January 27, 2004
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, D.C. 20044
Re: Notice 2003–36 on Eligible Property and the Simplified Service Cost Method
Dear Sir or Madam:
The American Institute of Certified Public Accountants (AICPA) respectfully offers the enclosed comments, pursuant to the request in Notice 2003–36, 2003–1 C.B. 992, on the simplified service cost method in general and, specifically, the qualifications of eligible property under reg. sections 1.263A–1(h)(2)(i)(D) and –2(b)(2)(i)(D). The AICPA is the largest professional association of certified public accountants in the United States, with more than 350,000 members in business, industry, public practice, government, and education.
The enclosed comments were developed by members of our Tax Accounting Technical Resource Panel and approved by the Tax Executive Committee. We would be pleased to discuss these comments with you or a member of your staff at any time. If you have any questions, please contact either Barry Tovig, Chair of the Tax Accounting Technical Resource Panel, at (202) 327–8821; or George White, AICPA Technical Manager, at (202) 434–9268.
Robert A. Zarzar
Chair, Tax Executive Committee
cc: Helen M. Hubbard, Tax Legislative Counsel
Sharon Kay, Tax Specialist
Robert M. Brown, Associate Chief Counsel (IT&A)
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
Comments on the Proposed Guidance
Eligible Property and the Simplified Service Cost Method
January 27, 2004
Developed by the
Notice 2003–36 Task Force
Robert Kilinskis, Chair
George White, AICPA Technical Manager
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
Comments on the Proposed Guidance for
Eligible Property and the Simplified Service Cost Method
This submission responds to Notice 2003–36, 1 which requested comments on the simplified service cost method in general and on issues relating to qualifications of eligible property under reg. sections 1.263A–1(h)(2)(i)(D) and –2(b)(2)(i)(D). Notice 2003–36 also requested comments on the ability of small business taxpayers to use the simplified service cost method under an assumption that small business taxpayers might not have costs separated into departments or functions. In response to that request, this submission was prepared by a task force of the Tax Accounting Technical Resource Panel and approved by the Tax Executive Committee.
The AICPA has supported the use of simplified methods, including the use of the simplified service cost method, to reduce administrative burdens posed by section 263A. The AICPA believes that any change in the simplified service cost method or restrictions placed on its use, such as introducing qualifications for eligible property, will reverse achievements in simplification under section 263A. Therefore, the AICPA recommends that the simplified service cost method remain available to all taxpayers in furtherance of the underlying simplification purpose and that any future guidance avoid restricting taxpayers' use of the simplified service cost method and simplified production method.
A. The Simplified Service Cost Method
The simplified service cost method provides a simplified method for determining capitalizable mixed service costs incurred during the taxable year with respect to eligible property. 2 Once elected by a taxpayer for any trade or business, the simplified service cost method applies to all production and resale activities of that trade or business associated with four categories of eligible property: (i) inventory property, (ii) non-inventory property held for sale, (iii) self-constructed assets substantially identical to and produced in the same manner as the taxpayer's inventory property or non-inventory property held for sale, and (iv) self-constructed assets produced on a routine and repetitive basis. 3 A taxpayer computes capitalizable mixed service costs under this simplified method by multiplying total mixed service costs (i.e., the total costs incurred by all departments or functions that perform mixed service activities) by an allocation ratio (reflecting either the total labor costs allocable to property produced or acquired for resale over total labor costs of the trade or business or the total production costs allocable to property produced or acquired for resale over total costs of the trade or business). 4 The product of that calculation represents the taxpayer's capitalizable mixed service costs.
The simplified service cost method offers taxpayers an alternative to the rigors of establishing factors or relationships between mixed service costs and production or resale activities as required by other permissible allocation methods under the regulations. In that regard, the simplified service cost method responds to the Congressional directive to "adopt other simplifying methods and assumptions where, in the judgment of the Secretary of the Treasury, the costs and other burdens of literal compliance may outweigh the benefits." 5
1. Use by Small Business Taxpayers
Small business taxpayers benefit from simplified methods that alleviate the costs and burdens of complying with the complexities of section 263A. Small business taxpayers subject to section 263A often lack sophisticated accounting systems and encounter practical difficulties in identifying and allocating costs to production and resale activities as envisioned under that Code section. The administrative effort required to account for costs and activities in accordance with the provisions of section 263A necessitates use of simplified methods to make compliance by small business taxpayers feasible. In particular, the simplified methods in the regulations, such as the simplified service cost method, better enable small business taxpayers to satisfy the capitalization objectives of section 263A without undue administrative hardship.
The simplified service cost method, which determines mixed service costs allocable to production and resale activities, is well suited for small business taxpayers. This simplified method allows a taxpayer to reasonably allocate certain indirect costs to production, resale, and other activities of the taxpayer associated with those costs, even though specific relationships between a cost and activity are not readily determinable. In a small business, one employee is likely to actively participate in many or all aspects of business operations, such as an owner/employee involved with purchasing, marketing, personnel, and other activities as needs arise. Because individual employees of a small business taxpayer likely perform numerous activities that cross-benefit production, resale, and mixed service functions, that taxpayer is less likely to have records to substantiate detailed allocations. The simplified service cost method provides an administrable means for allocating such costs to the various activities.
The application of the simplified service cost method to mixed service costs of a small business taxpayer reflects the longstanding practice of the Internal Revenue Service (the "Service") to allow those taxpayers to change to that simplified method. The Service has consistently allowed small business taxpayers to change to a method whereby they classify the costs associated with the business into three categories: those that are fully capitalizable, those that are fully deductible, and those that are partially capitalizable and partially deductible (total mixed service costs). The taxpayer then applies either the labor based or the production cost allocation ratio to the total mixed service costs to determine the capitalizable portion of the mixed service costs. The Service's consent to these changes reflects the understanding of both the Service and small business taxpayers that small business taxpayers qualify to use the simplified service cost method. The lack of identifiable departments or functions that perform mixed service activities within a small business should not preclude use of the simplified service cost method.
Members of the Technical Resource Panel took informal surveys of practitioners who provide service to small business clients, including tax compliance and tax consulting services. The practitioners responded that an overwhelming majority of their clients that are subject to section 263A use the simplified service cost method. In addition, the respondents stated that the accounting software packages generally used by small business taxpayers provide the detail necessary for the simplified service cost method. Contrary to the assumption in Notice 2003–36, small business taxpayers can, and do, use the simplified service cost method.
The AICPA believes that no changes are needed for small business taxpayers to be able to use the simplified service cost method.
2. Other Taxpayers and the Service
Other taxpayers and the Service benefit from the simplification reflected in the simplified service cost method. The effective administration of the uniform capitalization requirements of section 263A is enhanced by the use of simplified methods. Facts-and-circumstances based allocation methods can be more time consuming and costly for taxpayers to perform and more difficult for the Service to examine. The simplified service cost method provides a reasonable and verifiable means for allocating costs that benefit multiple activities.
Attempts to change or restrict the simplified service cost method would reverse achievements in simplification under section 263A. The method currently applies to all production and resale activities associated with eligible property. Limitations on the method would introduce unnecessary complexity into the allocation process. In particular, the introduction of more factual inquiries or computational variations to the application of the simplified service cost method will sacrifice the overall simplicity of the method.
The simplified service cost method, like all simplified methods, provides needed simplification in the administration of the tax laws. The simplified service cost method was originally provided as a mechanism to reduce the costs and burdens of complying with the capitalization requirements of section 263A. The capitalization requirements have not changed with respect to mixed service costs, and the simplified service cost method continues to advance the purpose of simplifying compliance under section 263A. Therefore, the AICPA recommends retaining the simplified service cost method in its current form and avoiding the issuance of guidance that might inadvertently restrict its use.
B. Eligible Property Under Reg. Sections 1.263A–1(h)(2)(i)(D) and—2(b)(2)(i)(D)
One category of eligible property under both the simplified service cost method and the simplified production method is "[s]elf constructed assets produced by the taxpayer on a routine and repetitive basis in the ordinary course of the taxpayer's trade or business." 6 The regulations themselves do not elaborate on or provide examples of the types of property that are described by this category. Notice 2003–36, however, noted uncertainty about the interpretation and application of "routine and repetitive" and requested comments relating to the qualifications of property included in that category.
Self-constructed assets were added to eligible property under both the simplified service cost method and the simplified production method in response to commentators' requests. The temporary regulations originally had limited those simplified methods to the production of inventory property and non-inventory property held for sale. 7 Numerous commentators recommended making these simplified procedures available to other production activities conducted in a trade or business. 8 In particular, commentators noted that taxpayers with significant production of self-constructed assets encounter the same accounting difficulties in allocating costs as taxpayers with inventory production 9 and a broader class of eligible property would provide administrative relief to more taxpayers. 10 Moreover, commentators anticipated that taxpayers engaged in the production of both inventory and self-constructed assets would be discouraged from using a simplified method for inventory if different allocation calculations were required for self-constructed assets. 11
In response to these recommendations, Notice 88–86 12 announced that final regulations would expand the categories of eligible property for each simplified method to include self-constructed assets produced on a routine and repetitive basis. The temporary regulations had limited property eligible for the simplified production method to inventory because that simplified method was "not appropriate for use in accounting for casual or occasional production of property, i.e., property which is not produced on a repetitive and routine basis." 13 The final regulations expanded the categories of eligible property for both the simplified production method and the simplified service cost method to include self-constructed assets produced on a routine and repetitive basis. 14
Like the other categories of eligible property in the final regulations, the category of self-constructed assets produced on a routine and repetitive basis focuses on the production activities of the taxpayer rather than inherent characteristics of the property produced. For example, property includible in the inventory of a taxpayer is a category of eligible property 15 based on the taxpayer's intention to sell the property irrespective of the nature of the property. A self-constructed asset, even an asset constructed once in a trade or business, likewise qualifies as eligible property as long as a taxpayer has routine and repetitive production activities throughout the year. This emphasis on production activities rather than quantity of assets produced is apparent in the final regulations from its omission of a reference to quantity such as that in Notice 88–86. The Notice had described self-constructed assets produced on a routine and repetitive basis with the following parenthetical: "( i.e., the taxpayer produces numerous items of such property within a taxable year)." 16 The omission of such reference in the final regulations suggests that the shared characteristics of eligible property reflects the particular activities of a taxpayer not the number of property items of that taxpayer.
The common understanding of "routine and repetitive" reinforces the notion that the category of eligible property is determined by a taxpayer's production activities. The American Heritage Dictionary defines "routine" as: "In accord with established procedure" and "Habitual; regular." 17 That dictionary defines "repetitive" as "[g]iven to or characterized by repetition" and defines "repetition" as "[t]he act or process or an instance of repeating or being repeated." 18 Because these meanings are more descriptive of activities than property, "routine and repetitive" reflects the unique nature of each taxpayer's production activities. In particular, the established, regular, or ordinary nature of production as well as its repetition is determinable from a taxpayer's specific facts and circumstances.
The importance of considering individual production activities of a taxpayer is apparent from comparing situations in which taxpayers produce self-constructed assets. For example, a manufacturer might take two or three days a month to build dies for use in a manufacturing process. The conclusion in this situation that die production is routine and repetitive would be based on the fact that the manufacturer undertakes production activities for a total of twenty-four to thirty-six days a year. Construction of a network for use in a taxpayer's business would also be routine and repetitive when the taxpayer continuously constructs the network over a two-to-three year period. The conclusion that network construction is routine and repetitive would be based on the fact that the taxpayer undertakes production on an almost daily basis. A taxpayer can produce various items, including large assets, on a routine and repetitive basis by having employees engage in production activities at various times throughout a year. The production activities occur on a routine and repetitive basis as appropriate for the business in each example. However, it is not possible to articulate qualifications that would apply consistently to the self-constructed asset in each example. Therefore, the AICPA believes no guidance is necessary to interpret and apply "routine and repetitive."
Although the AICPA believes it is not possible to provide qualifications applicable to all taxpayers, the AICPA recommends that self-constructed assets produced on a routine and repetitive basis remain eligible property for purposes of applying the simplified service cost method and simplified production method. The underlying reasons for including self-constructed assets in eligible property have not changed; i.e., the inclusion of self-constructed assets enhances simplification efforts under section 263A, provides more taxpayers with access to simplified methods, and avoids the complexity of performing separate calculations for inventory and other assets produced in the same trade or business. Moreover, the avoidance of different capitalization rules for different types of production activities makes the tax system more neutral and fair. 19
Having the simplified methods apply to self-constructed assets also avoids difficult situations in which information does not exist to allocate costs with facts-and-circumstances based methods. Facts-and-circumstances based allocation methods require taxpayers to compile annual employee surveys or other information to identify personnel time or another factor associated with various activities, including production, resale, and other activities of a trade or business. Because the production of self-constructed assets is not an income-producing activity in and of itself, not all taxpayers have the kinds of records needed to apply facts-and-circumstances based allocation methods to the production of those assets. Accordingly, the simplified methods, which allocate costs based on computed values rather than generated records, are particularly useful with respect to the production of self-constructed assets.
It is also worth noting that, with respect to the simplified service cost method, there is nothing intuitively distortive about allocating mixed service costs to the production of self-constructed assets based on relative labor costs or relative production costs. The authorization to use these alternative allocation bases for the production of inventory implies that they are reasonable. It is not apparent why those allocation bases are not equally reasonable with respect to the production of self-constructed assets, irrespective of whether such production occurs on a routine and repetitive basis. Thus, the AICPA recommends retaining self-constructed assets produced on a routine and repetitive basis as a category of eligible property for the simplified service cost method as well as the simplified production method.
The AICPA also recommends that the Treasury Department and Internal Revenue Service avoid issuing any guidance on "routine and repetitive" because such guidance might inadvertently restrict the use of the simplified service cost method and simplified production method. Notice 2003–36 indicates that guidance might clarify the interpretation and application of "routine and repetitive." As discussed above, it does not appear possible to provide consistent guidance with respect to all taxpayers' production activities. Any rules or standards are unlikely to reflect the common meaning of "routine and repetitive" and thereby would change, not clarify, the application of those simplified methods. Due to the large number of taxpayers that have been required to apply these simplified methods to self-constructed assets produced on a routine and repetitive basis, 20 a change in the application of those simplified methods would have a dramatic impact. Therefore, any clarification might serve to restrict the types of property that qualify as eligible property, which would reverse simplification achievements under section 263A and represent a change in those simplified methods of accounting.
1. 2003–1 C.B. 992, modified by Notice 2003–9, 2003-35 I.R.B. 429.
2. Reg. section 1.263A–1(h)(1).
3. See id. reg. section 1.263A–1(h)(2)(i).
4. See id. reg. section 1.263A–1(h)(3).
5. S. Rep. No. 99-313, at 142 (1986); see also Staff of Joint Comm. on Taxation, 100th Cong., General Explanation of the Tax Reform Act of 1986 at 510 (1987).
6. Reg. sections 1.263A–1(h)(2)(i)(D);–2(b)(2)(i)(D).
7. See Temp. reg. sections 1.263A–1T(b)(6)(ii); –1T(b)(5)(i).
8. See, e.g., Tax Executives Inst., Inc., Comments of Tax Executive Institute, Inc. on Temporary and Proposed Regulations Under Section 263A of the Internal Revenue Code of 1986 (1987), reprinted in TEI Comments on Inventory Capitalization Regulations, 87 Tax Notes Today 138–20.
9. See, e.g., American Inst. of Certified Pub. Accountants, American Institute of Certified Public Accountants Comments on Proposed and Temporary Regulations Relating to Uniform Capitalization Provisions (1987), reprinted in AICPA Argues That Capitalization of Depletion is Inappropriate, 87 Tax Notes Today 148–46.
10. See, e.g., Letter from David R. Burton, Manager, Tax Policy Center, U.S. Chamber of Commerce, to Commissioner, Internal Revenue Service (May 29, 1987), reprinted in U.S. Chamber of Commerce Suggests Broader Applicability of Simplified Resale and Simplified Service Cost Methods, 87 Tax Notes Today 130–39.
11. See, e.g., Letter from Peggy Duxbury, Director of Taxation, National Association of Manufacturers, to Commissioner, Internal Revenue Service (May 29, 1987), reprinted in National Association of Manufacturers Suggests Simplifications, Exemptions from Uniform Capitalization Rules, 87 Tax Notes Today 130-27.
12. 1988–2 C.B. 401.
14. T.D. 8482, 1993-2 C.B. 77.
15. See reg. sections 1.263A–1(h)(2)(i)(A);–2(b)(2)(i)(A).
16. Notice 88-86, 1988–2 C.B. 401, 402.
17. The American Heritage Dictionary of the English Language 1518 (4th ed. 2000).
19. President's Tax Proposals to Congress for Fairness, Simplicity, and Growth 202 (1985) ("Different rules regarding which production expenses must be capitalized apply to different types of activities. Long-term contracts, self-constructed assets, and inventories all have different capitalization rules. Replacement of the several different income tax accounting rules by uniform rules would make the income tax system more neutral and fairer.")
20. See reg. sections 1.263A–1(h)(2)(i);–2(b)(2)(i).