Interest Capitalization Issues under Sec. 263A(f)

For tax years 19941997, T computed capitalized interest under the Sec. 263A(f) (UNICAP) rules using the tax year as its computation period, with monthly measurement dates. For 1998, T switched to quarterly measurement dates without first obtaining the IRSs consent. Also, during an examination of 1997 and 1998, T sought to recalculate its capitalized interest for 1997 using quarterly measurement dates.

T capitalized interest expense for the construction of a new headquarters during 1997 and 1998. It determined its accumulated production expenditures (APEs) at each monthly measurement date by totaling the costs of the headquarters project incurred through the measurement date and subtracting 33% of such costs to reflect the costs of Sec. 1245 property, which T argues should be excluded from its APEs.

Measurement Dates

The first issue is whether the measurement dates used in the calculation of capitalized interest is an accounting method subject to Secs. 446 and 481. Under Regs. Sec. 1.263A-9(f)(2), T can modify its choice of measurement dates from one tax year to another; any such change is not a change in accounting method to which Secs. 446 and 481 apply. T is thus not required to seek IRS consent before changing its measurement dates from year to year.

However, once T chooses its measurement dates and files its return on that basis for a tax year, the doctrine of election generally prohibits it from subsequently altering its choice of measurement dates. The doctrine of election, as it applies to Federal tax law, consists of two elements: (1) a free choice between two or more alternatives and (2) an overt act by which a taxpayer communicates the choice to the IRS. A taxpayer who makes such an election may not, without the IRSs consent, retroactively revoke or amend it merely because another alternative appears to be more advantageous (Pacific National Co., 304 U.S. 191 (1938)).

In this case, T had a free choice of measurement dates for each tax year, and it communicated its choices to the IRS by means of its filed returns. Absent some special circumstances (which do not appear in the facts submitted), T is bound by its choices of measurement dates, and cannot modify them after they are made.

Real vs. Tangible Personal Property

The examiner argues that certain costs identified by T as Sec. 1245 property were real property for Sec. 263A(f) purposes and should not have been excluded from the calculation of APEs for the headquarters buildings. Thus, the second issue is whether an item classified as tangible personal property for Sec. 1245 purposes can constitute real property under Regs. Sec. 1.263A-8(c).

Under Regs. Sec. 1.263A-8(c)(1), real property includes land, unsevered natural products of land, buildings and inherently permanent structures. It further includes the structural components of buildings and inherently permanent structures (e.g., walls, partitions, doors, wiring, plumbing, central air conditioning and heating systems, pipes and ducts, elevators, escalators and other similar property).

Regs. Sec. 1.263A-8(c)(3) defines inherently permanent structures for purposes of the UNICAP rules, under which property might be an inherently permanent structure even if it is not classified as a building for purposes of former Sec. 48(a)(1)(B) and Regs. Sec. 1.48-1. Any property not otherwise described in Regs. Sec. 1.263A-8(c)(3) that constitutes other tangible property under the principles of former Sec. 48(a)(1)(B) and Regs. Sec. 1.48-1(d) is treated for Regs. Sec. 1.263A-8 purposes as an inherently permanent structure.

Sec. 263A(f)s legislative history contains nothing to indicate that Congress intended to apply the broad construction of tangible personal property under the investment tax credit (ITC) to the UNICAP rules. Accordingly, property classification as tangible personal property for purposes of former Sec. 48 should not determine the propertys classification for Sec. 263A(f) purposes. Thus, for example, the fact that electrical lines within a building might be classified (in whole or part) as tangible personal property for Sec. 1245 purposes does not determine whether they are tangible personal property or real property for Sec. 263A(f) interest capitalization purposes.

As a further example, the principle that local law property classification is irrelevant to property classification for ITC and Sec. 1245 purposes does not apply to Sec. 263A(f) property classification. In the absence of any applicable legislative direction to ignore the status of property under local law in the context of Sec. 263A(f), the local law characterization of property can be relevant in the classification of property as either tangible personal property or real property for Sec. 263A(f) purposes.

In the absence of a controlling test, property that does not qualify as a structural component under the ITC scheme because it does not relate to the operation or maintenance of a building, may be a structural component of the building, and thus real property under Regs. Sec. 1.263A-8(c), if it otherwise possesses sufficient indicia of being a structural component under that regulation (such as being permanently attached and qualifying as a fixture under local law). For example, electrical wiring in a building could qualify as a structural component under Regs. Sec. 1.263A-8(c), regardless of its ultimate use.

APEs

T based its APE calculation on an account that contains many different types of costs for the headquarters project, some of which are APEs. On project completion, T determined that x% of the total costs in that account were APEs. It then determined the APEs on each measurement date by multiplying the balance of the account on that date by x%.

The foregoing is not a proper method for determining the APEs on the various measurement dates of the project, because it would yield a correct result only in the rare circumstance in which the percentage of account costs included in the APEs remained perfectly constant from the beginning of the project to the end. Typically, the percentages of account costs included in APEs on the various measurement dates will vary, and will differ from the percentage of the total account costs included in APEs at the end of the project. Accordingly, the method does not provide an acceptable means for determining (or even estimating) the APEs on the various measurement dates.

Finally, T probably understates APEs as applied to this particular project. The percentage of account costs included in APEs would be relatively high in the beginning of the project, when most of the costs in the account would relate to land and the construction of the building. The percentage would gradually fall as the project reached completion and more costs for tangible personal property (such as furniture) were added to the account. The percentage would reach its lowest point at the end of the project. Under this scenario, the method used by T understates the APEs on the various measurement dates, because the final (and lowest) percentage of account costs allocable to APEs is projected back to all of the measurement dates over the projects life.

IRS Letter Ruling (TAM) 200252059 (12/26/02)