF DEFERRED ASSET.

Under the deferred asset method, the related party shall account for such capitalized interest as an asset in the same manner (and at the same time) as the producing taxpayer would have accounted for such capitalized interest (i.e., as depreciation, cost of goods sold, etc.) had such interest been capitalized into the basis of the qualified property on the taxpayer's books and records as a cost of the qualified property in issue. (See, however, the special rules provided in section IX(A)(1) of this notice, regarding sales of property by the producing taxpayer to a related party.) Thus, for example, interest capitalized by a related party with respect to the production expenditures of property produced for sale by a taxpayer shall not constitute deductible interest in any year for purposes of allocating and apportioning interest under section 1.861 of the regulations. Such capitalized interest shall be allocated and apportioned at the same time and in the same manner as the deduction for cost of goods sold would be taken into account by the taxpayer.

Interest capitalized by the related party shall be treated by the related party as its production expenditures and, consequently, shall not be included in the accumulated production expenditures of the taxpayer. The related party shall identify the capitalized interest as a deferred asset with the same degree of specificity used by the producing taxpayer to identify the underlying qualified property. Furthermore, because interest capitalized in prior periods must be included in accumulated production expenditures, the related party must capitalize additional interest expense with respect to the amount included in its deferred asset account in each subsequent year of the production period of the particular qualified property to which the interest relates. If the related party is required to capitalize interest with respect to a particular property for more than one taxable year, all amounts of capitalized interest that relate to the same property shall be taken into account as a single asset.

(3) CESSATION OF RELATED PARTY STATUS.

In the event that the taxpayer and the related party cease to be related, forthcoming regulations will provide that the deferred asset shall be treated in a manner consistent with the rules relating to the restoration of a deferred intercompany loss as provided in section 1.267(f)-1T (and, where applicable, section 1.267(f)-2T) of the regulations. For this purpose, the producing taxpayer shall be treated in the same manner as an "owner" of property, and the related party required to capitalize interest expense shall be treated as a "seller" of property. The producing taxpayer and all related parties with respect to the taxpayer (as defined in section VIII(A) or (B) of this notice) shall constitute the "group."

Thus, in the event that the related party (the seller, for purposes of section 1.267(f)-1T) leaves the group, the producing taxpayer shall increase its basis in the qualified property by the amount remaining in the deferred asset account of the related party that corresponds to the particular qualified property. See section 1.267(f)-1T(c)(7) of the regulations. Because the related party has left the group, it is not permitted to continue to amortize, deduct, or take into account the capitalized interest. See section 1.267(f)- 1T(c)(6) of the regulations. In contrast, if the producing taxpayer (the owner, for purposes of section 1.267(f)-1T of the regulations) leaves the group, the related party is permitted to take into account, in that taxable year, the amount remaining in the deferred asset account that corresponds to the particular property produced by the taxpayer. Moreover, in such a situation; the related party would take into account and include in taxable income any remaining portion of the adjustment under section 481(a) relating to interest capitalized on related party avoided cost debt with respect to the inventory property owned by the producing taxpayer leaving the group.

Further, in order to prevent the allowance of a "double deduction," forthcoming regulations under section 263A(f) will require that the basis of the stock in the related party owned by a member of the group be reduced by the amount remaining in the deferred asset account of the related party, where the related party eaves the group and the producing taxpayer increases its basis in the qualified property by such amount. The reduction of basis described in the preceding sentence shall be deemed to occur immediately prior to the time that the related party leaves the group.

(4) DIFFERENCES IN FISCAL YEARS.

As previously provided, a related party shall capitalize interest it incurs during the taxpayer's production period of the qualified property, equal to an amount that the producing taxpayer would have capitalized had the taxpayer itself incurred such interest expense. This rule shall apply regardless of whether the related party uses a different taxable year for Federal income tax purposes than the year of the producing taxpayer.

Assume for example, that the related party reports its income on a calendar year basis, and the producing taxpayer reports its income on a fiscal year ending September 30. Moreover, assume that the producing taxpayer is producing a building with a production period from August 1 to November 30, 1988. With respect to its taxable year ending December 31, 1988, the related party shall, if otherwise required, capitalize interest incurred from August 1, to November 30, 1988, on its related party avoided cost debt.

(B) SUBSTITUTE COST METHOD.

(1) IN GENERAL.

As provided in this section (IX)(B)(1), taxpayers may elect to use the substitute cost method. Under the substitute cost method, the producing taxpayer shall capitalize, during each year of the production period, certain "substitute" costs in lieu of the taxpayer's related parties being required to capitalize interest on their related party avoided cost debt. Taxpayers using the substitute cost method may avoid some of the administrative complexities involved in determining related party avoided cost debt under the deferred asset method.

Substitute costs consist of a pro-rata amount of all the taxpayer's costs that would be otherwise deductible by the taxpayer for the current taxable year, after application of all provisions of the Code. Thus, for example, substitute costs would typically include marketing and advertising expenses, as well as certain types of general and administrative expenses not otherwise subject to capitalization under the Code. In contrast, substitute costs do not include permanently nondeductible costs, costs which may be deductible in a future taxable year but are not deductible currently (see, e.g., sections 461(h) and 469 of the Code), or costs that are required to be capitalized (without regard to this section IX(B)), under any section of the Code (e.g., sections 263A and 460). Moreover, substitute costs include any interest expense incurred by the taxpayer during the taxable year on eligible debt that would not otherwise be subject to capitalization. For example, assume that the taxpayer incurred interest on eligible debt outside the production period of qualified property produced by the taxpayer. Such interest expense would be a substitute cost because such interest would not otherwise be subject to capitalization under section 263A(f).

(2) AMOUNT OF SUBSTITUTE COSTS CAPITALIZED.

Under the substitute cost method, the producing taxpayer shall capitalize its substitute costs up to an amount equal to the additional interest that would have been capitalized by the taxpayer had the taxpayer's eligible debt been equal to the average balance of its accumulated production expenditures during the production period.

For purposes of this method, the amount of additional interest that would have been capitalized by the taxpayer had the taxpayer's eligible debt been equal to the average balance of its accumulated production expenditures during the production period shall be determined by applying (i) the average Federal long-term rate (within the meaning of section 1274(d) of the Code) in effect during the production period within the taxable year, to (ii) the average balance of the taxpayer's remaining production expenditures outstanding during such time (i.e., the excess of the taxpayer's production expenditures over the actual balances of the taxpayer's traced and avoided cost debt).

If, however, a taxpayer using the substitute cost method can demonstrate that the amount of substitute costs capitalized under the provisions of the preceding paragraph exceeds the amount of interest that related parties would have capitalized under the deferred asset method (subject to the ordering rules described in section XI of this notice) with respect to the taxpayer's production expenditures for the taxpayer's taxable year, then the taxpayer may, if it chooses, capitalize only the amount of substitute costs equal to the amount of such interest.

With respect to producing taxpayers using the substitute cost method that are required to change their method of accounting for inventories under section 263A, the adjustment under section 481(a) relating to substitute costs capitalized by the producing taxpayer shall be taken into account in the same manner and at the same time as the taxpayer is required to take the adjustment under section 481(a) into account that relates to other costs capitalized under section 263A with respect to such inventory property.

(3) TAXPAYERS WITH INSUFFICIENT SUBSTITUTE COSTS.

A producing taxpayer using the substitute cost method for any taxable year might, depending upon the particular facts, not have substitute costs equal to, or greater than, the amount of additional interest that would have been capitalized by the taxpayer had the taxpayer's eligible debt been equal to the average balance of its accumulated production expenditures during the production period. In such a situation, parties related to the producing taxpayer under section VIII(A) or (B) of this notice are required to capitalize interest on related party avoided cost debt using the deferred asset method for such taxable year. The amount of the producing taxpayer's remaining production expenditures subject to the deferred asset method is determined by dividing (i) the amount of the taxpayer's substitute costs capitalized for the taxable year, by (ii) the average Federal long-term rate (within the meaning of section 1274(d) of the Code) in effect for the period. The resulting amount is then subtracted from the taxpayer's remaining production expenditures (i.e., the excess of the taxpayer's production expenditures over the amount of the taxpayer's traced and avoided cost debt), and the difference is the amount of the producing taxpayer's production expenditures subject to the deferred asset method.

For example, assume a taxpayer incurs $1 million in production expenditures, and allocates $600,000 of traced and avoided cost debt to such expenditures. Assume further that the average Federal long- term rate in effect for the period is 9.5 percent. Moreover, assume that the taxpayer has only $25,000 of substitute costs (and that these substitute costs are capitalized). The amount of the producing taxpayer's remaining production expenditures subject to the deferred asset method and related party avoided cost debt is $136,842. This amount is determined by dividing (i) the amount of the taxpayer's capitalized substitute costs ($25,000), by (ii) the average Federal long-term rate in effect for the period (9.5 percent). The resulting amount ($263,158) is then subtracted from the taxpayer's remaining production expenditures ($400,000), and the difference ($136,842) is the amount of the producing taxpayer's production expenditures subject to the deferred asset method. Thus, related parties (as defined in section VIII(A) or (B) of this notice) with respect to the taxpayer shall capitalize interest on eligible debt that the related parties incurred, during the production period of the property, with respect to $136,842 of production expenditures.

If, however, the taxpayer using the substitute cost method can demonstrate that the sum of the (i) capitalized substitute costs, and (ii) interest on related party avoided cost debt capitalized with respect to the taxpayer's remaining production expenditures (after application of the substitute cost method), exceeds the amount of interest that related parties would have capitalized under the deferred asset method with respect to the taxpayer's production expenditures for the producing taxpayer's taxable year, then the amount of interest on related party avoided cost debt otherwise subject to capitalization for such year may be decreased by such excess.

For example, assume the same facts as in the previous example above. In addition, assume the production expenditures of $136,842 would result in $13,000 of interest being capitalized by related parties under the deferred asset method. Moreover, assume that the taxpayer can demonstrate that, if the deferred asset method had applied (and the substitute cost method had not applied at all), a total amount of $30,000 of interest would have been capitalized by related parties with respect to the $400,000 of remaining production expenditures of the producing taxpayer for its taxable year. In such a situation, the sum of the substitute costs and related party interest otherwise capitalized would be equal to $38,000 ($25,000 plus $13,000), which exceeds the $30,000 of interest that related parties would have capitalized under the deferred asset method. Thus, under the substitute cost method, only $5,000 ($30,000 less $25,000) of interest would be capitalized by related parties under the deferred asset method, in addition to the $25,000 of substitute costs capitalized. If, in contrast, the taxpayer does not demonstrate that the sum of the substitute costs and related party interest otherwise capitalized exceeds the amount of interest that related parties would have capitalized under the deferred asset method, the taxpayer would capitalize $25,000 of substitute costs and related parties would capitalize $13,000 of interest on related party avoided cost debt.

(4) TREATMENT OF COSTS AND ACCOUNTING METHODS.

Substitute costs capitalized by the taxpayer under the substitute cost method shall be included in the accumulated production expenditures of the property and in inventory cost or basis in the same manner as all other capitalized costs under section 263A or 460. Similarly, such costs shall be recovered in the same manner and at the same time as all other costs that are capitalized with respect to the property (e.g., as cost of goods sold, an adjustment to basis, depreciation, or amortization).

Generally, under the substitute cost method, the taxpayer shall capitalize substitute costs incurred during its taxable year only with respect to qualified property held by the taxpayer as of the end of the taxpayer's taxable year. However, substitute costs incurred by a taxpayer shall be capitalized with respect to qualified property produced by the taxpayer during its taxable year, even though the taxpayer has sold or transferred the property before the end of its taxable year if, after such sale or transfer, a person related to the taxpayer still holds the property as of the end of the taxpayer's taxable year. (For purposes of the preceding sentence, two persons shall be treated as related if their relationship is described in section 267(b) or 707(b) of the Code.) In such a situation, the taxpayer shall capitalize substitute costs with respect to the qualified property, and such capitalized costs shall be taken into account by the taxpayer and included in the basis of the qualified property for all purposes of the Code.

In the case of a consolidated group of corporations or a parent- subsidiary controlled group of corporations (as described in section VIII(A) or (B) of this notice), the election to use the substitute cost method shall be made at the parent level and shall be applied with respect to all members of such group. An election to use the substitute cost method must be consistently applied with respect to all production of qualified property by all members of the consolidated group or parent-subsidiary controlled group of corporations.

(C) CHANGES OF ACCOUNTING METHODS - DEFERRED ASSET METHOD AND SUBSTITUTE COST METHOD.

The use of the deferred asset method or the substitute cost method shall be treated as a method of accounting. A parent may not change the method used by its members from one method of capitalization described in this section IX to the other method (e.g., from the deferred asset method to the substitute cost method) without obtaining the consent of the Commissioner, if a change from one capitalization method to the other has occurred within the five preceding taxable years. If, however, such a change in method of accounting has not occurred within the five preceding years, then the taxpayer may change its method of accounting from one method of capitalization to the other method, and such change shall be treated as an automatic change in method of accounting, made with the consent of the Commissioner. (The Internal Revenue Service may issue additional future guidance regarding this change in method of accounting to prescribe additional conditions and requirements applicable to such change in method of accounting.) A change in method of accounting described in the preceding sentence shall be effected on a "cut-off" basis, and no adjustment under section 481(a) shall be calculated or taken into account. Notwithstanding the provisions of this section IX(C), a change in method of capitalization from the deferred asset method to the substitute cost method is permitted for a group's first taxable year beginning on or after January 1, 1988, and such change shall be treated as an automatic change in method of accounting, made with the consent of the Commissioner. No adjustment under section 481(a) shall be calculated or taken into account with respect to such change.

(D) METHOD USED UNDER ANTI-ABUSE RULE.

As previously provided in section VIII(D) of this notice, the related party avoided cost rules, generally applicable only to related parties (as defined in section VIII(A) or (B) of this notice) also apply in any other case in which the producing taxpayer and any person (or persons) engage in any transaction with a principal purpose of avoiding the interest capitalization requirements of section 263A(f). If the anti-abuse rule described in section VIII(D) of this notice applies to a taxpayer and other persons, the taxpayer shall capitalize additional costs using the substitute cost method, as described in this section IX. With respect to producing taxpayers that do not have substitute costs equal to, or greater than, the amount of additional interest that would have been capitalized by the taxpayer had the taxpayer's eligible debt been equal to the average balance of its accumulated production expenditures during the production period, all persons who engaged, directly or indirectly, in transactions with a principal purpose of avoiding the interest capitalization requirements are required to capitalize interest on their avoided cost debt using the deferred asset method. The amount of the producing taxpayer's remaining production expenditures subject to the deferred asset method is determined by dividing (i) the amount of the taxpayer's capitalized substitute costs, by (ii) the average Federal long-term rate (within the meaning of section 1274(d) of the Code) in effect for the period. The resulting amount is then subtracted from the taxpayer's remaining production expenditures (i.e., the excess of the taxpayer's production expenditures over the amount of the taxpayer's traced and avoided cost debt), and the difference is the amount of the producing taxpayer's production expenditures subject to the deferred asset method.

X. EXAMPLES -- METHODS OF CAPITALIZATION AND RECOVERY.

EXAMPLE (1). C, a corporation producing qualified property, is a member of a parent-subsidiary controlled group of corporations. Assume that the sum of C's traced and avoided cost debt exceeds C's accumulated production expenditures. Since C's accumulated production expenditures do not exceed the total amount of its traced and avoided cost debt, neither the substitute cost method nor the deferred asset method applies.

EXAMPLE (2). C, a corporation producing qualified property, is a parent of a parent-subsidiary controlled group of corporations, consisting of C and its subsidiary, S1. C owns 100 percent of S1. Assume that the sum of C's traced and avoided cost debt is less than C's accumulated production expenditures. S1 is required to capitalize interest on its eligible debt with respect to the remaining production expenditures of C, regardless of the financial or regulatory accounting treatment of such interest, and regardless of the purpose for which, or when in time, such debt was incurred. Alternatively, C may elect to use the substitute cost method.

EXAMPLE (3). Assume the same facts as in Example (2), except that C owns 80 percent of S1. The same results as in Example (2) would occur, i.e., S1 would capitalize the same amount of interest with respect to the production expenditures of C as in Example (2).

EXAMPLE (4). A, a calendar year taxpayer, is producing qualified property, i.e., A is constructing a building. Assume that A, after having applied the tracing and avoided cost rules with respect to its own eligible debt, has remaining production expenditures attributable to the building throughout its entire 1987 taxable year with an monthly average balance of $600,000 (i.e., A's monthly average balance of cumulative production expenditures, reduced by A's monthly average balance of traced and avoided cost debt, equal $600,000). In addition, assume that B, the only person that is a related party to A (within the meaning of section VIII(A)), has eligible debt with an monthly average principal balance of $1,200,000 and interest payable at a 10 percent annual rate for B's entire taxable year. B is a calendar year taxpayer.

Assume that the deferred asset method is used. B shall capitalize interest expense on its avoided cost debt equal to an amount that A would have capitalized under section 263A with respect to the building had A directly incurred such debt. Thus, the amount of such interest is $60,000 ($600,000 x .10). B must capitalize $60,000 of interest expense, creating an asset with a basis of $60,000 and decreasing its interest expense by $60,000. In addition, assume that A sells the building on January 1, 1988. B would treat the asset, consisting of capitalized interest of $60,000, as sold in 1988 for $0, and hence B would increase cost of sales (and decrease taxable income) for 1988 by $60,000.

EXAMPLE (5). Assume the same facts as in Example (4), except that A places the building in service for use in its trade or business on January 1, 1988. Assume that in 1988 A depreciates 5 percent of the basis of the building. Similarly, assume that A would be entitled to depreciate the same amount in 1989. (These depreciation amounts are provided solely for purposes of illustration and do not actually reflect the recovery of costs required under section 168 of the Code.) B shall similarly depreciate 5 percent (or $3,000) of the basis of its asset and shall treat such amount as depreciation for all purposes of the Code. Thus, as of end of the 1988 taxable year, A has on hand a partially depreciated building, and B has an asset with an adjusted basis of $57,000.

EXAMPLE (6). Assume the same facts as in Example (4), except that A elects to use the substitute cost method. Thus, A will capitalize its substitute costs up to the amount determined by applying (i) the average of the Federal long-term rates in effect during the portion of the taxable year that includes the production period, to (ii) the average balance of A's remaining production expenditures outstanding during such period.

A will capitalize its substitute costs up to an amount equal to the product of the average balance of remaining production expenditures ($600,000) multiplied by the average Federal long-term rate in effect during the portion of the taxable year that includes the production period. Thus, for example, if the average Federal long-term rate in effect during the period is 9 percent, A would capitalize $54,000 of its substitute costs and include such costs in the basis of the building.

EXAMPLE (7). Assume the same facts as in Example (6), except that A has only $45,000 of substitute costs. Thus, A does not have substitute costs equal to, or greater than, the amount of interest that would have been capitalized by A had A's eligible debt been equal to the average balance of A's accumulated production expenditures. As a result, B is required to capitalize interest on related party avoided cost debt with respect to a portion of A's remaining production expenditures using the deferred asset method for such taxable year. The amount of A's remaining production expenditures subject to the deferred asset method is determined by dividing $45,000, the amount of A's capitalized substitute costs for the year, by (ii) the average Federal long-term rate in effect for the period. The resulting amount of $500,000 is then subtracted from A's remaining production expenditures of $600,000, and the difference of $100,000 is the amount of A's production expenditures subject to the deferred asset method. Thus, A capitalizes its substitute costs of $45,000 for the year, and B is required to capitalize interest on its related party avoided cost debt with respect to $100,000 of A's remaining production expenditures. (For purposes of the deferred asset method, the actual interest rate(s) on B's related party avoided cost debt, and not the average Federal long-term rate, shall be used to compute the amount of interest B capitalizes under the avoided cost method.)

EXAMPLE (8). Assume the same facts as in Example (5), except that P owns 100 percent of both A and B (and that P, A, and B join in the filing of a consolidated return). As of the beginning of 1989, P sells all of its stock in B to an unrelated purchaser, recognizing taxable gain on such sale. Under the rules of section 1.267(f)-1T of the regulations, A shall increase its basis in the building by $57,000, the amount remaining in the deferred asset account of B that corresponds to the qualified property. Similarly, for its 1989 taxable year, A shall increase its depreciation deduction relating to the building by $3,000, the amount that A would have been permitted to deduct had A itself incurred and capitalized the interest expense that was actually incurred by B. B is not permitted to depreciate or to deduct, in any way, any portion of the $57,000 amount remaining in its deferred asset account that corresponds to the qualified property. In addition, P shall reduce its basis in B's stock by $57,000, the amount remaining in its deferred asset account transferred to A, thus increasing the amount of gain recognized on the sale of such stock.

XI. DEFERRED ASSET METHOD - ORDERING RULES.

(A) TAXABLE YEARS BEGINNING BEFORE 1988.

For taxable years of the producing taxpayer beginning before January 1, 1988, if interest incurred by related parties becomes subject to the deferred asset method with respect to taxpayers' remaining production expenditures, then the taxpayers and related parties may use any reasonable ordering rule in determining (i) which related party's interest is first capitalized and (ii) the production expenditures of which producing taxpayer are first subject to the deferred asset method. In the case of a consolidated group of corporations (within the meaning of section VIII(A) of this notice), the ordering rule shall be established at the parent level and shall be applied with respect to all members of such group. If taxpayers and related parties can not (or do not wish to) agree on an ordering rule to be adopted by the parent, the parent may adopt a pro-rata ordering rule that allocates each related party's avoided cost debt to each producing taxpayer's excess production expenditures.

For example, assume that a consolidated group of corporations consists of the following four corporations: P, the common parent, and three subsidiary corporations, S1, S2, and S3. P and S1 are both engaged in the production of qualified property, and both corporations have accumulated production expenditures in excess of their traced and avoided cost debt, with such remaining accumulated production expenditures equal to an average of $100 and $200, respectively, during the production period of the properties. Assume further that neither S2 nor S3 is engaged in the production of qualified property, and that both corporations have outstanding eligible debt of $120 and $480, respectively, during the production period of the properties produced by P and S1. Any reasonable ordering rule may be established by P in determining (i) which related party's (i.e., S2 or S3) interest will be capitalized first; and (ii) which producing taxpayer's (i.e., P or S1) production expenditures will be subject to the deferred asset method first.

In the absence of any other reasonable ordering rule adopted by P, the total amount of related party avoided cost debt may be allocated pro-rata to the total amount of remaining production expenditures of all producing taxpayers, and interest shall be capitalized accordingly. Thus, in the absence of any other ordering rule, $20 of S2's debt would be allocated to the production expenditures of P, and $40 of S2's debt would be allocated to the production expenditures of S1. Similarly, $80 of S3's debt would be allocated to the production expenditures of P, and $160 of S3's debt would be allocated to the production expenditures of S1. S2 and S3 would then capitalize interest on such debt allocated to the production expenditures under the deferred asset method.

(B) TAXABLE YEARS BEGINNING ON OR AFTER JANUARY 1, 1988.

For taxable years of the producing taxpayers beginning on or after January 1, 1988, if interest incurred by related parties becomes subject to the deferred asset method with respect to producing taxpayers' remaining production expenditures, the following ordering rules shall apply in determining which related party's interest is first capitalized, and the production expenditures of which producing taxpayer are first subject to the deferred asset method: (i) with respect to producing taxpayers organized outside the United States, interest incurred by every related party organized outside the United States must be capitalized before the interest of any other related party is capitalized; (ii) with respect to producing taxpayers organized in the United States, interest incurred by every related party organized within the United States must be capitalized before the interest of any other related party is capitalized. In the case of a consolidated group of corporations or a parent-subsidiary controlled group (within the meaning of section VIII(A) or (B) of this notice), the ordering rule shall be established at the parent level and shall be applied with respect to all members of such group. Forthcoming guidance will provide additional ordering rules applicable to producing taxpayers and related parties.

XII. FLOW-THROUGH ENTITIES.

(A) IN GENERAL.

Section 263A(f)(2)(C) of the Code provides that, with respect to flow-through entities, the interest capitalization requirements of section 263A(f) (including the avoided cost method) shall, except as provided in regulations, be applied first at the entity level and then at the beneficiary level. The legislative history to the Act provides that "the interest capitalization rules are applied first at the level of a partnership (or other flow-through) entity, and then at the level of the partners (or beneficiaries), to the extent that the partnership has insufficient debt to support the production or construction expenditures." Senate Report at 144.

The provisions of section 263A(f)(2)(C) of the Code are subject to the general effective date provisions of sections 263A and 460. Thus, in the case of the production of noninventory property under section 263A, the rules are effective with respect to costs incurred after December 31, 1986, in taxable years ending after such date. In the case of inventory property, the rules are effective with respect to taxable years beginning after December 31, 1986; and, in the case of long-term contracts, the rules are effective with respect to long- term contracts entered into after February 28, 1986.

Based on the foregoing, with respect to any flow-through entity producing qualified property, i.e., property to which the interest capitalization rules apply, the entity shall first capitalize interest on its traced and avoided cost debt allocable to its production expenditures. If the production expenditures of the flow- through entity exceed its traced and avoided cost debt, the deferred asset method of capitalizing and recovering costs shall apply unless the entity elects the use of the substitute cost method as described in section IX of this notice. (See however, section XII(F) which provides de minimis rules with respect to the application of these provisions to flow-through entities.) For purposes of this notice, the term "flow-through entity" shall mean a partnership or an S corporation. A trust that is treated as owned by a grantor or a beneficiary under Subpart E, part I, subchapter J, chapter 1 of the Code (relating to grantor trusts), including a trust that is treated as a grantor trust pursuant to section 1361(d)(1)(A) of the Code (relating to qualified subchapter S trusts), shall be disregarded for purposes of section 263A (including section 263A(f)) and this notice.

In addition, to the extent that the flow-through entity producing qualified property (entity A) is itself owned by another flow-through entity (entity B), the provisions of this section shall apply to B and to the owners of B as if B itself were incurring A's production expenditures in an amount equal to the expenditures that are allocable to B. Similar principles shall apply if the owners of entity B are flow-through entities, and so on.

If a person (e.g., a corporate partner) is subject to the rules of both this section XII and section VIII (concerning related parties) of this notice, this section XII shall apply before the rules of section VIII apply.

(B) DEFERRED ASSET METHOD.

(1) IN GENERAL.

Under the deferred asset method, the remaining amount of the flow-through entity's production expenditures (i.e., the excess of the accumulated production expenditures of the entity over its traced and avoided cost debt) shall be allocated to the partners, or shareholders ("owners") of the entity based on their respective share (as defined in paragraph (G)(2) of this section XII) in the production expenditures of all qualified property during the production period of such property. Such owners, in turn, shall be subject to the interest capitalization rules (including the avoided cost method) with respect to such production expenditures of the qualified property as if the owners had incurred the production expenditures directly.

Thus, an owner of a flow-through entity shall capitalize interest incurred by such owner during the production period of the qualified property as if the owner had directly produced its share of such qualified property. (For purposes of determining when interest is incurred, the provisions of section V of this notice shall apply.) For example, assume that partner A owns a 50 percent interest in partnership B and that both A and B are calendar year taxpayers. Partnership B is constructing a building; thus, the interest capitalization rules of section 263A(f) apply to this activity. Similarly, assume that the production period of the building lasts six months, from April 1, 1987, to September 30, 1987, and that the average monthly balance of the building's production expenditures for such six-month period, reduced by partnership B's traced and avoided cost debt allocable to such expenditures, is $800,000. Partner A must capitalize any interest incurred by A on A's eligible debt during the production period of the building, using the avoided cost method, with respect to A's 50 percent share of the building's production expenditures (i.e., production expenditures with an average monthly balance of $400,000) as if A had directly engaged in such production activities.

Generally, an owner shall capitalize interest incurred during the owner's taxable year only with respect to qualified property held by an entity as of the end of the owner's taxable year in issue. Thus, assume in the preceding example that B had sold the building before the end of A's taxable year (i.e., before December 31, 1987). Generally, A would not capitalize any interest with respect to the building. (In contrast, if B had sold the building on January 1, 1988, A would be required to capitalize interest with respect to the building for A's taxable year ended December 31, 1987. Similarly, if B had constructed the building for use in its trade or business, and such building was placed in service by B before the end of A's taxable year, A would be required to capitalize interest with respect to the building.)

However, interest incurred by the owner shall be capitalized with respect to qualified property produced by the entity during the owner's taxable year, even though the entity has sold or transferred the property before the end of the owner's taxable year, if, after such sale or transfer, a person related to either such entity or the owner still holds the property as of the end of the owner's taxable year. (For purposes of the preceding sentence only, two persons shall be related if their relationship is described in section 267(b) or 707(b) of the Code.) In such a situation, the owner shall capitalize interest with respect to the qualified property as if the property were still held by the entity that produced such property. For example, assume that partnership B in the previous example had sold the building, before December 31, 1987, to partnership C, and that the relationship between partner A (or partnership B) and C is described in section 707(b). Partner A would be required to capitalize interest with respect to the building for the taxable year ended December 31, 1987, if C (or any other person related to A or B) owned the building on December 31, 1987.

(2) RECOVERY OF DEFERRED ASSET.

Under the deferred asset method, each owner shall create on its books and records an asset (a "deferred asset") consisting solely of the capitalized interest attributable to the owner's respective share of the production expenditures of the flow-through entity. Such owner shall then account for such capitalized interest in the same manner (and at the same time) as the flow-through entity would have accounted for such capitalized interest (i.e., as depreciation, cost of goods sold, etc.) had such interest been capitalized into the basis of the qualified property on the entity's books and records. Notwithstanding the foregoing, if the qualified property is sold or transferred to a person related to either the entity or the owner, then the owner shall continue to account for such capitalized interest as if the property were still held by the entity that initially produced the property. See section XII(B)(1) of this notice for the definition of related parties for sales or transfers of property by a flow-through entity.

If the owner sells or otherwise disposes of the interest (or a portion of such interest) in the flow-through entity in a transaction in which gain or loss is recognized, the remaining amount of such capitalized interest (or the appropriate portion of such amount) shall be taken into account by such owner and included in the owner's basis in computing the amount of gain or loss from such sale or disposition for all purposes of the Code and the regulations thereunder, (e.g., sections 267, 707, and 1502). Moreover, if the provisions of section 751 of the Code apply to such sale or disposition of the interest in the flow-through entity with respect to the qualified property, then the capitalized interest shall be taken into account in determining the amount realized with respect to the qualified property for purposes of section 751(a)(1) or (2). The transferee succeeding to an interest in the entity (as a result of such sale or disposition) shall not include any portion of the interest capitalized by the previous owner in computing its basis in the entity.

With respect to a dissolution or liquidation of a flow-through entity owning qualified property, if the qualified property is held by the owners of the entity after such dissolution or liquidation, the remaining amount of capitalized interest shall remain on the books and records of the owners. Such owners would then continue to account for such capitalized interest in the same manner as the owners account for the qualified property.

(See also section IX(A)(2) of this notice which provides general principles regarding the recovery of costs under the deferred asset method, which are applicable with respect to flow-through entities and their owners as well as related parties described in section VIII.)

(3) DIFFERENCES IN FISCAL YEARS.

As previously provided, an owner of a flow-through entity that is producing qualified property shall capitalize interest incurred by such owner during the production period of the qualified property, as if the owner had directly produced its share of such qualified property. If the entity uses a different taxable year for Federal income tax purposes than the year of its owner, the "lagged year" convention shall apply for purposes of the interest capitalization rules unless a facts and circumstances determination is used.

Under the lagged year convention, the owner shall capitalize interest incurred in its taxable year with respect to the remaining accumulated production expenditures of the entity outstanding during the taxable year of the entity that ends within or with the owner's taxable year. The owner shall capitalize interest on its eligible debt outstanding during each month of its taxable year with respect to the corresponding balance of remaining accumulated production expenditures outstanding during each month of the entity's taxable year. For purposes of this computation, the debt outstanding for the last month of the owner's taxable year shall be allocated to the entity's remaining production expenditures outstanding for the last month of the entity's taxable year. Similarly, the debt outstanding for the month preceding the last month of the owner's taxable year shall be allocated to the entity's remaining production expenditures for the month preceding the last month of the entity's taxable year, and so on.

Assume, for example, that shareholder D, a calendar year individual, owns an interest in S, an S corporation with a fiscal year ending September 30, that is producing a building throughout S's taxable year beginning October 1986 and ending September 30, 1987. Further assume that the building's production period lasted from October 1, 1986, to December 31, 1987, i.e., 15 months.

Under the lagged year convention , D shall capitalize interest on debt outstanding during each month of D's 1987 calendar year that corresponds to the accumulated production expenditures outstanding for each month of corporation S's taxable year ending on September 30, 1987. Thus, in calculating the amount of S's production expenditures that are allocable to D in calendar year 1987 (and that therefore attract interest of D for such year), the production expenditures of S for each month of S's taxable year beginning on October 1, 1986, and ending on September 30, 1987, shall be used, as opposed to the production expenditures of S for the months included in calendar year 1987. (Similarly, in calculating the amount of S's production expenditures that are allocable to D in calendar year 1988, the production expenditures outstanding for each month of S's taxable year beginning on October 1, 1987, and ending on September 30, 1988, shall be used.) Thus, D would capitalize interest incurred on its debt outstanding during the month of December 1987 (the last month of D's 1987 calendar year), with respect to S's remaining production expenditures outstanding during September 1987 (the last month of S's taxable year that ends within or with D's taxable year); interest incurred on D's debt outstanding in November 1987 shall be capitalized with respect to S's remaining production expenditures outstanding during August 1987, and so on.

Under the lagged year convention, owners are not required to take into account the entity's production expenditures that occur after the entity's fiscal year, for purposes of determining the amount of interest incurred during the owner's taxable year within which such entity's fiscal year ends that is subject to capitalization. The lagged year convention, if adopted, shall apply to any entity using a different taxable year than the year of its owner with respect to all of the entity's production activities and with respect to all of the entity's owners.

As previously provided, if an entity does not use the lagged year convention, then the facts and circumstances method shall apply. Under the facts and circumstances method, the owner shall capitalize interest incurred in its taxable year during the entity's production period of the qualified property by using the actual production expenditures of the entity for each month of the owner's taxable year. Thus, assume that corporation S in the previous example elects to use the facts and circumstances method, as opposed to the lagged year convention. Under the facts and circumstances method, the interest capitalized by shareholder D for calendar year 1987 shall be based on the production expenditures of S in the building for calendar year 1987, i.e., January 1987 through December 1987. Thus, in determining the interest capitalized by D with respect to D's share in the production expenditures for 1987, the production expenditures of S for October, November, and December, 1986 would not be taken into account. Instead, the production expenditures of S for calendar year 1987 (including October, November, and December 1987) would be taken into account in making such a determination. For example, interest incurred by D in December 1987 would be capitalized with respect to the production expenditures of S for December 1987, interest incurred by D in November 1987 would be capitalized with respect to the production expenditures S for November 1987, and so on.

The use of either the lagged year convention or the facts and circumstances method shall be determined by the entity and shall be treated as a method of accounting. Any adoption of either the lagged year convention or the facts and circumstances method by the entity shall be binding on all owners of the entity.

(4) DEFERRED ASSET METHOD AND FLOW-THROUGH ENTITIES - ORDERING RULES.

(a) TAXABLE YEARS BEGINNING BEFORE JANUARY 1, 1988.

For taxable years of the owner beginning before January 1, 1988, if the production expenditures of more than one flow-through entity become subject to the deferred asset method with respect to an owner, then the owner shall use any reasonable ordering rule in determining the amount of debt to allocate with respect to the remaining production expenditures of each entity.

(b) TAXABLE YEARS BEGINNING ON OR AFTER JANUARY 1, 1988.

For taxable years of the owner beginning on or after January 1, 1988, if the production expenditures of more than one flow-through entity become subject to the deferred asset method with respect to an owner, then the owner shall adopt a pro-rata ordering rule in determining the amount of debt to allocate with respect to the remaining production expenditures of each entity. Thus, the owner's debt shall be allocated with respect to its share of the remaining production expenditures of each entity based on the ratio of its share of each entity's remaining production expenditures to the aggregate amount of its share of all the entities' remaining production expenditures.

(C) SUBSTITUTE COST METHOD.

(1) IN GENERAL.

Under the substitute cost method, an entity producing qualified property shall capitalize its substitute costs in the manner provided in section IX(B)(1), (2), (3), and (4) of this notice. (For purposes of the substitute cost method, owners of the flow-through entity shall be treated as if they were related parties with respect to the producing taxpayer. See, e.g., sections IX(B)(2) and (3) of this notice regarding the use of the substitute cost method and related parties.)

In addition, as provided in section IX(B) of this notice, capitalized substitute costs are to be taken into account in the same manner as other costs required to be capitalized and included in the cost of qualified property. Similarly, such costs shall be recovered in the same manner and at the same time as all other costs that are capitalized with respect to the qualified property.

(2) TAXPAYERS WITH INSUFFICIENT SUBSTITUTE COSTS.

As provided in section IX(B)(3) of this notice, a producing taxpayer using the substitute cost method might, depending on the particular facts, not have substitute costs equal to, or greater than, the amount of interest that would have been capitalized by the taxpayer had the taxpayer's eligible debt been equal to the average balance of its accumulated production expenditures during the production period. In such a situation, the owners of the flow- through entity that is using the substitute cost method are required to capitalize interest on their avoided cost debt using the deferred asset method and the lagged year convention, as set forth in section XII(B)(3) of this notice. Section IX(B)(3) of this notice provides a formula for determining the amount of the producing flow-through entity's remaining production expenditures that are subject to the deferred asset method. Under that formula, the amount of the entity's remaining production expenditures subject to the deferred asset method is determined by dividing (i) the amount of the entity's substitute costs capitalized for the taxable year, by (ii) the average Federal long-term rate (within the meaning of section 1274(d) of the Code) in effect for the period. The resulting amount is then subtracted from the entity's remaining production expenditures (i.e., the excess of the entity's production expenditures over the amount of the entity's traced and avoided cost debt), and the difference is the amount of the entity's production expenditures subject to the deferred asset method.

(D) ACCOUNTING METHODS.

The use of the deferred asset method or the substitute cost method shall be treated as a method of accounting. With respect to a flow-through entity, the election to use these methods shall be made at the entity level. The provisions of section IX(C) of this notice (regarding changes of accounting methods) shall apply to flow-through entities and owners to which the interest capitalization rules apply.

(E) APPLICATION OF AVOIDED COST RULES TO FLOW-THROUGH ENTITIES OWNED BY PRODUCING TAXPAYERS.

(1) IN GENERAL.

For taxable years of the owner beginning on or after January 1, 1988, interest expense incurred on eligible debt of a flow-through entity (to the extent that such interest expense is otherwise deductible and such debt is not allocated by the entity to its own production expenditures with respect to qualified property) is treated as having been incurred by the owners of the entity for purposes of again applying the interest capitalization rules to the owners' production expenditures. Thus, an owner may be required to capitalize all or a portion of the interest expense included in the owner's "distributive share" (as defined in section XII(E)(2) of this notice) with respect to the flow-through entity. Such interest expense may be required to be capitalized with respect to the owner's production expenditures (or production expenditures of a related party, as described in section VIII(A) or (B) of this notice).

Moreover, interest incurred by a flow-through entity (entity A) that is included in the distributive share of the owner of such entity may be subject to capitalization by such owner with respect to the production expenditures of another flow-through entity (entity B) that is owned, in whole or in part, by such owner. In addition, to the extent that a flow-through entity incurring interest expense (entity A) is itself owned by another flow-through entity (entity C), the provisions of this section shall apply to C and to the owners of C as if C itself were incurring the interest expense of A included in C's distributive share. Similar principles shall apply if the owners of entity C are flow-through entities, and so on.

Generally, an owner shall capitalize interest incurred by the flow-through entity only with respect to qualified property held by the owner as of the end of the owner's taxable year in issue. However, interest incurred by the entity shall be capitalized by the owner with respect to qualified property produced by the owner during its taxable year, even though the owner has sold or transferred the property before the end of such year if, after such sale or transfer, a person related to the owner or the entity still holds the property as of the end of the owner's taxable year. (For purposes of the preceding sentence only, two persons shall be related if their relationship is described in section 267(b) or 707(b) of the Code.) With respect to any such sales to related parties, the capitalized interest with respect to the property shall be included in the owner's basis for all purposes of the Code and the regulations thereunder.

(2) DETERMINATION OF DISTRIBUTIVE SHARE.

For purposes of this section, the amount of interest expense in a partner's "distributive share" with respect to a partnership shall consist of the total interest expense included in the partner's distributive share of items specified in section 702(a) of the Code for the partnership's taxable year ending within or with the partner's taxable year. Similarly, the amount of interest expense in a shareholder's "distributive share" with respect to an S corporation shall consist of the total interest expense included in the shareholder's pro-rata share of items of income or nonseparately computed income or loss in section 1366(a)(1) of the Code for the corporation's taxable year ending within or with the shareholder's taxable year.

(3) MECHANICS OF RULES.

With respect to interest expense incurred by a flow-through entity and included in the distributive share of an owner, the owner shall capitalize such interest if the interest would have been capitalized had it been incurred directly by the owner. Thus, an owner shall capitalize interest expense of the flow-through entity if such interest expense was incurred (as modified by section V of this notice) by the flow-through entity during the owner's production period of the qualified property. However, the owner shall capitalize the entire amount of such interest expense only if the amount of interest corresponds to an amount of underlying entity-level debt that does not exceed the remaining production expenditures of the owner (i.e., the excess of the owner's production expenditures over its traced and avoided cost debt). Thus, to the extent that the interest expense included in the owner's distributive share exceeds the amount of interest described in the preceding sentence, the owner shall capitalize only the portion of such interest that corresponds to an amount of underlying entity debt that is equal to the remaining production expenditures of the owner.

For example, assume that partner A owns a 50 percent interest in partnership B, and that both A and B are calendar year taxpayers. (Partner A does not own an interest in any other flow-through entities.) Partner A is constructing a building with a production period of six months, from April 1, 1988, to September 30, 1988. Moreover, the average monthly balance of the building's production expenditures for such six-month period, reduced by A's traced and avoided cost debt allocable to the building, is $800,000. In addition, assume that B incurred $120,000 of interest expense ratably in 1988 with respect to debt of $1,000,000 bearing an annual interest rate of 12 percent. Thus, the amount of interest expense included in A's distributive share with respect to B for calendar year 1988 is $60,000 (($1,000,000 x .12) x 50%), consisting of interest of $5,000 per month that was incurred by B.

Partner A is required to capitalize this interest expense if the interest would have been capitalized by A had A incurred the interest directly. Partner A would have capitalized the interest expense only if the interest had been incurred during the production period of A's qualified property. The interest incurred by B during such production period is equal to $5,000 for each month during the entire six-month period. Moreover, A is required to capitalize the interest expense of B only if such interest corresponds to an amount of B's underlying debt that does not exceed the remaining production expenditures of A. The amount of debt to which the interest expense of $5,000 per month corresponds is debt with an average monthly balance for the production period of $500,000 (50 percent of $1,000,000), which does not exceed the remaining production expenditures of A that are equal to $800,000. Partner A would therefore capitalize the entire amount of interest incurred by B during the production period and included in A's distributive share, i.e., $30,000 ($5,000 of interest each month for six months). Moreover, after application of the above rules to A, A would have $300,000 of remaining production expenditures ($800,000 less $500,000) that could, if applicable, attract interest incurred by other persons related to A (as defined in section VIII of this notice).

In contrast, assume the same facts as in the example above, except that partnership B incurred $240,000 of interest expense ratably in 1988 with respect to debt of $2,000,000 bearing an annual interest rate of 12 percent. The amount of interest expense included in partner A's distributive share with respect to B for A's taxable year would be equal to $120 000 (($2 000,000 x .12) x 50%), consisting of interest of $10,000 per month that was incurred by B. The interest of $10,000 per month would correspond to underlying debt with an average monthly balance for the production period of $1,000,000 (50 percent of $2,000,000), which does exceed the remaining production expenditures of A equal to $800,000. Thus, A would capitalize only a portion of such interest that corresponds to the amount of underlying partnership debt equal to A's remaining production expenditures of $800,000. Such interest would be equal to $8,000 per month (i.e., $800,000/$1,000,000 multiplied by $10,000). Thus, A would capitalize interest equal to $48,000 (i.e., $8,000 of interest for six months). Moreover, after application of the above rules to A, A would have no remaining production expenditures that could attract interest incurred by other persons related to A.

(4) DIFFERENCES IN FISCAL YEARS.

As previously provided, an owner of a flow-through entity shall capitalize interest incurred by the flow-through entity if such interest would have been capitalized had it been incurred directly by the owner. If the entity uses a different taxable year for Federal income tax purposes than the year of its owner, then the owner shall capitalize interest incurred by the entity with reference to the actual interest incurred by the entity (and the underlying debt) for each month of the entity's taxable year ending within or with the taxable year of the owner, and by capitalizing such interest only if it was incurred in a month in which the owner was producing qualified property (including a month occurring before the beginning of the owner's taxable year). Thus, assume that shareholder D, a calendar year individual, owns an interest in S, an S corporation with a fiscal year ending September 30. D is producing a building with a production period lasting throughout D's calendar year 1988. Moreover, D's production expenditures exceed its traced and avoided cost debt. S is not producing property to which the interest capitalization rules apply. Moreover, S has eligible debt and interest expense thereon for its fiscal year ended September 30, 1988. The interest incurred by S that is included in D's distributive share and capitalized by D for calendar year 1988 shall be based on the interest expense (and underlying debt) of S and the production expenditures of D for the same period of time, i.e., the 12-month period from October 1987 through September 1988. Thus, for example, if interest included in D's distributive share for the calendar year 1988 was incurred by S in October 1987, then D would capitalize such interest with respect to D's production expenditures (if any) outstanding in October 1987. Such interest would be capitalized for D's taxable year ending December 31, 1988. (As provided in section XII(E)(1) of this notice, owners generally would capitalize interest expense of flow-through entities only where the owners held the qualified property as of the end of the owner's taxable year. Section XII(E)(1) provides certain exceptions to that rule regarding sales or transfers of qualified property by an owner to a person related to the owner). Similarly, S's interest expense incurred in September 1988 (and the underlying debt) would be allocable to D's production expenditures outstanding in September 1988, and would be capitalized accordingly.

(F) DE MINIMIS RULES.

(1) ENTITIES ENGAGED IN PRODUCTION ACTIVITIES.

Pursuant to the grant of regulatory authority in section 263A(f)(2)(C) of the Code, forthcoming regulations will provide that owners of a flow-through entity shall not be subject to the avoided cost rules with respect to the production expenditures of the entity if (i) the owner owns (as defined in section XII(G)(1) of this notice) 20 percent or less of the entity during all of the owner's taxable year, and (ii) the owner's respective aggregate share (as defined in section XII(G)(2) of this notice) in the production expenditures of all qualified property being produced by the flow- through entity, during the production period of the property, reduced by the entity's traced and avoided cost debt allocable to such expenditures, is equal to or less than $250,000, calculated no less frequently than on a monthly basis. If, during any portion of the taxable year, either requirement of the preceding sentence is not met, then the owner shall, if otherwise required, capitalize interest incurred by the owner during the entity's production period of the property with respect to such owner's share of the property's accumulated production expenditures.

(2) OWNERS ENGAGED IN PRODUCTION ACTIVITIES.

Similarly, for taxable years of the owner beginning on or after January 1, 1988, interest expense of a flow-through entity shall not be required to be capitalized with respect to the production expenditures of an owner if (i) the owner owns (as defined in section XII(G)(1) of this notice) 20 percent or less of the entity during all of the owner's taxable year; and (ii) the aggregate amount of otherwise deductible interest expense included in the owner's distributive share (as defined in section XII(E)(2) of this notice) with respect to its ownership in the flow-through entity for the owner's taxable year is less than $25,000. If, during any portion of the owner's taxable year, either requirement of the preceding sentence is not met, then the owner shall, if otherwise required, capitalize interest of the flow-through entity included in the owner's distributable share and allocable to the owner's production expenditures.

(3) FLOW-THROUGH ENTITIES - RELATED PARTIES.

For purposes of section XII(F)(1) of this notice (i.e., to determine an owner's aggregate share in the production expenditures of qualified property produced by a flow-through entity), and section XII(F)(2) of this notice (i.e., to determine the amount of interest expense included in an owner's distributive share with respect to a flow-through entity), all flow-through entities that are related shall be considered as one flow-through entity. For purposes of the preceding sentence only, flow-through entities shall be considered to be related if such flow-through entities are described in section 267(b) or 707(b) of the Code.

Moreover, for purposes of sections XII(F)(1) and (F)(2) of this notice, an owner will be considered as owning all flow-through entities owned by persons related to the owner. For purposes of the preceding sentence only, an owner and another person will be related if they are described in section 267(b) or 707(b) of the Code.

(G) DETERMINATION OF OWNER'S SHARE.

(1) OWNERSHIP IN ENTITY.

Section XII(F)(1) of this notice provides, in part, that the interest capitalization rules of section 263A(f) of the Code shall not apply to the owner's interest expense with respect to the production expenditures of a flow-through entity if the owner owns 20 percent or less of the entity during all of the owner's taxable year. Similarly, section XII(F)(2) of this notice provides, in part, that the interest capitalization rules shall not apply to interest expense of a flow-through entity with respect to the production expenditures of the owner if the owner owns 20 percent or less of the entity during all of the owner's taxable year.

The following rules shall apply in determining the ownership of a flow-through entity for purposes of the 20 percent test described in the preceding paragraph.

The ownership of a partnership for purposes of this section shall be based upon the partner's interest in the capital of the partnership. A partner's interest in the capital of a partnership may, at the election of the partnership, be determined with reference to the adjusted tax basis of partnership property. If the partnership elects to determine its partners' interests in partnership capital with reference to the adjusted tax basis of partnership property, each partner's interest in partnership capital shall equal that partner's share of the adjusted basis of partnership property (within the meaning of section 1.743-1(b)(1) of the regulations), reduced by the partner's share of partnership liabilities.

Similarly, a shareholder's ownership of an S corporation for purposes of this section shall be based on the percentage of the issued and outstanding shares (including nonvoting shares) of the corporation owned by the shareholder.

(2) SHARE OF PRODUCTION EXPENDITURES.

Section XII(F)(l) of this notice provides, in part, that the interest capitalization rules of section 263A(f) of the Code shall not apply to the owner's interest expense with respect to the production expenditures of a flow-through entity if the owner's respective aggregate share in the production expenditures of all qualified property being produced by the flow-through entity, reduced by the entity's traced and avoided cost debt allocable to such expenditures, is equal to or less than $250,000 during all of the owner's taxable year. Similarly, the interest capitalization rules require owners to capitalize interest only with respect to the owner's share of the production expenditures of all qualified property during the entity's production period of the property.

The determination of the owner's share of the production expenditures of all qualified property may be based on the same criteria used in determining the ownership of a flow-through entity, as provided in section XII(G)(1), above. Thus, for example, a partner's share in the production expenditures of a partnership during the production period of qualified property could be based on the partner's share in the capital of the partnership during such production period.

However, a partnership may, if it chooses, use any other method of determining a partner's interest in production expenditures of the partnership if such method is reasonably based on the economic interest of the owner in the production expenditures of the partnership, and the partnership consistently applies the method chosen (both with respect to other qualified property produced by the partnership and to future years). With respect to an S corporation, the criteria used in determining the ownership of the flow-through entity, as provided in section XII(G)(l), shall apply for purposes of this section XII(G)(2).

In addition, for purposes of this section, a flow-through entity may generally assume that an owner's share in production expenditures of all qualified property during the entity's taxable year is equal to the owner's share of such production expenditures as of the end of such taxable year of the entity ending within or with the owner's taxable year. Notwithstanding the preceding sentence, if significant differences exist between the owner's share in the production expenditures during the production period of such property and the owner's share in the production expenditures as of the end of the entity's taxable year, the entity shall make reasonable allowances for such differences in determining the owner's share in the production expenditures of the entity.

XIII. EXAMPLES -- FLOW-THROUGH ENTITIES.

EXAMPLE (1). Assume that Partnership H, a calendar-year taxpayer, is producing qualified property to which the interest capitalization rules apply in 1987, and does not elect to use the substitute cost method. The production period of the qualified property being produced by H lasts throughout the entire taxable year. Moreover, the monthly average balance of accumulated production expenditures for the entire year is equal to $1,000,000. In addition, assume that the monthly average balance of H's traced and avoided cost debt for the entire year is equal to $400,000. Moreover, assume that H is owned by two calendar-year, accrual-method partners, P1 and P2, whose interests in H are identical. Assume further that P1 has eligible debt (as defined in section II of this notice) of $600,000 with an annual interest rate of 10 percent. P2 has eligible debt of $100,000 with an annual interest rate of 12 percent. In addition, the eligible debt of P1 and P2 is outstanding during the entire production period of the property. Based on these facts, P1 and P2 are required to capitalize interest on their proportionate share of H's remaining production expenditures (equal to $300,000 each), in the same manner as if they were producing the property themselves. Thus, P1 is required to capitalize interest equal to $30,000, i.e., interest for one year with respect to $300,000 of debt with an annual interest rate of 10 percent. P2 is required to capitalize interest equal to $12,000 i.e., interest for one year with respect to $100,000 of debt with an annual interest rate of 12 percent.

EXAMPLE (2). Assume the same facts as in Example (1), except that P1 and P2 each own 5 percent of H, and that the monthly average balance of the property's accumulated production expenditures (reduced by H's traced and avoided cost debt allocable to such production expenditures) is equal to $6 million for the entire year. P1 and P2 are required to capitalize interest on their share of the production expenditures of H, because P1 and P2's share in the production expenditures of H (reduced by H's traced and avoided cost debt allocable to such production expenditures) are each greater than $250,000.

EXAMPLE (3). Assume the same facts as in Example (1), except that H has substitute costs (composed of general and administrative expenses that are currently deductible) of $70,000, and H elects to use the substitute cost method. Furthermore, assume that the average Federal long-term rate for the production period of the property within the taxable year is equal to 10 percent. Under the substitute cost method, H shall capitalize its substitute costs up to an amount equal to the additional interest that would have been capitalized by H had H's eligible debt been equal to the average balance of its accumulated production expenditures during the production period for the taxable year. The amount of additional interest that would have been capitalized by H, as described in the preceding sentence, is determined by applying the average Federal long- term rate in effect during the production period within the taxable year (10 percent), to (ii) the average balance of H's accumulated production expenditures reduced by H's traced and avoided cost debt ($600,000). Thus, the annual rate of 10 percent is applied to production expenditures with a monthly average balance of $600,000 for the entire year. The resulting amount of $60,000 represents the substitute costs that H is required to capitalize under the substitute cost method. Neither P1 nor P2 is required to capitalize interest with respect to the production expenditures of H.

EXAMPLE (4). Assume the same facts as in Example (3), except that H has substitute costs of $50,000. H does not have substitute costs equal to, or greater than, the amount of additional interest that would have been capitalized had H's eligible debt been equal to the average balance of its accumulated production expenditures during the production period. Thus, P1 and P2 are required to capitalize interest on their eligible debt using the deferred asset method. The amount of H's remaining production expenditures subject to the deferred asset method is determined by dividing (i) $50,000 (the amount of H's substitute costs capitalized for the taxable year), by (ii) 10 percent (the average Federal long-term rate in effect for the period). The resulting amount of $500,000 is subtracted from H's remaining production expenditures of $600,000, and the difference of $100,000 is the amount of H's production expenditures subject to the deferred asset method. Thus, P1 and P2 are each required to capitalize interest on their share of the production expenditures of H after application of the substitute cost method ($50,000 of production expenditures for each partner). In addition, H is required to capitalize $50,000 of its substitute costs.

EXAMPLE (5). Assume that Partnership I, a calendar-year accrual-basis taxpayer, is not engaged in the production of qualified property. I has eligible debt, outstanding during all of 1988, of $1,000,000 with an annual interest rate of 10 percent. In addition, assume that I is owned by two calendar- year partners, P3 and P4, whose interests in I are identical. Moreover, assume that P3 is producing qualified property in 1988. P3's monthly average balance of accumulated production expenditures for the entire year of 1988 exceeds its total monthly average balance of traced and avoided cost debt for such year by $400,000. In addition, assume that P4 is not directly producing qualified property, but that P4 owns 25 percent of J, a calendar-year S corporation that is producing qualified property in 1988 and that does not elect to use the substitute cost method. Moreover, assume that J's monthly average balance of accumulated production expenditures for the entire year of 1988 exceeds its total monthly average balance of traced and avoided cost debt by $1,200,000 for such year and that P4's share in such excess production expenditures is $300,000.

P3 and P4 are each treated as incurring interest of $50,000 (with underlying eligible debt of $500,000) from partnership I for purposes of the interest capitalization rules. Thus, P3 is required to allocate $400,000 of I's eligible debt to P3's excess production expenditures and to capitalize $40,000 of interest on that debt to such production expenditures for P3's 1988 taxable year. (Thus, P3 must capitalize $40,000 of the interest contained in P3's distributive share of partnership items from I.) Similarly, P4 is required to allocate $300,000 of I's eligible debt to P4's share of the excess production expenditures of J for P4's 1988 tax year. (Thus, P4 must capitalize $30,000 of the interest contained in P4's distributive share of partnership items from I.)

EXAMPLE (6). Assume the same facts as in Example (3), except that the taxable year in issue is 1987. Neither P3 nor P4 is required to capitalize interest with respect to the eligible debt of I, because the rules attributing interest expense (and the underlying debt) of a flow-through entity to its owners for purposes of the interest capitalization rules are not effective for taxable years of the owner beginning before January 1, 1988.

XIV. FILING OF AMENDED RETURNS.

Any change in method of accounting to comply with the interest capitalization requirements of section 263A(f) is an automatic change in method to be made in accordance with the effective date provisions of sections 263A and 460 of the Code. Any amended return filed by a taxpayer with respect to a taxable year ending on or after the date that section 263A or 460 is applicable to such taxpayer for the purpose of changing the taxpayer's method of accounting to comply with the provisions of this notice must be filed on or before June 15, 1989.

PROCEDURAL INFORMATION

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

FOR FURTHER INFORMATION

For further information regarding this notice, please contact Katherine Wambsgans at (202) 566-3288, Paulette Galanko at (202) 566- 3288, or Carol Conjura at (202) 566-3024 (not a toll-free call).