Td 8584

Search - 42 Results - td 8584

Page 1 of 70

1995-1 C.B. 20; T.D. 8584;
1995 IRB LEXIS 1822, *
DEPARTMENT OF THE TREASURY
Treasury Decision 8584
Capitalization of Interest
1995-1 C.B. 20; T.D. 8584; 1995 IRB LEXIS 1822
January 1995
[*1]
SUBJECT MATTER: Section 263A.-Capitalization and Inclusion in Inventory Costs of Certain
Expenses
APPLICABLE SECTIONS:
26 CFR 1.263A-0: Outline of regulations under section 263A. Internal Revenue Service 26 CFR Parts
1 and 602
TEXT:
AGENCY:
Internal Revenue Service (IRS), Treasury.
ACTION:
Final regulations.
SUMMARY:
This document contains final regulations relating to the requirement to capitalize interest with
respect to the production of property. The regulations provide guidance necessary for taxpayers to
comply with the requirement to capitalize interest with respect to certain produced property.
EFFECTIVE DATE:
January 1, 1995.
SUPPLEMENTAL INFORMATION:
Paperwork Reduction Act
The collections of information contained in these final regulations have been reviewed and approved
by the Office of Management and Budget in accordance with the Paperwork Reduction Act (44 U.S.C.
3504 (h)) under control number 1545-1265. The estimated average annual burden per recordkeeper
is 14 minutes. The estimated average annual reporting burden per respondent is 2 hours.

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 2 of 70

Comments concerning the accuracy of this burden estimate and suggestions for reducing this
burden should be sent to the Internal Revenue Service, Attn: IRS Reports Clearance Officer
PC:FP, [*2] Washington DC 20224, and to the Office of Management and Budget, Attn: Desk
Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington
DC 20503.
Background
On Friday, August 16, 1991, the Federal Register published proposed amendments (56 FR 40815
[IA-120-86, 1991-2 C.B. 999]) to the Income Tax Regulations (26 CFR part 1) under section 263A
(f) of the Internal Revenue Code (Code). Written comments responding to the notice were received
and a public hearing was held on November 20, 1991. After careful consideration of all the
comments, the proposed amendments are adopted, except as revised and renumbered by this
document.
IN GENERAL
The uniform capitalization rules of section 263A generally require the capitalization of certain costs
relating to the acquisition of property for resale or the production of property. Interest is a cost
subject to section 263A. Section 263A (f) provides special rules for capitalizing interest.
In general, section 263A (f) limits the capitalization of interest to interest that is paid or incurred
during the production period of certain property (referred to as designated property). Designated
property includes all real [*3] property and certain tangible personal property.
The amount of interest required to be capitalized is determined using the avoided cost method.
Under the avoided cost method, interest on any indebtedness directly attributable to production
expenditures for designated property (traced debt) is capitalized first. If production expenditures for
designated property exceed the amount of traced debt, interest on any other debt is capitalized to
the extent such interest could have been reduced if production expenditures had not been incurred.
The application of the avoided cost method does not depend on whether the taxpayer actually would
have used amounts expended for production to repay or reduce debt. Instead, the avoided cost
method is based on the assumption that if production expenditures had not been incurred, debt of
the taxpayer would have been repaid or reduced without regard to the taxpayer's subjective
intentions or to restrictions against repayment or use of the debt proceeds.
For example, if Corporation X has incurred $1.5 million of production expenditures for a unit of real
property it is constructing, and has an outstanding $1 million loan (from an unrelated party) for the
[*4] construction of the real property, Corporation X must capitalize interest on the loan as
provided in section 263A (f). In addition, because Corporation X has production expenditures ($1.5
million) that exceed traced debt ($1 million), Corporation X must capitalize interest on any other
debt (subject to certain limitations) as provided in section 263A (f). In general, to determine the
amount of interest it must capitalize on its other debt, Corporation X multiplies its excess production
expenditures ($.5 million) by a weighted average interest rate for its other debt.
Public Comments
SIMPLIFICATION
The proposed regulations include several provisions designed to reduce administrative complexity
without undermining the principles of section 263A (f). These provisions include (1) a de minimis
rule exempting certain insignificant production activities from the requirement to capitalize interest;
(2) an exception from the requirement to capitalize interest for inventory property that has a class
life of 20 years or more but does not satisfy the other classification thresholds for tangible personal

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 3 of 70

property; (3) an election not to trace debt to designated property; (4) an election to calculate [*5]
interest under the avoided cost method on a taxable year basis in lieu of a monthly or more frequent
basis; and (5) a simplified method to calculate the amount of interest required to be capitalized with
respect to certain inventory property.
Commentators made several suggestions for further simplifying the proposed rules. As discussed in
more detail below, the final regulations add a number of these simplifying suggestions. For example,
the final regulations permit certain small taxpayers to use a specified external rate as a substitute
for the weighted average interest rate. In addition, the final rules make the 3-month, $10,000 de
minimis rule of the proposed regulations more flexible by increasing the dollar threshold for
production expenditures to $1 million divided by the number of days in the production period.
Further, the final regulations shorten the time required to qualify for the suspension rule from 12
months to 120 consecutive days and apply the suspension rule retroactively.
DESIGNATED PROPERTY

In general
Designated property includes all real property produced by the taxpayer. Tangible personal property
produced by the taxpayer is also designated property, but only if it [*6] has a class life of 20
years or more, an estimated production period of more than 1 year and total production costs of
more than $1 million, or an estimated production period of more than 2 years.
De minimis exception
The proposed regulations provide a de minimis exception from interest capitalization for property
that would otherwise be designated property. This exception applies if the property has a production
period that does not exceed 3 months and a total cost of production that does not exceed $10,000.
Commentators recommended a number of changes to this de minimis rule. Several commentators
argued that the proposed de minimis rule should be liberalized by either applying the production
period and cost thresholds in the disjunctive or increasing the thresholds. One commentator
recommended that, in addition to a de minimis rule for property, the final regulations should provide
a "small taxpayer" exception.
The final regulations revise the 3 month, $10,000 de minimis rule. The revised rule liberalizes the de
minimis rule and provides more flexibility in its application by adopting a dollarday rule. As revised
the de minimis rule excepts from interest capitalization property with [*7] a production period of
not more than 90 days and a total cost of production that does not exceed $1,000,000 divided by
the number of days in the production period. The final regulations, however, do not adopt a small
taxpayer exception.
Commentators also recommended that interest that would be capitalized if property were
designated property be excluded from production costs in determining whether the $10,000
threshold of the proposed de minimis rule is met. The final regulations adopt this recommendation
for purposes of determining production expenditures under the revised de minimis rule.
Definition of real property
The proposed regulations provide that real property includes land, unsevered natural products of
land, buildings, and inherently permanent structures. An inherently permanent structure is property
that is affixed to real property and that will ordinarily remain affixed for an indefinite period of time.
Certain commentators believed that the proposed definition of real property is too broad. They
argued that the section 263A (f) regulations should define real property to exclude property

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 4 of 70

classified as section 1245 property, as well as property classified or treated as personal [*8]
property for investment tax credit purposes (former section 48).
Neither section 263A (f) nor its legislative history expressly defines "real property." Nevertheless,
the IRS and Treasury do not believe it is necessary or appropriate to define "real property" as
narrowly as some commentators have suggested.
Section 1245 provides for the recapture of the benefit of accelerated depreciation on, or
amortization with respect to, certain property. Congress clearly intended to classify certain real
property as property subject to the section 1245 rules. See section 1245 (a) (3) (B) and (C).
Nothing in either section 263A (f) or its legislative history (or in section 189, the predecessor of
section 263A (f), and its legislative history) suggests Congress intended to exclude real property
subject to section 1245 from the definition of real property for purposes of interest capitalization.
See S. Rep. No. 169, 98th Cong., 2d Sess. 1-280 n. 19 (1984).
Congress intended that the benefit of the investment tax credit apply expansively under former
section 48. See H. Rep. No. 1447, 87th Cong., 2d Sess. (1962) 1962-3 C.B. 405, 415. Consistent
with this intent, tangible personal property was not to be [*9] defined narrowly and was not to
follow state law. Id. Nothing in the legislative history of section 263A (f) suggests, however, that
Congress intended that such a broad definition of personal property be adopted for interest
capitalization purposes.
Some commentators interpreted certain language in proposed § 1.263A (f)-1 (relating to the
classification of property for purposes of former section 48 and § 1.48-1 (c) and § 1.48-1 (d)) to
provide that property that would otherwise be an inherently permanent structure under section
263A (f) (i.e., because it is affixed to real property and will ordinarily remain affixed for an indefinite
period of time) is not an inherently permanent structure under section 263A (f) if such property
would constitute property in the nature of machinery under the principles of former section 48 and §
1.48-1 (c).
As indicated above, however, the IRS and Treasury do not believe that the classification or
treatment of property as personal property for purposes of former section 48 should be
determinative of the classification of property as personal property for purposes of section 263A (f).
Accordingly, the final regulations provide that a structure may be an [*10] inherently permanent
structure, and not property in the nature of machinery or essentially an item of machinery, even if
the structure is necessary to operate or use, supports, or is otherwise associated with machinery.
Classification thresholds for personal property
Under the proposed regulations, designated property includes tangible personal property that is (i)
property with a class life of 20 years or more, but only if produced for self-use, (ii) property with an
estimated production period exceeding 2 years (2-year property), or (iii) property with an estimated
production period exceeding 1 year and a cost exceeding $1 million (1-year property).
Commentators made recommendations regarding the $1 million cost threshold for 1-year property
and the production period thresholds for 1-year and 2-year property produced under a contract.
One commentator recommended the final regulations clarify whether interest that would be required
to be capitalized if property were designated property is taken into account in determining whether
the production costs for property exceed the $1 million production costs threshold. The final
regulations clarify that such interest is not taken into account [*11] in determining whether
property is designated property.
Classification thresholds for personal property produced under a contract
In the case of tangible personal property produced under a contract, the proposed regulations
require the contractor and the customer each to determine whether the 1-year and 2-year
production period thresholds are satisfied. For this purpose, the proposed regulations require the

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 5 of 70

customer to treat the production period as beginning on the earlier of the date the contract is
executed or the date the customer's accumulated production expenditures are at least 5 percent of
the customer's total estimated production expenditures (contract date rule). One commentator
recommended that a customer be allowed to elect to use the contract date rule, and in the absence
of an election, treat the production period as beginning when the customer's accumulated
production expenditures are at least 5 percent of the total estimated production expenditures.
The final regulations retain the contract date rule. However, to address commentators' concerns, the
final regulations provide that a customer may elect to determine the 1-and 2-year production period
thresholds by treating [*12] the customer's production period as beginning on the date that
aggregate accumulated production expenditures for both the contractor and the customer are at
least 5 percent of the customer's estimated production expenditures for the property. The IRS and
Treasury believe that a 5-percent rule based only on production expenditures incurred by a
customer could be abused (e.g. a customer could avoid designated property classification and, thus,
interest capitalization by simply withholding payments to the contractor).
Definition of a contract
Section 263A (g) (2) provides that the taxpayer shall be treated as producing any property produced
for the taxpayer under a contract with the taxpayer. The final regulations under section 263A
(relating to the capitalization of costs other than interest) published in the Federal Register on
August 9, 1993, reserved the definition of a contract for this purpose.
The preamble to those regulations stated that the definition of a contract was being studied under
the section 263A (f) regulations. Commentators believed that the definition of a contract provided in
the proposed regulations under section 263A (f) should be modified, for example, to exclude
[*13] routine purchase orders.
For purposes of determining whether property is produced under a contract, the final regulations
define a contract as any agreement providing for the production of property if the agreement is
entered into before the production of the property to be delivered under the contract is completed.
Whether an agreement exists depends on all the facts and circumstances. Facts and circumstances
to be taken into account include making a prepayment, or entering into an arrangement to make a
prepayment, for property prior to the date of completion of the production of property or incurring
significant expenditures for property of specialized design or specialized application.
In response to commentators' concerns, the amendments to the final regulations provide that a
routine purchase order for the production of fungible property is not a contract for purposes of
section 263A (g) (2). Under this rule, an agreement will not be treated as a routine purchase order
for the production of fungible property if the seller is required to make more than de minimis
modifications to the property to tailor it to the customer's specific needs, or if at the time the
agreement is entered [*14] into, the customer knows or has reason to know that the seller cannot
satisfy the agreement within 30 days out of existing stocks and normal production of finished goods.
THE AVOIDED COST METHOD

In general
The proposed regulations require taxpayers to use the avoided cost method described in proposed §
1.263A (f)-2 to calculate the amount of interest required to be capitalized under section 263A (f). A
number of commentators argued that, for purposes of capitalizing interest under section 263A (f),
taxpayers should be permitted to elect to use Statement of Financial Accounting Standards No. 34
(SFAS 34), which establishes standards for capitalizing interest for financial statement purposes.
Congress indicated that it intended interest to be capitalized under the avoided cost method, using
rules similar to those applicable under former section 189. See S. Rep. No. 313, 99th Cong., 2d

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 6 of 70

Sess. 144 (1986). Former section 189 applied rules similar to those contained in Financial
Accounting Standards Board (FASB) Statement No. 34. H. R. Conf. Rep. No. 760, 97th Cong., 2d
Sess. 484-85 (1982). The proposed section 263A (f) regulations adopt an approach similar to the
rules in SFAS 34 in that they [*15] treat interest that would have been avoided if production
expenditures had been used to repay indebtedness of the taxpayer as interest subject to
capitalization.
Although the proposed regulations use an approach similar to SFAS 34, the IRS and Treasury are
not persuaded that the regulations should be changed to permit the use of the financial accounting
rules of SFAS 34 instead of the avoided cost method in the proposed regulations. The IRS and
Treasury believe that the results obtained by applying SFAS 34 could diverge significantly from the
results obtained by applying tax principles. For example, differences in the amount of interest
capitalized could result because: the bases of assets for book and tax purposes differ; SFAS 34
allows more discretion and subjectivity (e.g., in identifying borrowings used to determine interest
capitalization) than does the statute; and materiality standards used under financial accounting
rules may not be acceptable for tax purposes. Accordingly, the final regulations do not permit the
use of SFAS 34 as an alternative to the avoided cost method set forth in the regulations.
Accounts payable and simplification rule for tracing
Under the proposed regulations, [*16] the calculation of the amount of interest required to be
capitalized is made by reference to eligible debt. Eligible debt generally includes all debt of the
taxpayer on which interest is deductible in computing taxable income. However, noninterest bearing
debt is excluded from the definition of eligible debt unless the debt is traced debt (or, if the taxpayer
makes an election not to trace debt, is debt that would have been treated as traced debt in the
absence of such an election).
Commentators indicated that noninterest bearing debt such as accounts payable should be treated
as eligible debt whether or not the debt is traced to the accumulated production expenditures of
designated property.
The IRS and Treasury continue to believe that treating all noninterest bearing debt as eligible debt is
inconsistent with Congressional intent. Such treatment is not similar to the FASB 34 rule and would
distort the interest capitalization rate. The final regulations, therefore, maintain the treatment
prescribed in the proposed regulations.
Some commentators believed that it is administratively impracticable or virtually impossible for
certain taxpayers to determine the noninterest bearing debt traced [*17] to the accumulated
production expenditures of designated property. These commentators recommended that, if the
regulations do not treat all accounts payable as eligible debt, the regulations should provide a
simplification measure under which a taxpayer may "deem" a certain portion of noninterest bearing
debt as constituting traced debt.
One commentator suggested a safe harbor under which the amount of noninterest bearing debt
deemed to be traced debt would be that portion of accounts payable equal to the ratio of the
production expenditures for designated property over the production expenditures for all property.
The IRS and Treasury believe that this recommendation would not sufficiently approximate the
portion of noninterest bearing debt that is traced debt for all or certain segments of taxpayers.
Moreover, the IRS and Treasury were unable to establish a workable safe harbor. Finally, except for
immaterial amounts, taxpayers must perform the same sort of tracing to adjust production
expenditures for noninterest bearing accounts payable when they prepare financial statements.
Under SFAS 34, the expenditures that attract interest capitalization include only expenditures
requiring [*18] the payment of cash, the transfer of other assets, or the incurring of a liability on
which interest is charged. Accordingly, the final regulations do not adopt a safe harbor under which
a certain portion of noninterest bearing debt would be deemed traced debt.
Interest capitalized on traced debt

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 7 of 70

Under the avoided cost method in the proposed regulations, the interest capitalized on debt traced
to the accumulated production expenditures for a unit of designated property includes the interest
on the traced debt for the entire measurement period for any measurement period in which
production occurs (traced debt amount).
Commentators objected to this rule because the production period of a unit may not begin on the
first day of the first measurement period of the production period and may not end on the last day
of the last measurement period of the production period. In these situations, the commentators
argued that only interest incurred on traced debt for the actual number of days encompassing the
production period of a unit should constitute the traced debt amount.
The IRS and Treasury believe that the proposed traced debt amount rule is an appropriate
simplification measure. Moreover, [*19] a taxpayer desiring a more precise traced debt amount
can effect greater precision by choosing more frequent measurement dates. Under the proposed
rule, taxpayers can choose their measurement periods, the choice is not a method of accounting,
and taxpayers may change measurement periods each taxable year. Accordingly, the final
regulations adopt the proposed traced debt amount rule without change.
External rate-substitute for weighted average interest rate
The avoided cost method involves the capitalization of two amounts of interest with respect to a unit
of property: (1) an amount of interest with respect to traced debt, and (2) an amount of interest
with respect to nontraced debt. The amount of interest required to be capitalized with respect to
nontraced debt is determined by multiplying the accumulated production expenditures that exceed
traced debt for a unit (excess expenditures) by the weighted average interest rate determined on all
eligible debt of a taxpayer other than traced debt (nontraced debt).
To simplify the interest capitalization computation with respect to nontraced debt, commentators
suggested that the final regulations permit taxpayers to elect to use an external [*20] rate as a
substitute for the weighted average interest rate. Most commentators suggested the election of a
rate based on the applicable federal rate (AFR). Certain commentators believed that small
taxpayers, at a minimum, should be allowed this simplifying election.
The IRS and Treasury believe that an election to use an external rate as a substitute for the
weighted average interest rate on nontraced debt would generally be inappropriate because of the
difficulty in establishing a suitable external rate for all taxpayers. Accordingly, the final regulations
do not adopt the recommendation to permit all taxpayers to elect to use an external rate as a
substitute for the weighted average interest rate.
The final regulations do, however, permit certain small taxpayers to elect to use the highest AFR
under section 1274 (d) in effect during the computation period plus 3 percentage points (AFR plus
3) as a substitute for the weighted average interest rate. A taxpayer may elect to use the AFR plus 3
for a taxable year if the average annual gross receipts of the taxpayer (or any predecessor) for the
preceding 3 taxable years do not exceed $10,000,0000 (the $10,000,000 gross receipts test), and
[*21] the taxpayer has met the $10,000,000 gross receipts test for all prior taxable years
beginning after December 31, 1994. The rules of § 1.263A-3 (b) apply in determining whether a
taxpayer satisfies the $10,000,000 gross receipts test. A taxpayer making the AFR plus 3 election
may not trace debt.
NOTIONAL PRINCIPAL CONTRACTS
The treatment of notional principal contracts and other derivatives under section 263A (f) is
reserved in the final regulations.
DEFINITION OF UNIT OF PROPERTY

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 8 of 70

The proposed regulations provide that a unit includes any components owned by the taxpayer or a
related party that are functionally interdependent. Components of property are functionally
interdependent when the placing in service of one component is dependent on the placing in service
of one or more other components.
Certain commentators recommended that the final regulations adopt the definition of a unit provided
under § 1.167 (a)-11 (d) (2) (vi), which defines a unit of property for purposes of applying the
elective alternative depreciation (ADR) repair allowance provisions. Section 1.167 (a)-11 (d) (2) (vi)
defines a unit to include each operating unit that performs a discrete function and that a taxpayer
[*22] customarily acquires for original installation and retires as a unit. Commentators argued
that taxpayers are already familiar with this definition of a unit.
The IRS and Treasury believe that section 263A (f) and its legislative history indicate that property
includes the functionally interdependent components of property. Congress repealed former section
189 (relating to the capitalization of interest and taxes during the construction period of real
property) and enacted the more expansive, uniform capitalization rules under section 263A (f).
Under former section 189, an entire building (including the land component) was property to which
interest was capitalized. See H.R. Conf. Rep. No. 760, 97th Cong., 2d Sess. 48 (1982). The IRS and
Treasury believe that Congress did not intend that property be defined more narrowly under section
263A (f) than under former section 189. Accordingly, under section 263A (f), property also includes
an entire building (including the land component), as the aggregation of functionally interdependent
components of property. Section 263A (f) defines property uniformly, and therefore, property in all
circumstances includes the functionally interdependent [*23] components of property.
Treating the functionally interdependent components of property as a single property for interest
capitalization is consistent with the concept of a single property that applies under section 167 in
determining the date on which components of a single property are placed in service. As the
commentators recognized, this concept of a single property may differ from the concept of a single
or separate property that taxpayers use for other purposes (e.g., for computing amounts of
depreciation deductions or separately tracking the bases of assets).
The § 1.167 (a)-11 (d) (2) (vi) definition of a unit may not encompass the functionally
interdependent components of property. This definition of a unit applied for purposes of applying the
alternative depreciation (ADR) repair allowance provisions, which were elective. The provisions
provided a simplification procedure for treating a taxpayer's expenditures as either capitalized
expenditures or deductible expenses. Taxpayers that elected the provisions, and used this § 1.167
(a)-11 (d) (2) (vi) definition of a unit, were required to use the same standard that other taxpayers
used in determining the date on which property [*24] was placed in service (i.e., the standard
consistent with the concept of a single property as an aggregation of functionally interdependent
components). Accordingly, the final regulations do not adopt commentators' recommendation to
modify the definition of a unit of property.
COMMON FEATURE RULES

Land attributable to benefitted property
Under the proposed regulations, an allocable share of a common feature that benefits real property
and the real property being benefitted are a single unit of real property (common feature rule). The
production period for the entire unit begins when production begins on either the benefitted real
property or a common feature allocable to the unit. Thus, commencing production on only a
common feature results in interest being capitalized not only on the costs of the common feature
but also on the costs of land underlying the benefitted property.
Commentators argued that the proposed common feature rule produces harsh consequences. For
example, when construction commences on a single common feature that benefits each house in a
housing development, interest capitalization commences on all land in the housing development

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 9 of 70

even if no direct production activity [*25] has been undertaken on any house. Commentators also
indicated that the proposed interest suspension rule provides insufficient relief in these
circumstances. Under the proposed regulations, interest capitalization may be suspended
prospectively for a unit only when production activities have ceased for the unit for at least a 12month period. Thus, in the case of the housing development described above, the proposed
regulations would require interest on land costs attributable to the houses to be capitalized from the
commencement of construction of the common feature until the 13th month after its completion.
Interest capitalization would be required with respect to those costs for that period even if no direct
production activity will be undertaken on the houses for several years.
The final regulations continue to provide that the allocable share of a common feature and the
benefitted property are a single unit of real property, but provide two new rules in response to the
commentators' concerns. Under the first new rule, the land costs of the benefitted property are not
treated as included in the accumulated production expenditures for the unit (i.e., are not treated as
included in [*26] the costs that attract interest capitalization) until a direct production activity
commences on the benefitted property. Thus, for example, if no direct production activities have
been undertaken on planned houses, such as clearing and grading activities on the land underlying
the houses, the cost of the land underlying the houses is not treated as included in the accumulated
production expenditures for the unit. This treatment is permitted until direct production activities
begin on the houses, even though the production periods for the house units have begun because
production has begun on common features benefitting the houses. The second new rule provides
that if after clearing and grading has been undertaken with respect to the land attributable to the
benefitted property (the land underlying the houses in the above example), there is no direct
production activity taken with respect to the benefitted property for a period of at least 120
consecutive days, the accumulated production expenditures attributable to the benefitted property
are treated as not included in the accumulated production expenditures of the unit from the first
measurement period after the beginning of the 120-day [*27] period until the measurement
period in which direct production activity resumes with respect to the benefitted property.
Benefitted property completed
The proposed regulations indicate that, when benefitted property is sold or placed in service prior to
the completion of a common feature allocable to a unit, the costs of the benefitted property and
allocable common features no longer attract interest capitalization. See § 1.263A-10 (b) (6),
Example 5.
Commentators suggested that the final regulations provide a rule under which the costs of a
benefitted property would not be included in accumulated production expenditures when the
benefitted property is completed prior to the completion of a common feature included in the unit,
irrespective of whether such benefitted property is sold or placed in service.
The IRS and Treasury believe the exception provided in the proposed regulations should not be
extended to cases where a benefitted property is not sold or placed in service prior to the
completion of the common feature. Accordingly, the final regulations do not adopt the
commentators' recommendation.
Rev. Proc. 92-29, 1992-1 C.B. 748, permits a developer to include in the basis of properties [*28]
sold their allocable share of the estimated cost of common improvements without regard to whether
the costs are incurred under section 461 (h) of the Code, relating to economic performance. As of
the end of any taxable year, however, the total amount of common improvement costs included in
the basis of the properties sold may not exceed the amount of common improvement costs that
have been incurred under section 461 (h) ("the alternative cost limitation"). The final regulations
clarify that Rev. Proc. 92-29 does not affect the determination of accumulated production
expenditures of unsold units even if the costs of common improvements for those unsold units have
been used to determine the alternative cost limitation for purposes of including common
improvement costs in the basis of sold units.
UTILITIES-CONSTRUCTION WORK IN PROCESS

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 10 of 70

Under the proposed regulations, the accumulated production expenditures for a unit of property (i.e,
the costs that attract interest capitalization) generally include the amount of the direct and indirect
costs that are required to be capitalized with respect to the unit.
Certain commentators indicated that if construction work in process (CWIP) is included [*29] in
rate base for ratemaking purposes (of utilities, for example), the CWIP should be excluded from the
accumulated production expenditures. These commentators pointed out that in enacting section
263A (f), Congress intended to match the interest incurred in producing property with the related
income from property. These commentators argued that by including CWIP in rate base for
ratemaking purposes, income is currently taken into account, and that to match interest with its
related income, the interest attributable to CWIP should be currently deductible. They believed that
to achieve this match, CWIP should be excluded from accumulated production expenditures.
Under the avoided cost method of section 263A (f), CWIP expenditures are incurred with respect to
property produced, and no statutory exception excludes them from the production expenditures for
property. The legislative history of section 263A (f) indicates that the avoided cost method is
intended to apply to a taxpayer, such as a regulated utility company, irrespective of whether the
method is required, authorized, or considered appropriate under financial or regulatory accounting
principles. See H.R. Conf. Rep. No. 841, 99th [*30] Cong., 2d Sess. 11-309 (1986). CWIP is
therefore intended to be included in the production expenditures for property produced, and interest
capitalized with respect to CWIP is intended to become a cost of the property produced, which is
recovered as the property is used in the taxpayer's trade or business. Moreover, the suggestion that
the commentators urge the IRS and Treasury to adopt in the final regulations is inconsistent with
the rules that apply to determine the date on which CWIP is placed in service for depreciation
purposes and is inconsistent with the rules that apply under broader section 263A provisions to
capitalize other direct and indirect costs to CWIP during periods for which the commentators argue
the CWIP is generating income.
Further, the commentators' suggestion would not present a consistent resolution to the matching
concerns that the commentators argue exist with respect to the treatment of CWIP within regulated
utilities industries. Interest incurred prior to the beginning of the production period on CWIP that is
not included in rate base, for example, presents matching concerns that would not be resolved by
the commentators' suggestion. For this and the other [*31] reasons summarized above, the
commentators' suggestion has not been adopted in the final regulations.
As an alternative suggestion, commentators urged the IRS and Treasury to adopt a book conformity
rule for the treatment of interest on CWIP. This suggestion was not adopted, however, for principally
the same reasons that the use of the SFAS 34 computation as a substitute for section 263A (f)
avoided cost computations was not adopted. Additionally, the difference between the regulatory
accounting for CWIP and the required statutory treatment of CWIP under section 263A (f) is but one
example of the many inconsistencies between regulatory and tax accounting (some of which were
illustrated above). Therefore, the IRS and Treasury believe it would be inappropriate to adopt a
book conformity rule for interest capitalization alone given the existence of these other
inconsistencies.
IMPROVEMENTS TO REAL PROPERTY

Property taken out of service
The proposed regulations provide special rules for determining the accumulated production
expenditures for an improvement to existing real property. The accumulated production
expenditures for an improvement include all direct and indirect costs required to [*32] be
capitalized with respect to the improvement, plus an allocable portion of the cost of associated land.
Additionally, the adjusted bases of any existing structure or common features that directly benefit or
are incurred by reason of the improvement are included in the accumulated production expenditures

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 11 of 70

if they either are not already placed in service or must be taken out of service in order to complete
the improvement.
Commentators indicated that sometimes property must be temporarily disconnected or otherwise
taken out of service for health, safety, or regulatory reasons in order to make certain improvements
(e.g., a power generating facility must be taken out of service in order to make capital
improvements). Commentators suggested that the regulations provide that property is taken out of
service only if the property is taken out of service for depreciation purposes.
The final regulations do not adopt the suggestion concerning when property should be considered
taken out of service. However, the final regulations provide a de minimis rule for property taken out
of service. Under the de minimis rule, the aggregate costs of all property or common features taken
out of service to [*33] complete an improvement (associated property costs) are excluded from
the accumulated production expenditures for the improvement unit during its production period if,
on the date the production period of the unit begins, the taxpayer reasonably expects that on no
date during the production period of the unit will the accumulated production expenditures for the
unit, determined without regard to associated property costs, exceed 5 percent of associated
property costs.
Inclusion of land
The proposed regulations provide that an improvement to existing real property includes the
allocable portion of land associated with the improvement. As such, the basis of land may be
included in the accumulated production expenditures for more than one unit of designated property.
For example, a portion of the basis of land included in the accumulated production expenditures for
a building unit must also be included in the accumulated production expenditures for a separate
tenant improvement unit.
Commentators objected to this rule. They suggested that, once land was included in the
accumulated production expenditures for a unit of property, it should not be included in the
accumulated production expenditures [*34] for any other unit of property.
Section 263A (f) (4) (C) provides that the production expenditures for property include all
capitalized costs of property, whether or not those costs are incurred during the production period of
property. Land expenditures are part of the capitalized costs of property, and land costs should be
included in the accumulated production expenditures for property during its production period, even
if they are incurred before the production period. Accordingly, the final regulations do not adopt the
commentators' recommendation.
END OF THE PRODUCTION PERIOD-CUSTOMIZING ACTIVITIES
The proposed regulations provide that the production period generally ends for a unit of property
that will be held for sale on the date the unit is ready to be held for sale and all production activities
reasonably expected to be undertaken with respect to the unit are completed. The proposed
regulations provide that the production period generally ends for a unit of property produced for
selfuse on the date the unit is ready to be placed in service and all production activities reasonably
expected to be undertaken with respect to the unit are completed.
Commentators believe it is unfair [*35] for the production period to continue for a residential or
commercial unit that is complete except for activities relating to "de minimis" production
expenditures for customized features chosen by a buyer or lessee. These features, which include
carpeting, cabinets, appliances, wall coverings, and flooring, are often not added to a unit until an
identified buyer or lessee selects the features, or the unit is sold. These commentators
recommended that the production period should end for a unit when only "de minimis" customizing
activities remain to be performed.
The final regulations do not adopt this recommendation, however, because the IRS and Treasury

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 12 of 70

continue to believe that customizing activities are production activities and that the production
period does not end until these activities are completed. Nevertheless, a shortened, retroactive
suspension period rule adopted in the final regulations (and explained below) will provide relief in
situations that involve long periods of delay in the performance of customizing activities.
SUSPENSION PERIOD
The proposed regulations provide that, when production activities related to the production of a unit
of designated property cease for [*36] a period of 12 consecutive months, the capitalization of
interest is not required (i.e., is suspended) for the period beginning with the 13th month of
cessation. The suspension period ends when production activities resume. For administrative
convenience, the proposed regulations use an objective time test, and therefore, the reasons for
suspending production are not considered.
Commentators believed that the rule in the proposed regulations unduly delays the suspension of
interest capitalization. They argued that a taxpayer should not have to wait 12 months before
suspending interest capitalization if production activities cease for reasons such as strikes, fires, or
natural disasters. Some commentators believed that the determination of whether activities have
ceased should be a facts and circumstances test and that interest capitalization should be suspended
in the month following the cessation of production activities. Others argued that the cessation period
should be only 3 or 4 months. Still others argued that, if the 12-month cessation period is retained,
the suspension of interest capitalization should apply retroactively as of the first month of cessation.
In response to these [*37] comments, the final regulations shorten the cessation period from 12
consecutive months to 120 consecutive days and, once the cessation period is satisfied, permit
taxpayers to retroactively suspend interest capitalization as of the first measurement period
following the measurement period in which production activities ceased. Alternatively, if the
cessation period spans more than one taxable year, and a taxpayer does not want to file an
amended return for the prior year, the taxpayer may suspend the capitalization of interest with
respect to its units of designated property beginning with the first measurement period of the
taxable year in which the 120-day period is satisfied.
In connection with the shorter 120-day cessation period, however, the final regulations introduce
several new criteria for determining whether production activities are considered to have ceased.
Production activities are not considered to have ceased under the final regulations if they cease
because of any delays inherent in the asset production process.
OIL AND GAS PROVISIONS

Section 614 costs in accumulated production expenditures
Under the proposed regulations, the costs with respect to a section 614 property [*38] (section
614 costs) are included in the accumulated production expenditures for the first well in a multiphase development. Each subsequent well includes a pro rata share of these undepleted costs based
on total wells that the taxpayer could feasibly drill on the section 614 property. However, the
taxpayer may partition the section 614 costs among the number of wells to be drilled on the section
614 property if the taxpayer can devise a "definite plan" upfront that identifies the number and
location of wells to be drilled.
Commentators indicated that the "definite plan" requirement is impracticable. According to them,
the number and location of wells to be drilled on a property may not be known on the date that a
first drilling activity is undertaken on the section 614 property. Commentators, therefore, suggested
that the final regulations allow taxpayers to partition the section 614 costs among the number of
wells "feasibly expected" to be drilled on the section 614 property. Alternatively, commentators
suggested that the final regulations require taxpayers to include the section 614 costs only in the
accumulated production expenditures for a first well drilled on the section 614 [*39] property.

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 13 of 70

The final regulations retain the definite plan rule. In light of the unique nature of a mineral interest
and the circumstances surrounding the development of such an interest, however, the final
regulations revise the rule for taxpayers unable to establish a definite plan. Under the revised rule,
the section 614 costs are generally only included once in the accumulated production expenditures
for a first productive well unit on the section 614 property. (However, the final regulations provide
that the undepleted portion of section 614 costs allocated to the first productive well unit must be
included in the accumulated production expenditures for an improvement to the unit.) The final
regulations provide that a first productive well unit generally includes all wells that are drilled on a
section 614 property prior to the date the first productive well on the property is placed in service
and all production activities reasonably expected to be undertaken are completed. Accordingly, the
section 614 costs are included in a unit (to attract interest capitalization) from the date the first
physical site activity is undertaken with respect to the section 614 property until the date [*40]
the first productive well on the section 614 property is placed in service and all production activities
reasonably expected to be undertaken are completed. Generally, each well on a section 614
property that is drilled subsequent to such date comprises a separate unit of property. The IRS and
Treasury believe this rule is more objective and practical than a rule that would require the section
614 costs to be partitioned among the number of wells "feasibly expected" to be drilled on a section
614 property.
The final regulations provide a rule for common feature costs similar to the rule provided for section
614 property costs. Under the final regulations, the costs of the common features are generally
included only in the accumulated production expenditures for the first productive well unit.
Beginning of production period
The proposed regulations provide that the production period begins for an oil or gas well on the first
date physical site preparation activities are undertaken with respect to the property.
Certain commentators believed that the production period should begin for an onshore oil or gas
well unit on the "spud date," rather than on the first date of physical site preparation [*41]
activity. Commentators indicated that taxpayers often do not separately track the first date of
physical site activity on a property, but do maintain records with respect to the spud date for
purposes of applying other provisions of the Code, such as section 291 (b).
The IRS and Treasury do not believe that the spud date is an appropriate date to adopt as the
beginning of the production period for an onshore oil or gas well unit. The spud date may occur long
after the first date that a physical site preparation activity is undertaken on a section 614 property.
Using the spud date could, therefore, be too great a deviation from the general rule that treats site
preparation as the beginning of the production period of other real property. Accordingly, the final
regulations do not adopt the commentators' recommendation regarding the spud date.
Surface equipment and end of production period
The proposed regulations provide that the production period generally ends for an oil or gas well on
the date that surface production equipment is installed and the well is placed in service.
Commentators argued that the production period for a well unit should not continue beyond the date
a "christmas [*42] tree" is installed on the well and that the accumulated production expenditures
for the well should not include the costs of surface production equipment.
The final regulations provide that the production period generally ends for a productive well unit on
the date that the productive well included in the unit is placed in service and all production activities
reasonably expected to be undertaken are completed. These rules are consistent with the general
rules that apply in the case of other types of produced property.

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 14 of 70

Casing point
The proposed regulations provide that the production period generally ends for a nonproductive well
on the date that the nonproductive well is plugged and abandoned.
Commentators believed that the production period for a nonproductive well unit should end at the
casing point, which they indicate is the date that a decision is made not to complete the well for
production.
The final regulations do not address the date on which the production period ends for a
nonproductive well. The IRS and Treasury believe, however, that the general standards that apply in
the case of other types of abandoned property should be used to determine the date on which the
production [*43] period ends for a nonproductive well.
Allocation of capitalized interest to depreciable or depletable unit components
The proposed regulations provide that the interest required to be capitalized with respect to a unit is
added to the basis of designated property, rather than to the bases of any assets used to produce
the designated property. Additionally, interest required to be capitalized with respect to the
production of land is added to the basis of any related depreciable improvement.
Commentators believed that the final regulations should provide that interest required to be
capitalized with respect to an oil or gas well unit is first capitalized into the basis of the unit's
depreciable property components, if any, prior to the bases of the unit's depletable property
components. The commentators believed that this rule is substantially similar to the rule in the
proposed regulations with respect to the allocation of capitalized interest to components of a land
improvement unit.
The IRS and Treasury believe that interest capitalized with respect to components of a unit of
property that are not subject to an allowance for depreciation or depletion is appropriately added to
the basis [*44] of the components of a unit of property that are subject to an allowance for
depreciation or depletion. Thus, the proposed regulations provided that interest capitalized with
respect to land, the cost of which is not depreciable or depletable, is added to the basis of related
depreciable improvements, if any. However, interest capitalized with respect to the depletable
property components of a well unit is subject to an allowance for depletion. Accordingly, the final
regulations do not adopt commentators' suggestions.
Independent producer onshore well exemption
Certain commentators suggested that independent producer onshore wells should be exempted from
interest capitalization based on their belief that the compliance costs for these wells outweigh the
tax revenues to be gained.
Under section 263A (c) (3), Congress exempted from the uniform capitalization rules certain costs
incurred with respect to oil and gas activities, but did not exempt oil and gas activities themselves.
Thus, the IRS and Treasury do not believe that a specific exemption for all independent onshore
wells is appropriate. Accordingly, the final regulations do not provide a specific exemption for
independent onshore [*45] wells.
EXAMPLES
The final regulations provide examples, but delete the comprehensive real estate example. The IRS
anticipates providing illustrations of interest capitalization in other guidance.
RELATED PERSON RULES

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 15 of 70

In general
Section 263A (i) provides that the Secretary shall prescribe such regulations as may be necessary or
appropriate to carry out the purposes of the uniform capitalization rules, including regulations to
prevent the use of related persons, pass-through entities, or intermediaries to avoid these rules.
Notice 88-99, issued August 17, 1988, provides the principal source of guidance concerning the
application of related person rules under section 263A (f). Notice 88-99 generally provides that if a
taxpayer is producing designated property and has accumulated production expenditures that
exceed the total amount of its eligible debt, one or more related persons (generally members of the
same parent-subsidiary controlled group as defined in section 1563 (a) (1), whether or not filing
consolidated returns) must capitalize interest with respect to the excess expenditures. Under Notice
88-99, the related persons, in effect, capitalize interest with respect to the excess expenditures
[*46] as if the related persons had incurred those expenditures directly. The notice provides
similar rules in the case of flow through entities (i.e., partnerships or S corporations).
The proposed regulations also provide certain related person rules and direct taxpayers to follow
applicable administrative pronouncements in applying the rules. More comprehensive related person
rules will be proposed at a future date under a separate regulations project. Until more specific rules
are provided under related person regulations, however, Notice 88-99 generally indicates the
position of the IRS with respect to the application of related person rules under section 263A (f). To
the extent that Notice 88-99 rules are modified by specific provisions in, or principles of, these final
regulations, the rules and principles of the final regulations are controlling.
Consolidated return interest rule
Consistent with the purposes of section 263A (f), the proposed regulations provide that to the extent
of a consolidated group's outside interest deduction, the consolidated group must currently report,
rather than defer, the interest income on intragroup debt on which it capitalizes interest
(consolidated section 263A (f) [*47] interest rule). Without this rule, a consolidated group could
effectively avoid capitalizing interest under section 263A (f) if the group were to capitalize interest
on intragroup debt, but at the same time defer reporting the associated interest income and deduct
outside interest equal to or less than the interest capitalized.
Certain taxpayers believed that the consolidated section 263A (f) interest rule does not apply unless
and until final regulations are issued under section 263A or section 1502. The IRS and Treasury
believe, however, that a consolidated group that effectively deducts interest by capitalizing interest
on intragroup debt under section 263A (f) and deferring the associated interest income on the debt
adopts an unreasonable interpretation of the statute and legislative history of section 263A (f) to the
extent the associated interest income on the intragroup debt is less than or equal to the group's
outside interest expense deductions.
Comments on related person rules
Commentators submitted comments on certain related persons issues. In particular, commentators
believed that, under Notice 88-99 and the proposed rules, capitalizing interest on the intragroup
debt of [*48] an affiliated group that is not a consolidated group may create an overcapitalization
of interest. According to the commentators, overcapitalization may occur, for example, if two or
more members capitalize interest with respect to the same debt (e.g., back-to-back loans).
Additionally, one commentator believed that interest on debt owed to a producing member by a
nonproducing member should not be subject to capitalization.
In response to commentator concerns, the IRS and Treasury are studying whether the amount of
interest capitalized by the related person members of an affiliated group should be limited to the
interest incurred by all affiliated group members on outside debt, less any interest capitalized by the

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 16 of 70

producing member on outside and intragroup debt. It is generally the intent of Notice 88-99 and the
final regulations to prevent taxpayers from avoiding the purposes of interest capitalization through
the use of related persons. The IRS and Treasury welcome additional comments on this and other
related person issues that should be addressed in future related person regulations.
ACCOUNTING METHOD CHANGES
The final section 263A (f) regulations are generally effective for taxable [*49] years beginning on
or after January 1, 1995. Taxpayers that have previously adopted methods of accounting under
section 263A (f) may be required to change their methods of accounting under section 263A (f) to
comply with the final regulations. Within 30 days, the IRS will issue a revenue procedure prescribing
the procedures, terms, and conditions for effecting method changes necessary due to the
promulgation of these regulations.
The revenue procedure will facilitate election of early application of the regulations to the first
taxable year beginning on or after January 1, 1994 so that taxpayers may combine, within the same
taxable year, changes under the final section 263A (f) regulations and changes under the final
general section 263A regulations.
CLARIFICATION OF MIXED SERVICE COSTS DE MINIMIS RULES
The final regulations clarify the application of the 90 percent de minimis rule for mixed service
department costs contained in the final main section 263A regulations. Under that rule, an electing
taxpayer is not required to allocate any portion of a mixed service department's costs to property
produced or acquired for resale if 90 percent or more of the department's costs are deductible
[*50] service costs. The final regulations clarify that if this election is made, the taxpayer must
also allocate all of a mixed service department's costs to property produced or acquired for resale if
90 percent or more of the department's costs are capitalizable service costs.
Special Analyses
It has been determined that this Treasury decision is not a significant regulatory action as defined in
EO 12866. Therefore, a regulatory assessment is not required. It also has been determined that
section 553 (b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory
Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a Regulatory
Flexibility Analysis is not required. Pursuant to section 7805 (f) of the Internal Revenue Code, the
notice of proposed rulemaking preceding these regulations was submitted to the Small Business
Administration for comment on its impact on small business.

Adoption of Amendments to the Regulations
Accordingly, 26 CFR parts 1 and 602 are amended as follows:

Paragraph 1. The authority citation for part 1 is amended by adding the following
citation:

Authority: 26 U.S.C. 7805
Sections 1.263A-8 through 1.263 A-15
[*51] also issued under 26 U.S.C. 263A (i).

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 17 of 70

Par. 2. Section 1.263A-0 is amended by revising the introductory text, removing the
word "Reserved" after § 1.263A-2 (a) (1) (ii) (B) (2), removing the word "Reserved"
after §§ 1.263A-3 (c) (4) (vi) (A) through (C) to reflect issuance of T.D. 8559 on August
5, 1994, and adding the following headings for §§ 1.263A-8 through 1.263A-15 to read
as follows:

§ 1.263A-0 Outline of regulations under section 263A.
This section lists the paragraphs and §§ 1.263A-1 through 1.263A-3 and §§
1.263A-8 through 1.263A-15.

§ 1.263A-8 Requirement to capitalize interest.
(a) In general.
(1) General rule.
(2) Treatment of interest required to be capitalized.
(3) Methods of accounting under section 263A (f).
(4) Special definitions.
(i) Related person.
(ii) Placed in service.
(b) Designated property.
(1) In general.
(2) Special rules.
(i) Application of thresholds.
(ii) Relevant activities and costs.
(iii) Production period and cost of production.
(3) Excluded property.
(4) De minimis rule.
(i) In general.
(ii) Determination of total production expenditures.
(c) Definition of real property.
(1) In general.

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 18 of 70

(2) Unsevered natural products of land.
(3) Inherently permanent structures.
(4) [*52] Machinery.
(i) Treatment.
(ii) Certain factors not determinative.
(d) Production.
(1) Definition of produce.
(2) Property produced under a contract.
(i) Customer.
(ii) Contractor.
(iii) Definition of a contract.
(iv)Determination of whether thresholds are satisfied.
(A) Customer.
(B) Contractor.
(v) Exclusion for property subject to long-term contract rules.
(3) Improvements to existing property.
(i) In general.
(ii) Real property.
(iii) Tangible personal property.
§ 1.263A-9 The avoided cost method.
(a) In general.
(1) Description.
(2) Overview.
(i) In general.
(ii) Rules that apply in determining amounts.
(3) Definitions of interest and incurred.
(4) Definition of eligible debt.
(b) Traced debt amount.
(1) General rule.

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 19 of 70

(2) Identification and definition of traced debt.
(3) Example.
(c) Excess expenditure amount.
(1) General rule.
(2) Interest required to be capitalized.
(3) Example.
(4) Treatment of interest subject to a deferral provision.
(5) Definitions.
(i) Nontraced debt.
(A) Defined.
(B) Example.
(ii) Average excess expenditures.
(A) General rule.
(B) Example.
(iii) Weighted average interest rate.
(A) Determination of rate.
(B) Interest incurred on nontraced debt.
(C) Average nontraced debt.
(D)Special rules if taxpayer [*53] has no nontraced debt or rate is
contingent.
(6) Examples.
(7) Special rules where the excess expenditure amount exceeds incurred
interest.
(i) Allocation of total incurred interest to units.
(ii) Application of related person rules to average excess expenditures.
(iii) Special rule for corporations.
30 1995-1 C.B.
(d) Election not to trace debt.
(1) General rule.
(2) Example.
(e) Election to use external rate.

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 20 of 70

(1) In general.
(2) Eligible taxpayer.
(f) Selection of computation period and measurement dates and application
of averaging conventions.
(1) Computation period.
(i) In general.
(ii) Method of accounting.
(iii) Production period beginning or ending during the computation period.
(2) Measurement dates.
(i) In general.
(ii) Measurement period.
(iii) Measurement dates on which accumulated production expenditures must
be taken into account.
(iv) More frequent measurement dates.
(3) Examples.
(g) Special rules.
(1) Ordering rules.
(i) Provisions preempted by section 263A (f).
(ii) Deferral provisions applied before this section.
(2) Application of section 263A (f) to deferred interest.
(i) In general.
(ii) Capitalization of deferral amount.
(iii) Deferred capitalization. (iv) Substitute capitalization.
(A) General [*54] rule.
(B) Capitalization of amount carried forward.
(C) Method of accounting. (v) Examples.
(3) Simplified inventory method.
(i) In general.
(ii) Segmentation of inventory.
(A) General rule.

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 21 of 70

(B) Example.
(iii) Aggregate interest capitalization amount.
(A) Computation period and weighted average interest rate.
(B) Computation of the tentative aggregate interest capitalization amount.
(C) Coordination with other interest capitalization computations.
(1) In general.
(2) Deferred interest.
(3) Other coordinating provisions.
(D) Treatment of increases or decreases in the aggregate interest
capitalization amount.
(E) Example.
(iv) Method of accounting.
(4) Financial accounting method disregarded.
(5) Treatment of intercompany transactions.
(i) General rule.
(ii) Special rule for consolidated group with limited outside borrowing.
(iii) Example.
(6) Notional principal contracts and other derivatives. [Reserved]
(7) 15-day repayment rule.
§ 1.263A-10 Unit of property.
(a) In general.
(b) Units of real property.
(1) In general.
(2) Functional interdependence.
(3) Common features.
(4) Allocation of costs to unit.
(5) Treatment of costs when a common feature is included in a unit of real
property.
(i) General rule.
(ii) Production [*55] activity not undertaken on benefitted property.

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 22 of 70

(A) Direct production activity not undertaken.
(1) In general.
(2) Land attributable to a benefitted property.
(B) Suspension of direct production activity after clearing and grading
undertaken.
(1) General rule.
(2) Accumulated production expenditures.
(iii) Common feature placed in service before the end of production of a
benefitted property.
(iv) Benefitted property sold before production completed on common
feature.
(v) Benefitted property placed in service before production completed on
common feature.
(6) Examples.
(c) Units of tangible personal property.
(d) Treatment of installations.
§ 1.263A-11 Accumulated production expenditures.
(a) General rule.
(b) When costs are first taken into account.
(1) In general.
(2) Dedication rule for materials and supplies.
(c) Property produced under a contract.
(1) Customer.
(2) Contractor.
(d) Property used to produce designated property.
(1) In general.
(2) Example.
(3) Excluded equipment and facilities.
(e) Improvements.
(1) General rule.
(2) De minimis rule.

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 23 of 70

(f) Mid-production purchases.
(g) Related person costs.
(h) Installation.
§ 1.263A-12 Production period.
(a) In general.
(b) Related person activities.
(c) Beginning [*56] of production period.
(1) In general.
(2) Real property.
(3) Tangible personal property.
(d) End of production period.
(1) In general.
(2) Special rules.
(3) Sequential production or delivery.
(4) Examples.
(e) Physical production activities.
(1) In general.
(2) Illustrations.
(f) Activities not considered physical production.
(1) Planning and design.
(2) Incidental repairs.
(g) Suspension of production period.
(1) In general.
(2) Special rule.
(3) Method of accounting.
(4) Example.
§ 1.263A-13 Oil and gas activities.
(a) In general.
(b) Generally applicable rules.

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 24 of 70

(1) Beginning of production period.
(i) Onshore activities.
(ii) Offshore activities.
(2) End of production period.
(3) Accumulated production expenditures.
(i) Costs included.
(ii) Improvement unit.
(c) Special rules when definite plan not established.
(1) In general.
(2) Oil and gas units.
(i) First productive well unit.
(ii) Subsequent units.
(3) Beginning of production period.
(i) First productive well unit.
(ii) Subsequent wells.
(4) End of production period.
(5) Accumulated production expenditures.
(i) First productive well unit,
(ii) Subsequent well unit.
(6) Allocation of interest capitalized with respect to first productive well unit.
(7) Examples.
§ 1.263A-14 Rules for related persons.
§ 1.263A-15 Effective dates, transitional rules, and anti-abuse rule.
(a) [*57] Effective dates.
(b) Transitional rule for accumulated production expenditures.
(1) In general.
(2) Property used to produce designated property.
(c) Anti-abuse rule.

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 25 of 70

Par. 3. Section 1.263A-1 is amended by revising the third sentence of paragraph (g) (4)
(ii) to read as follows:

§ 1.263A-1 Uniform capitalization of costs.

(g)
(4)
(ii)
Under this election, however, if 90 percent or more of a mixed
service department's costs are capitalizable service costs, a taxpayer must
allocate 100 percent of the department's costs to the production or resale
activity benefitted.

Par. 4. Section 1.263A-2 is amended by revising paragraph (a) (1) (ii) (B) (2) to read as
follows:

§ 1.263A-2 Rules relating to property produced by the taxpayer.
(a)
(2) Definition of a contract -(0 General rule. Except as provided under
paragraph (a) (1) (ii) (B) (2) (ii) of this section, a contract is any agreement
providing for the production of property if the agreement is entered into
before the production of the property to be delivered under the contract is
completed. Whether an agreement exists depends on all the facts and
circumstances. Facts and circumstances indicating an agreement include,
[*58] for example, the making of a prepayment, or an arrangement to
make a prepayment, for property prior to the date of the completion of
production of the property, or the incurring of significant expenditures for
property of specialized design or specialized application that is not intended
for self-use.
(ii) Routine purchase order exception. A routine purchase order for fungible
property is not treated as a contract for purposes of this section. An
agreement will not be treated as a routine purchase order for fungible
property, however, if the contractor is required to make more than de
minimis modifications to the property to tailor it to the customer's specific
needs, or if at the time the agreement is entered into, the customer knows
or has reason to know that the contractor cannot satisfy the agreement
within 30 days out of existing stocks and normal production of finished
goods.

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 26 of 70

Par. 5. Section 1.263A-7 is added and reserved and §§ 1.263A-8 through 1.263A-15 are
added to read as follows:

§ 1.263A-8 Requirement to capitalize interest.
(a) In general -(1) General rule. Capitalization of interest under the avoided
cost method described in § 1.263A-9 is required with respect to the [*59]
production of designated property described in paragraph (b) of this section.
(2) Treatment of interest required to be capitalized. In general, interest that
is capitalized under this section is treated as a cost of the designated
property and is recovered in accordance with § 1.263A-1 (c) (4). Interest
capitalized by reason of assets used to produce designated property (within
the meaning of § 1.263A-11 (d)) is added to the basis of the designated
property rather than the bases of the assets used to produce the designated
property. Interest capitalized with respect to designated property that
includes both components subject to an allowance for depreciation or
depletion and components not subject to an allowance for depreciation or
depletion is ratably allocated among, and is treated as a cost of, components
that are subject to an allowance for depreciation or depletion.
(3) Methods of accounting under section 263A (f). Except as otherwise
provided, methods of accounting and other computations under §§ 1.263A-8
through 1.263A-15 are applied on a taxpayer, as opposed to a separate and
distinct trade or business, basis.
(4) Special definitions - (i) Related person. Except as otherwise [*60]
provided, for purposes of §§ 1.263A-8 through 1.263A-15, a person is
related to a taxpayer if their relationship is described in section 267(b) or
707 (b).
(ii) Placed in service. For purposes of §§ 1.263A-8 through 1.263A-15,
placed in service has the same meaning as set forth in § 1.46-3 (d).
(b) Designated property-(1) In general. Except as provided in paragraphs
(b) (3) and (b) (4) of this section, designated property means any property
that is produced and that is either:

(i) Real property; or
(ii) Tangible personal property (as defined in § 1.263A-2 (a) (2))
which meets any of the following criteria:

(A) Property with a class life of 20 years or more under
section 168 (long-lived property), but only if the property
is not property described in section 1221 (1) in the hands
of the taxpayer or a related person,

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 27 of 70
(B) Property with an estimated production period (as defined
in § 1.263A-12) exceeding 2 years (2-year property), or

(C)Property with an estimated production period exceeding
1 year and an estimated cost of production exceeding
$1,000,000 (1-year property).

(2) Special rules -(i) Application of thresholds. The thresholds described in
paragraphs (b) (1) (ii) (A), (B), and (C) of this [*61] section are applied
separately for each unit of property (as defined in § 1.263A-10).
(ii) Relevant activities and costs. For purposes of determining whether
property is designated property, all activities and costs are taken into
account if they are performed or incurred by, or for, the taxpayer or any
related person and they directly benefit or are incurred by reason of the
production of the property.
(iii) Production period and cost of production. For purposes of applying the
classification thresholds under paragraphs (b) (1) (ii) (B) and (C) of this
section to a unit of property, the taxpayer is required, at the beginning of
the production period, to reasonably estimate the production period and the
total cost of production for the unit of property. The taxpayer must maintain
contemporaneous written records supporting the estimates and
classification. If the estimates are reasonable based on the facts in existence
at the beginning of the production period, the taxpayer's classification of the
property is not modified in subsequent periods, even if the actual length of
the production period or the actual cost of production differs from the
estimates. To be considered reasonable, estimates [*62] of the production
period and the total cost of production must include anticipated expense and
time for delay, rework, change orders, and technological, design or other
problems. To the extent that several distinct activities related to the
production of the property are expected to occur simultaneously, the period
during which these distinct activities occur is not counted more than once.
The bases of assets used to produce a unit of property (within the meaning
of § 1.263A-11 (d)) and any interest that would be required to be capitalized
if a unit of property were designated property are disregarded in making
estimates of the total cost of production for purposes of this paragraph (b)
(2) (iii).
(3) Excluded property. Designated property does not include:

(i) Timber and evergreen trees that are more than 6 years old when
severed from the roots, or

(ii) Property produced by the taxpayer for use by the taxpayer other
than in a trade or business or an activity conducted for profit.

(4) De minimis rule -(i) Ingeneral. Designated property does not include
property for which-

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 28 of 70

(A) The production period does not exceed 90 days; and
(B) The total production expenditures do not exceed $1,000,000
divided [*63] by the number of days in the production period.

(ii) Determination of total production expenditures. For purposes of
determining whether the condition of paragraph (b) (4) (i) (B) of this section
is met with respect to property, the cost of land, the adjusted basis of
property used to produce property, and interest that would be capitalized
with respect to property if it were designated property are excluded from
total production expenditures.
(c) Definition of real property- (1) Ingeneral. Real property includes land,
unsevered natural products of land, buildings, and inherently permanent
structures. Any interest in real property of a type described in this paragraph
(c), including fee ownership, co-ownership, a leasehold, an option, or a
similar interest is real property under this section. Real property includes the
structural components of both buildings and inherently permanent
structures, such as walls, partitions, doors, wiring, plumbing, central air
conditioning and heating systems, pipes and ducts, elevators and escalators,
and other similar property. Tenant improvements to a building that are
inherently permanent or otherwise classified as real property within the
meaning of [*64] this paragraph (c) (1) are real property under this
section. However, property produced for sale that is not real property in the
hands of the taxpayer or a related person, but that may be incorporated into
real property by an unrelated buyer, is not treated as real property by the
producing taxpayer (e.g., bricks, nails, paint, and windowpanes).
(2) Unsevered natural products of land. Unsevered natural products of land
include growing crops and plants, mines, wells, and other natural deposits.
Growing crops and plants, however, are real property only if the
preproductive period of the crop or plant exceeds 2 years.
(3) Inherently permanent structures. Inherently permanent structures
include property that is affixed to real property and that will ordinarily
remain affixed for an indefinite period of time, such as swimming pools,
roads, bridges, tunnels, paved parking areas and other pavements, special
foundations, wharves and docks, fences, inherently permanent advertising
displays, inherently permanent outdoor lighting facilities, railroad tracks and
signals, telephone poles, power generation and transmission facilities,
permanently installed telecommunications cables, broadcasting [*65]
towers, oil and gas pipelines, derricks and storage equipment, grain storage
bins and silos. For purposes of this section, affixation to real property may
be accomplished by weight alone. Property may constitute an inherently
permanent structure even though it is not classified as a building for
purposes of former section 48 (a) (1) (B) and § 1.48-1. Any property not
otherwise described in this paragraph (c) (3) that constitutes other tangible
property under the principles of former section 48 (a) (1) (B) and § 1.48-1
(d) is treated for the purposes of this section as an inherently permanent
structure.
(4) Machinery -(i) Treatment. A structure that is property in the nature of
machinery or is essentially an item of machinery or equipment is not an

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 29 of 70

inherently permanent structure and is not real property. In the case,
however, of a building or inherently permanent structure that includes
property in the nature of machinery as a structural component, the property
in the nature of machinery is real property.
(ii) Certain factors not determinative. A structure may be an inherently
permanent structure, and not property in the nature of machinery or
essentially an item of machinery, even if [*66] the structure is necessary
to operate or use, supports, or is otherwise associated with, machinery.
(d) Production- (1) Definition of produce. Produce is defined as provided in
section 263A (g) and § 1.263A-2 (a) (1) (i).
(2) Property produced under a contract-(i) Customer. A taxpayer is treated
as producing any property that is produced for the taxpayer (the customer)
by another party (the contractor) under a contract with the taxpayer or an
intermediary. Property produced under a contract is designated property to
the customer if it is real property or tangible personal property that satisfies
the classification thresholds described in paragraph (b) (1) (ii) of this
section. If property produced under a contract will become part of a unit of
designated property produced by the customer in the customer's hands, the
property produced under the contract is designated property to the
customer.
(ii) Contractor. Property produced under a contract is designated property to
the contractor if it is real property, 2-year property, or 1-year property and
the property produced under the contract is not excluded by reason of
paragraph (d) (2) (v) of this section.
(iii) Definition of a contract. For [*67] purposes of this paragraph (d) (2),
contract has the same meaning as under § 1.263A-2 (a) (1) (ii) (B) (2).
(iv) Determination of whether thresholds are satisfied. In the case of
tangible personal property produced under a contract, the customer and the
contractor each determine under this paragraph (d) (2), whether the
property satisfies the classification thresholds described in paragraph (b) (1)
(ii) of this section. Thus, tangible personal property may be designated
property with respect to either, or both, the customer and the contractor.
The provisions of paragraph (b) (2) (iii) of this section are modified as set
forth in this paragraph (d) (2) (iv) for purposes of determining whether
tangible personal property produced under a contract is 2-year property or
1-year property.
(A) Customer. In determining a customer's estimated cost of production, the
customer takes into account costs and payments that are reasonably
expected to be incurred by the customer, but does not take into account
costs incurred (or to be incurred) by an unrelated contractor. In determining
the customer's estimated length of the production period, the production
period is treated as beginning on the earlier [*68] of the date the contract
is executed or the date that the customer's accumulated production
expenditures for the unit are at least 5 percent of the customer's total
estimated production expenditures for the unit. The customer, however, may
elect to treat the production period as beginning on the date the sum of the
accumulated production expenditures of the contractor (or contractors if
more than one contractor is producing components for the unit of property)
and of the customer are at least 5 percent of the customer's estimated
production expenditures for the unit.
(B) Contractor. In determining a contractor's estimated cost of production,

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 30 of 70

the contractor takes into account only the costs that are reasonably
expected to be incurred by the contractor, without any reduction for
payments from the customer. In determining the contractor's estimated
length of the production period, the production period is treated as
beginning on the date the contractor's accumulated production expenditures
(without any reduction for payments from the customer) are at least 5
percent of the contractor's total estimated accumulated production
expenditures.
(v) Exclusion for property subject to long-term contract [*69] rules.
Property described in paragraph (b) of this section is designated property
with respect to a contractor only if-

(A) The contract is not a long-term contract (within the meaning of
section 460 (f)); or

(B) The contract is a home construction contract (within the meaning of
section 460 (e) (6) (A)) with respect to which the requirements of
section 460 (e) (1) (B) (i) and (ii) are not met.

(3) Improvements to existing property -(i) Ingeneral. Any improvement to
property described in § 1.263 (a)-1 (b) constitutes the production of
property. Generally, any improvement to designated property constitutes the
production of designated property. An improvement is not treated as the
production of designated property, however, if the de minimis exception
described in paragraph (b) (4) of this section applies to the improvement. In
addition, paragraph (d) (3) (iii) of this section provides an exception for
certain improvements to tangible personal property. Incidental maintenance
and repairs are not treated as improvements under this paragraph (d) (3).
See § 1.162-4.
(ii) Real property. The rehabilitation or preservation of a standing building,
the clearing of raw land prior to sale, and the [*70] drilling of an oil well
are activities constituting improvements to real property and, therefore, the
production of designated property. Similarly, the demolition of a standing
building generally constitutes an activity that is an improvement to real
property and, therefore, the production of designated property. See the
exceptions, however, in paragraphs (b) (3) and (b) (4) of this section.
(iii) Tangible personal property. If the taxpayer has treated a unit of tangible
personal property as designated property under this section, an
improvement to such property constitutes the production of designated
property regardless of the remaining useful life of the improved property (or
the improvement) and, except as provided in paragraph (b) (4) of this
section, regardless of the estimated length of the production period or the
estimated cost of the improvement. If the taxpayer has not treated a unit of
tangible personal property as designated property under this section, an
improvement to such property constitutes the production of designated
property only if the improvement independently meets the classification
thresholds described in paragraph (b) (1) (ii) of this section.
§ 1.263A-9 The avoided cost method.

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 31 of 70

(a) [*71] In general -(1) Description. The avoided cost method described
in this section must be used to calculate the amount of interest required to
be capitalized under section 263A (f). Generally, any interest that the
taxpayer theoretically would have avoided if accumulated production
expenditures (as defined in § 1.263A-11) had been used to repay or reduce
the taxpayer's outstanding debt must be capitalized under the avoided cost
method. The application of the avoided cost method does not depend on
whether the taxpayer actually would have used the amounts expended for
production to repay or reduce debt. Instead, the avoided cost method is
based on the assumption that debt of the taxpayer would have been repaid
or reduced without regard to the taxpayer's subjective intentions or to
restrictions (including legal, regulatory, contractual, or other restrictions)
against repayment or use of the debt proceeds.
(2) Overview -(i) Ingeneral. For each unit of designated property (within the
meaning of § 1.263A-8 (b)), the avoided cost method requires the
capitalization of-

(A) The traced debt amount under paragraph (b) of this section, and
(B) The excess expenditure amount under paragraph (c) of this
[*72] section.

(ii) Rules that apply in determining amounts. The traced debt and excess
expenditure amounts are determined for each taxable year or shorter
computation period that includes the production period (as defined in §
1.263A-12) of a unit of designated property. Paragraph (d) of this section
provides an election not to trace debt to specific units of designated
property. Paragraph (f) of this section provides rules for selecting the
computation period, for calculating averages, and for determining
measurement dates within the computation period. Special rules are in
paragraph (g) of this section.
(3) Definitions of interest and incurred. Except as provided in the case of
certain expenses that are treated as a substitute for interest under
paragraphs (c) (2) (iii) and (g) (2) (iv) of this section, interest refers to all
amounts that are characterized as interest expense under any provision of
the Code, including, for example, sections 482, 483, 1272, 1274, and 7872.
Incurred refers to the amount of interest that is properly accruable during
the period of time in question determined by taking into account the loan
agreement and any applicable provisions of the Internal Revenue laws
[*73] and regulations such as section 163, § 1.446-2, and sections 1271
through 1275.
(4) Definition of eligible debt. Except as provided in this paragraph (a) (4),
eligible debt includes all outstanding debt (as evidenced by a contract, bond,
debenture, note, certificate, or other evidence of indebtedness). Eligible debt
does not include-

(i) Debt (or the portion thereof) bearing interest that is disallowed

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 32 of 70

under a provision described in § 1.163-8T (m) (7) (ii);

(ii) Debt, such as accounts payable and other accrued items, that
bears no interest, except to the extent that such debt is traced
debt (as defined in paragraph (b) (2) of this section);

(iii) Debt that is borrowed directly or indirectly from a person related
to the taxpayer and that bears a rate of interest that is less than
the applicable Federal rate in effect under section 1274 (d) on the
date of issuance;
(iv) Debt (or the portion thereof) bearing personal interest within the
meaning of section 163 (h) (2);

(v) Debt (or the portion thereof) bearing qualified residence interest
within the meaning of section 163 (h) (3);

(vi) Debt incurred by an organization that is exempt from Federal
income tax under section 501 (a), except to the extent [*74]
interest on such debt is directly attributable to an unrelated trade
or business of the organization within the meaning of section 512;

(vii) Reserves, deferred tax liabilities, and similar items that are not
treated as debt for Federal income tax purposes, regardless of the
extent to which the taxpayer's applicable financial accounting or
other regulatory reporting principles require or support treating
these items as debt; and

(viii) Federal, State, and local income tax liabilities, deferred tax
liabilities under section 453A, and hypothetical tax liabilities
under the look-back method of section 460 (b) or similar
provisions.

(b) Traced debt amount -(1) General rule. Interest must be capitalized with
respect to a unit of designated property in an amount (the traced debt
amount) equal to the total interest incurred on the traced debt during each
measurement period (as defined in paragraph (f) (2) (ii) of this section) that
ends on a measurement date described in paragraph (f) (2) (iii) of this
section. See the example in paragraph (b) (3) of this section. If any interest
incurred on the traced debt is not taken into account for the taxable year
that includes the measurement period because [*75] of a deferral
provision, see paragraph (g) (2) of this section for the time and manner for
capitalizing and recovering that amount. This paragraph (b) (1) does not
apply if the taxpayer elects under paragraph (d) of this section not to trace
debt.
(2) Identification and definition of traced debt. On each measurement date
described in paragraph (f) (2) (iii) of this section, the taxpayer must identify
debt that is traced debt with respect to a unit of designated property. On

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 33 of 70

each such date, traced debt with respect to a unit of designated property is
the outstanding eligible debt (as defined in paragraph (a) (4) of this section)
that is allocated, on that date, to accumulated production expenditures with
respect to the unit of designated property under the rules of § 1.163-8T.
Traced debt also includes unpaid interest that has been capitalized with
respect to such unit under paragraph (b) (1) of this section and that is
included in accumulated production expenditures on the measurement date.
(3) Example. The provisions of paragraphs (b) (1) and (b) (2) of this
section are illustrated by the following example.
Example. Corporation X, a calendar year taxpayer, is engaged in the
production [*76] of a single unit of designated property during 1995 (unit
A). Corporation X adopts a taxable year computation period and quarterly
measurement dates. Production of unit A starts on January 14, 1995, and
ends on June 16, 1995. On March 31, 1995 and on June 30, 1995,
Corporation X has outstanding a $1,000,000 loan that is allocated under the
rules of § 1.163-8T to production expenditures with respect to unit A. During
the period January 1, 1995, through June 30, 1995, Corporation X incurs
$50,000 of interest related to the loan. Under paragraph (b) (1) of this
section, the $50,000 of interest Corporation X incurs on the loan during the
period January 1, 1995, through June 30, 1995, must be capitalized with
respect to unit A.
(c) Excess expenditure amount -(1) General rule. If there are accumulated
production expenditures in excess of traced debt with respect to a unit of
designated property on any measurement date described in paragraph (f)
(2) (iii) of this section, the taxpayer must, for the computation period that
includes the measurement date, capitalize with respect to the unit the
excess expenditure amount calculated under this paragraph (c) (1).
However, if the sum of the excess [*77] expenditure amounts for all units
of designated property of a taxpayer exceeds the total interest described in
paragraph (c) (2) of this section, only a prorata amount (as determined
under paragraph (c) (7) of this section) of such interest must be capitalized
with respect to each unit. For each unit of designated property, the excess
expenditure amount for a computation period equals the product of-

(i) The average excess expenditures (as determined under paragraph
(c) (5) (ii) of this section) for the unit of designated property for
that period, and

(ii) The weighted average interest rate (as determined under
paragraph (c) (5) (iii) of this section) for that period.

(2) Interest required to be capitalized. With respect to an excess
expenditure amount, interest incurred during the computation period is
capitalized from the following sources and in the following sequence but not
in excess of the excess expenditure amount for all units of designated
property:

(i) Interest incurred on nontraced debt (as defined in paragraph (c)

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 34 of 70

(5) (i) of this section);

(ii) Interest incurred on borrowings described in paragraph (a) (4) (iii)
of this section (relating to certain borrowings from related
persons); [*78] and

(iii) In the case of a partnership, guaranteed payments for the use of
capital (within the meaning of section 707 (c)) that would be
deductible by the partnership if section 263A (f) did not apply.

(3) Example. The provisions of paragraph (c) (1) and (2) of this section are
illustrated by the following example.
Example. (i) P, a partnership owned equally by Corporation A and Individual
B, is engaged in the construction of an office building during 1995. Average
excess expenditures for the office building for 1995 are $2,000,000. When P
was formed, A and B agreed that A would be entitled to an annual
guaranteed payment of $70,000 in exchange for A's capital contribution. The
only borrowing of P, A, and B for 1995 is a loan to P from an unrelated
lender of $1,000,000 (loan #1). The loan is nontraced debt and bears
interest at an annual rate of 10 percent. Thus, P's weighted average interest
rate (determined under paragraph (c) (5) (iii) of this section) is 10 percent
and interest incurred during 1995 is $100,000.
(ii) In accordance with paragraph (c) (1) of this section, the excess
expenditure amount is $200,000 ($2,000,000 × 10%). The interest
capitalized under paragraph (c) (2) of this [*79] section is $170,000
($100,000 of interest plus $70,000 of guaranteed payments).
(4) Treatment of interest subject to a deferral provision. If any interest
described in paragraph (c) (2) of this section is not taken into account for
the taxable year that includes the computation period because of a deferral
provision described in paragraph (g) (1) (ii) of this section, paragraph (c)
(2) of this section is first applied without regard to the amount of the
deferred interest. After applying paragraph (c) (2) without regard to the
deferred interest, if the amount of interest capitalized with respect to all
units of designated property for the computation period is less than the
amount that would have been capitalized if a deferral provision did not
apply, see paragraph (g) (2) of this section for the time and manner for
capitalizing and recovering the difference (the shortfall amount).
(5) Definitions -(i) Nontraced debt-(A) Defined. Nontraced debt means all
eligible debt on a measurement date other than any debt that is treated as
traced debt with respect to any unit of designated property on that
measurement date. For example, nontraced debt includes eligible debt that
is allocated to expenditures [*80] that are not capitalized under section
263A (a) (e.g., expenditures deductible under section 174 (a) or 263 (c)).
Similarly, even if eligible debt is allocated to a production expenditure for a
unit of designated property, the debt is included in nontraced debt on
measurement dates before the first or after the last measurement date for
that unit of designated property.
Thus, nontraced debt may include debt that was previously treated as traced
debt or that will be treated as; traced debt on a future measurement date.

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 35 of 70

(B) Example. The provisions of paragraph (c) (5) (i) (A) of this section are
illustrated by the following example.
Example. In 1995, Corporation X begins, but does not complete, the
construction of two office buildings that are separate units of designated
property as defined in § 1.263A-10 (Property D and Property E). At the
beginning of 1995, X borrows $2,500,000 (the $2,500,000 loan), which will
be used exclusively to finance production expenditures for Property D.
Although interest is paid currently, the entire principal amount of the loan
remains outstanding at the end of 1995. Corporation X also has outstanding
during all of 1995 a long-term loan with a principal amount [*81] of
$2,000,000 (the $2,000,000 loan). The proceeds of the $2,000,000 loan
were used exclusively to finance the production of Property C, a unit of
designated property that was completed in 1994. Under the rules of
paragraph (b) (2) of this section, the portion of the $2,500,000 loan
allocated to accumulated production expenditures for property D at each
measurement date during 1995 is treated as traced debt for that
measurement date. The excess, if any, of $2,500,000 over the amount
treated as traced debt at each measurement date during 1995 is treated as
nontraced debt for that measurement date, even though it is expected that
the entire $2,500,000 will be treated as traced debt with respect to Property
D on subsequent measurement dates as more of the proceeds of the loan
are used to finance additional production expenditures. In addition, the
entire principal amount of the $2,000,000 loan is treated as nontraced debt
for 1995, even though it was treated as traced debt with respect to Property
C in a previous period.
(ii) Average excess expenditures -(A) General rule. The average excess
expenditures for a unit of designated property for a computation period are
computed by-

(1) Determining [*82] the amount (if any) by which accumulated
production expenditures exceed traced debt at each measurement
date during the computation period; and

(2) Dividing the sum of these amounts by the number of measurement
dates during the computation period.

(B) Example. The provisions of paragraph (c) (5) (ii) (A) of this section are
illustrated by the following example.
Example. Corporation X, a calendar year taxpayer, is engaged in the
production of a single unit of designated property during 1995 (unit A).
Corporation X adopts the taxable year as the computation period and
quarterly measurement dates. The production period for unit A begins on
January 14, 1995, and ends on June 16, 1995. On March 31, 1995, and on
June 30, 1995, Corporation X has outstanding $1,000,000 of traced debt
with respect to unit A. Accumulated production expenditures for unit A on
March 31, 1995, are $1,400,000 and on June 30, 1995, are $1,600,000.
Accumulated production expenditures in excess of traced debt for unit A on
March 31, 1995, are $400,000 and on June 30, 1995, are $600,000.
Average excess expenditures for unit A during 1995 are therefore $250,000

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 36 of 70

([$400,000 $plus; $600,000 + $0 + $0] 4).
(iii) Weighted [*83] average interest rate -(A) Determination of rate. The
weighted average interest rate for a computation period is determined by
dividing interest incurred on non-traced debt during the period by average
nontraced debt for the period.
(B) Interest incurred on nontraced debt. Interest incurred on nontraced debt
during the computation period is equal to the total amount of interest
incurred during the computation period on all eligible debt minus the amount
of interest incurred during the computation period on traced debt. Thus, all
interest incurred on nontraced debt during the computation period is
included in the numerator of the weighted average interest rate, even if the
underlying nontraced debt is repaid before the end of a measurement period
and excluded from nontraced debt outstanding for measurement dates after
repayment, in determining the denominator of the weighted average interest
rate. However, see paragraph (g) (7) of this section for an election to treat
eligible debt that is repaid within the 15-day period immediately preceding a
quarterly measurement date as outstanding on that measurement date. See
paragraph (a) (3) of this section for the definitions of interest and [*84]
incurred.
(C) Average nontraced debt. The average nontraced debt for a computation
period is computed by-

(1) Determining the amount of nontraced debt outstanding on each
measurement date during the computation period; and

(2) Dividing the sum of these amounts by the number of measurement
dates during the computation period.

(D) Special rules if taxpayer has no nontraced debt or rate is contingent. If
the taxpayer does not have non-traced debt outstanding during the
computation period, the weighted average interest rate for purposes of
applying paragraphs (c) (1) and (c) (2) of this section is the highest
applicable Federal rate in effect under section 1274 (d) during the
computation period. If interest is incurred at a rate that is contingent at the
time the return for the year that includes the computation period is filed, the
amount of interest is determined using the higher of the fixed rate of
interest (if any) on the underlying debt or the applicable Federal rate in
effect under section 1274 (d) on the date of issuance.
(6) Examples. The following examples illustrate the principles of this
paragraph (c):

Example 1. (i) W, a calendar year taxpayer, is engaged in the
production of a unit [*85] of designated property during 1995.
For purposes of applying the avoided cost method of this section,
W uses the taxable year as the computation period. During
1995, W's only debt is a $1,000,000 loan bearing interest at a
rate of 7 percent from Y, a person that is related to W. Assuming

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 37 of 70

the applicable Federal rate in effect under section 1274 (d) on
the date of issuance of the loan is 10 percent, the loan is not
eligible debt under paragraph (a) (4) of this section. However,
even though W has no eligible debt, W incurs $70,000
($1,000,000 x 7%) of interest during the computation period.
This interest is described in paragraph (c) (2) of this section and
must be capitalized under paragraph (c) (1) of this section to the
extent it does not exceed W's excess expenditure amount for the
unit of property.
(ii) W determines, under paragraph (c) (5) (ii) of this section,
that average excess expenditures for the unit of property are
$600,000. Assuming the highest applicable Federal rate in effect
under section 1274 (d) during the computation period is 10
percent, W uses 10 percent as the weighted average interest
rate for purposes of determining the excess expenditure amount.
See paragraph [*86] (c) (5) (iii) (D) of this section. In
accordance with paragraph (c) (1) of this section, the excess
expenditure amount is therefore $60,000. Because this amount
does not exceed the total amount of interest described in
paragraph (c) (2) of this section ($70,000), W is required to
capitalize $60,000 of interest with respect to the unit of
designated property for the 1995 computation period.
Example 2.(i) Corporation X, a calendar year taxpayer, is
engaged in the production of a single unit of designated property
during 1995 (unit A). Corporation X adopts the taxable year as
the computation period and quarterly measurement dates.
Production of unit A begins in 1994 and ends on June 30, 1995.
On March 31, 1995, and on June 30, 1995, Corporation X has
outstanding $1,000,000 of eligible debt (loan #1) that is
allocated under the rules of § 1.163-8T to production
expenditures for unit A. During each of the first two quarters of
1995, $30,000 of interest is incurred on loan #1. The loan is
repaid on July 1, 1995. Throughout 1995, Corporation X also has
outstanding $2,000,000 of eligible debt (loan #2) which is not
allocated under the rules of § 1.163-8T to the production of unit
A. During [*87] 1995, $200,000 of interest is incurred on this
nontraced debt. Accumulated production expenditures on March
31, 1995, are $1,400,000 and on June 30, 1995, are
$1,600,000. Accumulated production expenditures in excess of
traced debt on March 31, 1995, are $400,000 and on June 30,
1995, are $600,000.
(ii) Under paragraph (b) (1) of this section, the amount of
interest capitalized with respect to traced debt is $60,000
($30,000 for the measurement period ending March 31, 1995,
and $30,000 for the measurement period ending June 30, 1995).
Under paragraph (c) (5) (ii) of this section, average excess
expenditures for unit A are $250,000 ([($1,400,000 ?
$1,000,000) + ($1,600,000 − $1,000,000) + $0
+ $0] 4). Under paragraph (c) (5) (iii) (C) of this section,
average nontraced debt is $2,000,000 ([$2,000,000 +
$2,000,000 + $2,000,000 + $2,000,000] 4). Under
paragraph (c) (5) (iii) (B) of this section, interest incurred on
nontraced debt is $200,000 ($260,000 of interest incurred on all
eligible debt less $60,000 of interest incurred on traced debt).
Under paragraph (c) (5) (iii) (A) of this section, the weighted
average interest rate is 10 percent ($200,000 $2,000,000).

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 38 of 70

[*88] Under paragraph (c) (1) of this section, Corporation X
capitalizes the excess expenditure amount of $25,000 ($250,000
× 10%), because it does not exceed the total amount of interest
subject to capitalization under paragraph (c) (2) of this section
($200,000). Thus, the total interest capitalized with respect to
unit A during 1995 is $85,000 ($60,000 + $25,000).

(7) Special rules where the excess expenditure amount exceeds incurred
interest-(i) Allocation of total incurred interest to units. For a computation
period in which the sum of the excess expenditure amounts under paragraph
(c) (1) of this section for all units of designated property exceeds the total
amount of interest (including deferred interest) available for capitalization,
as determined under paragraph (c) (2) of this section, the amount of
interest that is allocated to a unit of designated property is equal to the
product of-

(A) The total amount of interest (including deferred interest) available
for capitalization, as determined under paragraph (c) (2) of this
section; and

(B) A fraction, the numerator of which is the average excess
expenditures for the unit of designated property and the
denominator of which is the [*89] sum of the average excess
expenditures for all units of designated property.

(ii) Application of related person rules to average excess expenditures.
Certain excess expenditures must be taken into account by the persons (if
any) required to capitalize interest with respect to production expenditures
of the taxpayer under applicable related person rules. For each computation
period, the amount of average excess expenditures that must be taken into
account by such persons for each unit of the taxpayer's property is
computed by-

(A) Determining, for the computation period, the amount (if any) by
which the excess expenditure amount for the unit exceeds the
amount of interest allocated to the unit under paragraph (c) (7) (i)
of this section; and

(B) Dividing the excess by the weighted average interest rate for the
period.

(iii) Special rule for corporations. If a corporation is related to another
person for the purposes of the applicable related party rules, the District
Director upon examination may require that the corporation apply this
paragraph (c) (7) and other provisions of the regulations by excluding
deferred interest from the total interest available for capitalization.

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 39 of 70

(d) Election [*90] not to trace debt-(1) General rule. Taxpayers may elect
not to trace debt. If the election is made, the average excess expenditures
and weighted average interest rate under paragraph (c) (5) of this section
are determined by treating all eligible debt as nontraced debt. For this
purpose, debt specified in paragraph (a) (4) (ii) of this section (e.g.,
accounts payable) may be included in eligible debt, provided it would be
treated as traced debt but for an election under this paragraph (d). The
election not to trace debt is a method of accounting that applies to the
determination of capitalized interest for all designated property of the
taxpayer. The making or revocation of the election is a change in method of
accounting requiring the consent of the Commissioner under section 446 (e)
and § 1.446-1 (e).
(2) Example. The provisions of paragraph (d) (1) of this section are
illustrated by the following example.
Example. (i) Corporation X, a calendar year taxpayer, is engaged in the
production of a single unit of designated property during 1995 (unit A).
Corporation X adopts the taxable year as the computation period and
quarterly measurement dates. At each measurement date (March 31, June
[*91] 30, September 30, and December 31) Corporation X has the
following outstanding indebtedness:

Noninterest-bearing accounts payable traced
to unit A

$

Noninterest-bearing accounts payable that are
not traced to unit A

$

Interest-bearing loans that are eligible debt
within the meaning of paragraph (a) (4) of
this section

$

(ii) Corporation X elects under this paragraph (d) not to trace debt. Eligible
debt at each measurement date for purposes of calculating the weighted
average interest rate under paragraph (c) (5) (iii) of this section is
$1,000,000 ($100,000 + $900,000).
(e) Election to use external rate -(1) In general. An eligible taxpayer may
elect to use the highest applicable Federal rate (AFR) under section 1274 (d)
in effect during the computation period plus 3 percentage points (AFR plus
3) as a substitute for the weighted average interest rate determined under
paragraph (c) (5) (iii) of this section. A taxpayer that makes this election
may not trace debt. The use of the AFR plus 3 as provided under this
paragraph (e) (1) constitutes a method of accounting. A taxpayer makes the
election to use the AFR plus 3 method by using the AFR plus 3 as the
taxpayer's [*92] weighted average interest rate, and any change to the
AFR plus 3 method by a taxpayer that has never previously used the method
does not require the consent of the Commissioner. Any other change to or
from the use of the AFR plus 3 method under this paragraph (e) (1) (other
than by reason of a taxpayer ceasing to be an eligible taxpayer) is a change
in method of accounting requiring the consent of the Commissioner under
section 446 (e) and § 1.446-1 (e). All changes to or from the AFR plus 3
method are effected on a cut-off basis.
(2) Eligible taxpayer. A taxpayer is an eligible taxpayer for a taxable year for

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 40 of 70

purposes of this paragraph (e) if the average annual gross receipts of the
taxpayer for the three previous taxable years do not exceed $10,000,000
(the $10,000,000 gross receipts test) and the taxpayer has met the
$10,000,000 gross receipts test for all prior taxable years beginning after
December 31, 1994. For purposes of this paragraph (e) (2), the principles of
section 263A (b) (2) (B) and (C) and § 1.263A-3 (b) apply in determining
whether a taxpayer is an eligible taxpayer for a taxable year.
(f) Selection of computation period and measurement dates and application
of averaging [*93] conventions -(1) Computation period -(i) In general. A
taxpayer may (but is not required to) make the avoided cost calculation on
the basis of a full taxable year. If the taxpayer uses the taxable year as the
computation period, a single avoided cost calculation is made for each unit
of designated property for the entire taxable year. If the taxpayer uses a
computation period that is shorter than the full taxable year, an avoided cost
calculation is made for each unit of designated property for each shorter
computation period within the taxable year. If the taxpayer uses a shorter
computation period, the computation period may not include portions of
more than one taxable year and, except as provided in the case of short
taxable years, each computation period within a taxable year must be the
same length. In the case of a short taxable year, a taxpayer may treat a
period shorter than the taxpayer's regular computation period as the first or
last computation period, or as the only computation period for the year if the
year is shorter than the taxpayer's regular computation period. A taxpayer
must use the same computation periods for all designated property produced
during a single [*94] taxable year.
(ii) Method of accounting. The choice of a computation period is a method of
accounting. Any change in the computation period is a change in method of
accounting requiring the consent of the Commissioner under section 446 (e)
and § 1.446-1 (e).
(iii) Production period beginning or ending during the computation period.
The avoided cost method applies to the production of a unit of designated
property on the basis of a full computation period, regardless of whether the
production period for the unit of designated property begins or ends during
the computation period.
(2) Measurement dates -(i) In general. If a taxpayer uses the taxable year
as the computation period, measurement dates must occur at quarterly or
more frequent regular intervals. If the taxpayer uses computation periods
that are shorter than the taxable year, measurement dates must occur at
least twice during each computation period and at least four times during
the taxable year (or consecutive 12-month period in the case of a short
taxable year). The taxpayer must use the same measurement dates for all
designated property produced during a computation period. Except in the
case of a computation period that [*95] differs from the taxpayer's regular
computation period by reason of a short taxable year (see paragraph (f) (1)
(i) of this section), measurement dates must occur at equal intervals during
each computation period that falls within a single taxable year. For any
computation period that differs from the taxpayer's regular computation
period by reason of a short taxable year, the measurement dates used by
the taxpayer during that period must be consistent with the principles and
purposes of section 263A (f). A taxpayer is permitted to modify the
frequency of measurement dates from year to year.
(ii) Measurement period. For purposes of this section, measurement period
means the period that begins on the first day following the preceding
measurement date and that ends on the measurement date.

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 41 of 70

(iii) Measurement dates on which accumulated production expenditures must
be taken into account. The first measurement date on which accumulated
production expenditures must be taken into account with respect to a unit of
designated property is the first measurement date following the beginning of
the production period for the unit of designated property. The final
measurement date on which accumulated [*96] production expenditures
with respect to a unit of designated property must be taken into account is
the first measurement date following the end of the production period for the
unit of designated property. Accumulated production expenditures with
respect to a unit of designated property must also be taken into account on
all intervening measurement dates. See § 1.263A-12 to determine when the
production period begins and ends.
(iv) More frequent measurement dates. When in the opinion of the District
Director more frequent measurement dates are necessary to determine
capitalized interest consistent with the principles and purposes of section
263A (f) for a particular computation period, the District Director may
require the use of more frequent measurement dates. If a significant
segment of the taxpayer's production activities (the first segment) requires
more frequent measurement dates than another significant segment of the
taxpayer's production activities, the taxpayer may request a ruling from the
Internal Revenue Service permitting, for a taxable year and all subsequent
taxable years, a segregation of the two segments and, notwithstanding
paragraph (f) (2) (i) of this section, [*97] the use of the more frequent
measurement dates for only the first segment. The request for a ruling must
be made in accordance with any applicable rules relating to submissions of
ruling requests. The request must be filed on or before the due date
(including extensions) of the original Federal income tax return for the first
taxable year to which it will apply.
(3) Examples. The following examples illustrate the principles of this
paragraph (f):

Example 1. Corporation X, a calendar year taxpayer, is engaged
in the production of designated property during 1995.
Corporation X adopts the taxable year as the computation period
and quarterly measurement dates. Corporation X must identify
traced debt, accumulated production expenditures, and
nontraced debt at each quarterly measurement date (March 31,
June 30, September 30, and December 31). Under paragraph (c)
(5) (ii) of this section, Corporation X must calculate average
excess expenditures for each unit of designated property by
determining the amount by which accumulated production
expenditures exceed traced debt for each unit at the end of each
quarter and dividing the sum of these amounts by four. Under
paragraph (c) (5) (iii) (C) of [*98] this section, Corporation X
must calculate average nontraced debt by determining the
amount of nontraced debt outstanding at the end of each quarter
and dividing the sum of these amounts by four.
Example 2. Corporation X, a calendar year taxpayer, is engaged
in the production of designated property during 1995.
Corporation X adopts a 6-month computation period with two
measurement dates within each computation period. Corporation
X must identify traced debt, accumulated production
expenditures, and nontraced debt at each measurement date

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 42 of 70

(March 31 and June 30 for the first computation period and
September 30 and December 31 for the second computation
period). Under paragraph (c) (5) (ii) of this section, Corporation
X must, for each computation period, calculate average excess
expenditures for each unit of designated property by determining
the amount by which accumulated production expenditures
exceed traced debt for each unit at each measurement date
during the period and dividing the sum of these amounts by two.
Under paragraph (c) (5) (iii) (C) of this section, Corporation X
must calculate average nontraced debt for each computation
period by determining the amount of nontraced [*99] debt
outstanding at each measurement date during the period and
dividing the sum of these amounts by two.
Example 3. (i) Corporation X, a calendar year taxpayer, is
engaged in the production of two units of designated property
during 1995. Production of Unit A starts in 1994 and ends on
June 20, 1995. Production of Unit B starts on April 15, 1995, but
does not end until 1996. Corporation X adopts the taxable year
as its computation period and does not elect under paragraph
(d) of this section not to trace debt. Corporation X uses quarterly
measurement dates and pays all interest on eligible debt in the
quarter in which the interest is incurred. During 1995,
Corporation X has two items of eligible debt. The debt and the
manner in which it is used are as follows:

#

Principal

Annual rate

Period
outstanding

1

$1,000,000

9%

1/01-9/01

2

2,000,000

11%

6/01-12/31

Use

(ii) Based on the annual 9 percent rate of interest, Corporation X
incurs $7,500 of interest during each month that Loan #1 is
outstanding.
(iii) Accumulated production expenditures at the end of each
quarter during 1995 are as follows:

Measurement Date

Unit A

Unit

March 31

$1,200,000

$-0

June 30

$1,800,000

$ 500,

Sept. 30

-0-

$1,000

Dec. 31

-0-

$1,600

(iv) [*100] Corporation X must first determine the amount of
interest incurred on traced debt and capitalize the interest
incurred on this debt (the traced debt amount). Loan #1 is
allocated to Unit A on the March 31 and June 30 measurement
dates. Accordingly, Loan #1 is treated as traced debt with
respect to unit A for the measurement periods beginning January

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 43 of 70

1 and ending June 30. The interest incurred on Loan #1 during
the period that Loan #1is treated as traced debt must be
capitalized with respect to Unit A. Thus, $45,000 ($7,500 per
month for 6 months) is capitalized with respect to Unit A.
(v) Second, Corporation X must determine average excess
expenditures for Unit A and Unit B. For Unit A, this amount is
$250,000 ([$200,000 + $800,000 + $0 + $0] 4).
For Unit B, this amount is $775,000 ([$0 + $500,000 +
$1,000,000 + $1,600,000] ÷ 4).
(vi) Third, Corporation X must determine the weighted average
interest rate and apply that rate to the average excess
expenditures for Units A and B. The rate is equal to the total
amount of interest incurred on nontraced debt (i.e., interest
incurred on all eligible debt reduced by interest incurred on
traced debt) divided by the [*101] average nontraced debt.
The interest incurred on nontraced debt equals $143,333
([$1,000,000 × 9% × 8/12] + [$2,000,000 × 11% × 7/12]
− $45,000). The average nontraced debt equals $1,500,000
([$0 + $2,000,000 + $2,000,000 + $2,000,000]
4). The weighted average interest rate of 9.56 percent
($143,333 $1,500,000), is then applied to average excess
expenditures for Units A and

B. Accordingly, Corporation X capitalizes an additional $23,900 ($250,000 ×
9.56%) with respect to Unit A and $74,090 ($775,000 × 9.56%) with
respect to Unit B (the excess expenditure amounts).
(g) Special rules -(1) Ordering rules -(i) Provisions preempted by section
263A (f). Interest must be capitalized under section 263A (f) before the
application of section 163 (d) (regarding the investment interest limitation),
section 163 (j) (regarding the limitation on interest paid to a taxexempt
related person), section 266 (regarding the election to capitalize carrying
charges), section 469 (regarding the limitation on passive losses), and
section 861 (regarding the allocation of interest to United States sources).
Any interest that is capitalized under section 263A (f) is not taken into
account as interest [*102] under those sections. However, in applying
section 263A (f) with respect to the excess expenditure amount, the
taxpayer must capitalize all interest that is neither investment interest under
section 163 (d), exempt related person interest under section 163 (j), nor
passive interest under section 469 before capitalizing any interest that is
either investment interest, exempt related person interest, or passive
interest. Any interest that is not required to be capitalized after the
application of section 263A (f) is then taken into account as interest subject
to sections 163 (d), 163 (j), 266, 469, and 861. If, after the application of
section 263A (f), interest is deferred under sections 163 (d), 163 (j), 266, or
469, that interest is not subject to capitalization under section 263A (f) in
any subsequent taxable year.
(ii) Deferral provisions applied before this section. Interest (including
contingent interest) that is subject to a deferral provision described in this
paragraph (g) (1) (ii) is subject to capitalization under section 263A (f) only
in the taxable year in which it would be deducted if section 263A (f) did not
apply. Deferral provisions include sections 163 (e) (3), 267, [*103] 446,
and 461, and all other deferral or limitation provisions that are not described
in paragraph (g) (1) (i) of this section. In contrast to the provisions of

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 44 of 70

paragraph (g) (1) (i) of this section, deferral provisions are applied before
the application of section 263A (f).
(2) Application of section 263A (f) to deferred interest -(i) In general. This
paragraph (g) (2) describes the time and manner of capitalizing and
recovering the deferral amount. The deferral amount for any computation
period equals the sum of-

(A) The amount of interest that is incurred on traced debt that is
deferred during the computation period and is not deductible for
the taxable year that includes the computation period because of a
deferral provision described in paragraph (g) (1) (ii) of this section,
and

(B) The shortfall amount described in paragraph (c) (40 of this section.

(ii) Capitalization of deferral amount. The rules described in paragraph (g)
(2) (iii) of this section apply to the deferral amount unless the taxpayer
elects under paragraph (g) (2) (iv) of this section to capitalize substitute
costs.
(iii) Deferred capitalization. If the taxpayer does not elect under paragraph
(g) (2) (iv) of this section [*104] to capitalize substitute costs, deferred
interest to which the deferral amount is attributable (determined under any
reasonable method) is capitalized in the year or years in which the deferred
interest would have been deductible but for the application of section 263A
(f) (the capitalization year). For this purpose, any interest that is deferred
from a prior computation period is taken into account in subsequent
capitalization years in the same order in which the interest was deferred. If a
unit of designated property to which previously deferred interest relates is
sold before the capitalization year, the deferred interest applicable to that
unit of property is taken into account in the capitalization year and treated
as if recovered from the sale of the property. If the taxpayer continues to
hold, throughout the capitalization year, a unit of depreciable property to
which previously deferred interest relates, the adjusted basis and applicable
recovery percentages for the unit of property are redetermined for the
capitalization year and subsequent years so that the increase in basis is
accounted for over the remaining recovery periods beginning with the
capitalization year. See Example [*105] 2 of paragraph (g) (2) (v) of this
section.
(iv) Substitute capitalization -(A) General rule. In lieu of deferred
capitalization under paragraph (g) (2) (iii) of this section, the taxpayer may
elect the substitute capitalization method described in this paragraph (g) (2)
(iv). Under this method, the taxpayer capitalizes for the computation period
in which interest is incurred and deferred (the deferral period) costs that
would be deducted but for this paragraph (g) (2) (iv) (substitute costs). The
taxpayer must capitalize an amount of substitute costs equal to the deferral
amount for each unit of designated property, or if less, a prorata amount
(determined in accordance with the principles of paragraph (c) (7) (i) of this
section) of the total substitute costs that would be deducted but for this
paragraph (g) (2) (iv) during the deferral period. If the entire deferral
amount is capitalized pursuant to this paragraph (g) (2) (iv) in the deferral

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 45 of 70

period, any interest incurred and deferred in the deferral period is neither
capitalized nor deducted during the deferral period and, unless subsequently
capitalized as a substitute cost under this paragraph (g) (2) (iv), is
deductible in the [*106] appropriate subsequent period without regard to
section 263A (f).
(B) Capitalization of amount carried forward. If the taxpayer has an
insufficient amount of substitute costs in the deferral period, the amount by
which substitute costs are insufficient with respect to each unit of designated
property is a deferral amount carryforward to succeeding computation
periods beginning with the next computation period. In any carryforward
year, the taxpayer must capitalize an amount of substitute costs equal to the
deferral amount carryforward or, if less, a prorata amount (determined in
accordance with the principles of paragraph (c) (7) (i) of this section) of the
total substitute costs that would be deducted during the carryforward year or
years (the carryforward capitalization year) but for this paragraph (g) (2)
(iv) (after applying the substitute cost method of this paragraph (g) (2) (iv)
to the production of designated property in the carryforward period). If a
unit of designated property to which the deferral amount carryforward
relates is sold prior to the carryforward capitalization year, substitute costs
applicable to that unit of property are taken into account in the carryforward
[*107] capitalization year and treated as if recovered from the sale of the
property. If the taxpayer continues to hold, throughout the capitalization
year, a unit of depreciable property to which a deferral amount carryforward
relates, the adjusted basis and applicable recovery percentages for the unit
of property are redetermined for the carryforward capitalization year and
subsequent years so that the increase in basis is accounted for over the
remaining recovery periods beginning with the carryforward capitalization
year. See Example 2 of paragraph (g) (2) (v) of this section.
(C) Method of accounting. The substitute capitalization method under this
paragraph (g) (2) (iv) is a method of accounting that applies to all
designated property of the taxpayer. A change to or from the substitute
capitalization method is a change in method of accounting requiring the
consent of the Commissioner under section 446 (e) and § 1.446-1 (e).
(v) Examples. The following examples illustrate the application of the
avoided cost method when interest is subject to a deferral provision:

Example 1. (i) Corporation X is a calendar year taxpayer and
uses the taxable year as its computation period. During 1995, X
[*108] is engaged in the construction of a warehouse which X
will use in its storage business. The warehouse is completed and
placed in service in December 1995. X's average excess
expenditures for 1995 equal $1,000,000. Throughout 1995, X's
only outstanding debt is nontraced debt of $900,000 and
$1,200,000, bearing interest at 15 percent and 9 percent,
respectively, per year. Of the $243,000 interest incurred during
the year ([$900,000 × 15%] + [$1,200,000 × 9%]
= [$135,000 + $108,000]), $75,000 is deferred
under section 267 (a) (2).
(ii) X must first determine the amount of interest required to be
capitalized under paragraph (c) (1) of this section for 1995 (the
deferral period) without applying section 267 (a) (2). The
weighted average interest rate is 11.6 percent ([$135,000
+ $108,000] $2,100,000), and the excess expenditure

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 46 of 70

amount under paragraph (c) (1) of this section is $116,000
($1,000,000 × 11.6%). Under paragraph (c) (4) of this section,
X must then determine the amount of interest that would be
capitalized by applying paragraph (c) (2) of this section without
regard to the amount of deferred interest. Disregarding deferred
interest, the amount of interest [*109] available for
capitalization is $168,000 ([$900,000 × 15%] +
[$1,200,000 × 9%] + $75,000). Thus, the full excess
expenditure amount ($116,000) is capitalized from interest that
is not deferred under section 267 (a) (2) and there is no shortfall
amount.
Example 2. (i) The facts are the same as in Example 1, except
that $140,000 of interest is deferred under section 267 (a) (2) in
1995. The taxpayer does not elect to use the substitute
capitalization method. This interest is also deferred in 1996 but
would be deducted in 1997 if section 263A (f) did not apply. As
in Example 1, the excess expenditure amount is $116,000.
However, the amount of interest available for capitalization after
excluding the amount of deferred interest is $103,000
([$900,000 × 15%] + [$1,200,000 times; 9%] +
$140,000). Thus, only $103,000 of interest is capitalized with
respect to the warehouse in 1995. Since $116,000 of interest
would be capitalized if section 267 (a) (2) did not apply, the
deferral amount determined under paragraphs (c) (2) and (g)
(2) (i) of this section is $13,000 ($116,000 plus; $103,000), and
$13,000 of deferred interest must be capitalized in the year in
which it would [*110] be deducted if section 263A (f) did not
apply.
(ii) The $140,000 of interest deferred under section 267 (a) (2)
in 1995 would be deducted in 1997 if section 263A (f) did not
apply. X is therefore required to capitalize an additional $13,000
of interest with respect to the warehouse in 1997 and must
redetermine its basis and recovery percentage.

(3) Simplified inventory method -(i) In general. This paragraph (g) (3)
provides a simplified method of capitalizing interest expense with respect to
designated property that is inventory. Under this method, the taxpayer
determines beginning and ending inventory and cost of goods sold applying
all other capitalization provisions, including, for example, the simplified
production method of § 1.263A-2 (b), but without regard to the
capitalization of interest with respect to inventory. The taxpayer must
establish a separate capital asset, however, in an amount equal to the
aggregate interest capitalization amount (as defined in paragraph (g) (3)
(iii) (C) of this section). Under the simplified inventory method, increases in
the aggregate interest capitalization amount from one year to the next
generally are treated as reductions in interest expense, [*111] and
decreases in the aggregate interest capitalization amount from one year to
the next are treated as increases to cost of goods sold.
(ii) Segmentation of inventory -(A) General rule. Under the simplified
inventory method, the taxpayer first separates its total ending inventory
value into segments that are equal to the total ending inventory value
divided by the inverse inventory turnover rate. Each inventory segment is
then assigned an age starting with one year and increasing by one year for
each additional segment. The inverse inventory turnover rate is determined

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 47 of 70

by finding the average of beginning and ending inventory, dividing the
average by the cost of goods sold for the year, and rounding the result to
the nearest whole number. Beginning and ending inventory amounts are
determined using total current cost of inventory for the year (rather than
carrying value). Cost of goods sold, however, may be determined using
either total current cost or the taxpayer's inventory method. In addition, for
purposes of this paragraph (g) (3) (ii), current costs for a year (and, if
applicable, the cost of goods sold for the year under the taxpayer's inventory
method) are determined without regard [*112] to the capitalization of
interest with respect to inventory.
(B) Example. The provisions of paragraph (g) (3) (ii) (A) of this section are
illustrated by the following example.
Example. X, a taxpayer using the FIFO inventory method, determines that
total cost of goods sold for 1995 equals $900, and the cost of both beginning
and ending inventory equals $3,000. Thus, X's inverse inventory turnover
rate equals 3 (3.33 rounded to the nearest whole number). Total ending
inventory of $3,000 is divided into three segments of $1,000 each. One
segment is treated as 3-year-old inventory, one segment is treated as 2year-old inventory, and one segment is treated as 1-year-old inventory.
(iii) Aggregate interest capitalization amount -(A) Computation period and
weighed average interest rate. If a taxpayer elects the simplified inventory
method, the taxpayer must use the taxable year as its computation period
and use the weighted average interest rate determined under this paragraph
(g) (3) (iii) (A) in determining the aggregate interest capitalization amount
defined in paragraph (g) (3) (iii) (C) of this section and in determining the
amount of interest capitalized with respect to any designated [*113]
property that is not inventory. Under the simplified inventory method, the
taxpayer determines the weighted average interest rate in accordance with
paragraph (c) (5) (iii) of this section, treating all eligible debt (other than
debt traced to noninventory property in the case of a taxpayer tracing debt)
as nontraced debt (i.e., without tracing debt to inventory). A taxpayer that
has elected under paragraph (e) of this section to use an external rate as a
substitute for the weighted average interest rate determined under
paragraph (c) (5) (iii) of this section uses the rate described in paragraph
(e) (1) as the weighted average interest rate.
(B) Computation of the tentative aggregate interest capitalization amount.
The weighted average interest rate is compounded annually by the number
of years assigned to a particular inventory segment to produce an interest
factor (applicable interest factor) for that segment. The amounts determined
by multiplying the value of each inventory segment by its applicable interest
factor are then combined to produce a tentative aggregate interest
capitalization amount.
(C) Coordination with other interest capitalization computations -(1) In
general. If [*114] the tentative aggregate interest capitalization amount
for a year exceeds the aggregate interest capitalization amount (defined in
paragraph (g) (3) (iii) (D) of this section) as of the close of the preceding
year, then, for purposes of applying the rules of paragraph (c) (7) of this
section, the excess is treated as an excess expenditure amount and the
inventory to which the simplified inventory method of this paragraph (g) (3)
applies is treated as a single unit of designated property. If, after these
modifications, no paragraph (c) (7) interest allocation is necessary (i.e., the
excess expenditure amounts for all units of designated property do not
exceed the total amount of interest (including deferred interest) available for
capitalization), the aggregate interest capitalization amount generally equals

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 48 of 70

the tentative aggregate interest capitalization amount. If, on the other hand,
a paragraph (c) (7) allocation is necessary, the tentative aggregate interest
capitalization amount is generally adjusted to reflect the results of that
allocation (i.e., the increase in the aggregate interest capitalization amount
is limited to the amount of interest allocated to inventory, reduced, [*115]
however, by any substitute costs that are capitalized with respect to
inventory under applicable related party rules).
(2) Deferred interest. In determining the aggregate interest capitalization
amount, the tentative aggregate interest capitalization amount is adjusted
(after the application of paragraph (c) (7) of this section) as appropriate to
reflect the deferred interest rules of paragraph (g) (2) of this section. The
tentative aggregate interest capitalization amount would be reduced, for
example, by the amount of a taxpayer's deferred interest for a taxable year
unless the taxpayer has elected the substitute capitalization method under
paragraph (g) (2) (iv).
(3) Other coordinating provisions. The Commissioner may prescribe, by
revenue ruling or revenue procedure, additional provisions to coordinate the
election and use of the simplified inventory method with other interest
capitalization requirements and methods. See § 601.601 (d) (2) (ii) (b) of
this chapter.
(D) Treatment of increases or decreases in the aggregate interest
capitalization amount. Except as otherwise provided in this paragraph (g) (3)
(iii) (D), increases in the aggregate interest capitalization amount from one
[*116] year to the next are treated as reductions in interest expense, and
decreases in the aggregate interest capitalization amount from one year to
the next are treated as increases to cost of goods sold. To the extent a
taxpayer capitalizes substitute costs under either applicable related party
rules or the deferred interest rules in paragraph (g) (2) of this section,
increases in the aggregate interest capitalization amount are treated as
reductions in applicable substitute costs, rather than interest expense.
(E) Example. The provisions of this paragraph (g) (3) (iii) are illustrated by
the following example.
Example. The facts are the same as in the example in paragraph (g) (3) (ii)
(B) of this section, and, in addition X determines that its weighted average
interest rate for 1995 is 10 percent. Additionally, assume that X has no
deferred interest in 1995 or 1996 and no deferral amount carryforward to
either 1995 or 1996 (See paragraph (g) (2) of this section.) Also assume
that no allocation is necessary under paragraph (c) (7) of this section in
either 1995 or 1996. Under the rules of paragraph (g) (3) (ii) of this section,
S divides ending inventory into segments of $1,000 each. One [*117]
segment is 1-year old inventory, one segment is 2-year old inventory, and
one segment is 3-year old inventory. Under paragraph (g) (3) (iii) (B) of this
section, X must compute the applicable interest factor for each segment. The
applicable interest factor for the 1-year old inventory is not compounded.
The applicable interest factor for the 2-year old inventory is compounded for
1 year. The applicable interest factor for the 3-year old inventory is
compounded for 2 years. The interest factor applied to the 1-year old
inventory segment is 1. The interest factor applied to the 2-year old
inventory segment is .21 [(1.1 × 1.1) − 1]. The interest factor applied to the
3-year old inventory is .331 [(1.1 × 1.1 × 1.1) − 1]. Thus, the tentative
aggregate interest capitalization amount for 1995 is $641 (1,000 × [.1
+ .21 + .331]). Because X has no deferred interest in 1995, no
deferral amount carryforward to 1995, and no required allocation under
paragraph (c) (7) of this section in 1995, X's aggregate interest

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584
capitalization
capitalization
capitalization
from 1995 to
1996.

Page 49 of 70
amount equals its $641 tentative aggregate interest
amount. If, in 1996, X computes an aggregate interest
amount of $750, the $109 [*118] increase in the amount
1996 would be treated as a reduction in interest expense for

(iv) Method of accounting. The simplified inventory method is a method of
accounting that must be elected for and applied to all inventory within a
single trade or business of the taxpayer (within the meaning of section 446
(d) and § 1.446-1 (d)). This method may be elected only if the inventory in
that trade or business consists only of designated property and only if the
taxpayer's inverse inventory turnover rate for that trade or business (as
defined in paragraph (g) (3) (ii) (A) of this section) is greater than or equal
to one. A change from or to the simplified inventory method is a change in
method of accounting requiring the consent of the Commissioner under
section 446 (e) and § 1.446-(1) (e).
(4) Financial accounting method disregarded. The avoided cost method is
applied under this section without regard to any financial or regulatory
accounting principles for the capitalization of interest. For example, this
section determines the amount of interest that must be capitalized without
regard to Financial Accounting Standards Board (FASB) Statement Nos. 34,
71, and 90, issued [*119] by the Financial Accounting Standards Board,
Norwalk, CT 06856-5116. Similarly, taxpayers are not permitted to net
interest income and interest expense in determining the amount of interest
that must be capitalized under this section with respect to certain restricted
tax-exempt borrowings even though netting is permitted under FASB
Statement No. 62.
(5) Treatment of intercompany transactions -(i) General rule. If interest
capitalized under section 263A (f) by a member of a consolidated group
(within the meaning of § 1.1502-1 (h)) with respect to a unit of designated
property is attributable to a loan from another member of the group (the
lending member), the intercompany transaction provisions of the
consolidated return regulations do not apply to the lending member's
interest income with respect to that loan, except as provided in paragraph
(g) (5) (ii) of this section. For this purpose, the capitalized interest expense
that is attributable to a loan from another member is determined under any
method that reasonably reflects the principles of the avoided cost method,
including the traced and nontraced concepts. For purposes of this paragraph
(g) (5) (i) and paragraph (g) (5) (ii) [*120] of this section, in order for a
method to be considered reasonable it must be consistently applied.
(ii) Special rule for consolidated group with limited outside borrowing. If, for
any year, the aggregate amount of interest income described in paragraph
(g) (5) (i) of this section for all members of the group with respect to all
units of designated property exceeds the total amount of interest that is
deductible for that year by all members of the group with respect to debt of
a member owed to nonmembers (group deductible interest) after applying
section 263 A (f), the intercompany transaction provisions of the
consolidated return regulations are applied to the excess, and the amount of
interest income that must be taken into account by the group under
paragraph (g) (5) (i) of this section is limited to the amount of the group
deductible interest. The amount to which the intercompany transaction
provisions of the consolidated return regulations apply by reason of this
paragraph (g) (5) (ii) is allocated among the lending members under any
method that reasonably reflects each member's share of interest income
described in paragraph (g) (5) (i) of this section. If a lending member has
[*121] interest income that is attributable to more than one unit of

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 50 of 70

designated property, the amount to which the intercompany transaction
provisions of the consolidated return regulations apply by reason of this
paragraph (g) (5) (ii) with respect to the member is allocated among the
units in accordance with the principles of paragraph (c) (7) (i) of this
section.
(iii) Example. The provisions of paragraph (g) (5) (ii) of this section are
illustrated by the following example.
Example, (i) P and S1 are the members of a consolidated group. In 1995, S1
begins and completes the construction of a shopping center and is required
to capitalize interest with respect to the construction. S1's average excess
expenditures for 1995 are $5,000,000. Throughout 1995, S1's only
borrowings include a $6,000,000 loan from P bearing interest at an annual
rate of 10 percent ($600,000 per year). Under the avoided cost method, S1
is required to capitalize interest in the amount of $500,000 ([$600,000
$6,000,000] × $5,000,000).
(ii) P's only borrowing from unrelated lenders is a $2,000,000 loan bearing
interest at an annual rate of 10 percent ($200,000 per year). Under the
principles of paragraph (g) (5) (ii) of this [*122] section, because the
aggregate amount of interest described in paragraph (g) (5) (i) of this
section ($500,000) exceeds the aggregate amount of currently deductible
interest of the group ($200,000), the intercompany transaction provisions of
the consolidated return regulations apply to the excess of $300,000 and the
amount of P's interest income that is subject to current inclusion by reason
of paragraph (g) (5) (i) of this section is limited to $200,000.
(6) Notional principal contracts and other derivatives. [Reserved]
(7) 15-day repayment rule. A taxpayer may elect to treat any eligible debt
that is repaid within the 15-day period immediately preceding a quarterly
measurement date as outstanding as of that measurement date for purposes
of determining traced debt, average nontraced debt, and the weighted
average interest rate. This election may be made or discontinued for any
computation period and is not a method of accounting.
§ 1.263A-10 Unit of property.
(a) In general. The unit of property as defined in this section is used as the
basis to determine accumulated production expenditures under § 1.263A-11
and the beginning and end of the production period under § 1.263A-12.
Whether [*123] property is 1-year or 2-year property under § 1.263A-8
(b) (1) (ii) is also determined separately with respect to each unit of
property as defined in this section.
(b) Units of real property -(1) In general. A unit of real property includes any
components of real property owned by the taxpayer or a related person that
are functionally interdependent and an allocable share of any common
feature owned by the taxpayer or a related person that is real property even
though the common feature does not meet the functional interdependence
test. When the production period begins with respect to any functionally
interdependent component or any common feature of the unit of real
property, the production period has begun for the entire unit of real
property. See, however, paragraph (b) (5) of this section for rules under
which the costs of a common feature or benefitted property are excluded
from accumulated production expenditures for one or more measurement
dates. The portion of land included in a unit of real property includes land on

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 51 of 70

which real property (including a common feature) included in the unit is
situated, land subject to setback restrictions with respect to such property,
and any [*124] other contiguous portion of the tract of land other than
land that the taxpayer holds for a purpose unrelated to the unit being
produced (e.g., investment purposes, personal use purposes, or specified
future development as a separate unit of real property).
(2) Functional interdependence. Components of real property produced by,
or for, the taxpayer, for use by the taxpayer or a related person are
functionally interdependent if the placing in service of one component is
dependent on the placing in service of the other component by the taxpayer
or a related person. In the case of property produced for sale, components
of real property are functionally interdependent if they are customarily sold
as a single unit. For example, the real property components of a singlefamily house (e.g., the land, foundation, and walls) are functionally
interdependent. In contrast, components of real property that are expected
to be separately placed in service or held for resale are not functionally
interdependent. Thus, dwelling units within a multiunit building that are
separately placed in service or sold (within the meaning of § 1.263A-12 (d)
(1)) are treated as functionally independent of any other [*125] units,
even though the units are located in the same building.
(3) Common features. For purposes of this section, a common feature
generally includes any real property (as defined in § 1.263A-8 (c)) that
benefits real property produced by, or for, the taxpayer or a related person,
and that is not separately held for the production of income. A common
feature need not be physically contiguous to the real property that it
benefits. Examples of common features include streets, sidewalks,
playgrounds, clubhouses, tennis courts, sewer lines, and cables that are not
held for the production of income separately from the units of real property
that they benefit.
(4) Allocation of costs to unit. Except as provided in paragraph (b) (5) of this
section, the accumulated production expenditures for a unit of real property
include, in all cases, the costs that directly benefit, or are incurred by reason
of the production of, the unit of real property. Accumulated production
expenditures also include the adjusted basis of property used to produce the
unit of real property. The accumulated costs of a common feature or land
that benefits more than one unit of real property, or that benefits designated
[*126] property and property other than designated property, is
apportioned among the units of designated property, or among the
designated property and property other than designated property, in
determining accumulated production expenditures. The apportionment of the
accumulated costs of the common feature (allocable share) or land
(attributable land costs) generally may be made using any method that is
applied on a consistent basis and that reasonably reflects the benefits
provided. For example, an apportionment based on relative costs to be
incurred, relative space to be occupied, or relative fair market values may be
reasonable.
(5) Treatment of costs when a common feature is included in a unit of real
property -(i) General rule. Except as provided in this paragraph (b) (5), the
accumulated production expenditures of a unit of real property include the
costs of functionally interdependent components (benefitted property) and
an allocable share of the cost of common features throughout the entire
production period of the unit. See § 1.263A-12, relating to the production
period of a unit of property.
(ii) Production activity not undertaken on benefitted property -(A) Direct

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 52 of 70

production activity [*127] not undertaken -(1) In general. The costs of
land attributable to a benefitted property may be treated as not included in
accumulated production expenditures for a unit of real property for
measurement dates prior to the first date a production activity (direct
production activity), including the clearing and grading of land, has been
undertaken with respect to the land attributable to the benefitted property.
Thus, the costs of land attributable to a benefitted property (as opposed to
land attributable to the common features) with respect to which no direct
production activities have been undertaken may be treated as not included
in the accumulated production expenditures of a unit of real property even
though a production activity has begun on a common feature allocable to the
unit.
(2) Land attributable to a benefitted property. For purposes of this
paragraph (b) (5) (ii), land attributable to a benefitted property includes all
land in the unit of real property that includes the benefitted property other
than land for a common feature. (Thus, land attributable to a benefitted
property does not include land attributable to a common feature.)
(B) Suspension of direct production activity [*128] after clearing and
grading undertaken -(1) General rule. This paragraph (b) (5) (ii) (B) may be
used to determine the accumulated production expenditures for a unit of real
property, if the only production activity with respect to a benefitted property
has been clearing and grading and no further direct production activity is
undertaken with respect to the benefitted property for at least 120
consecutive days (i.e., direct production activity has ceased). Under this
paragraph (b) (5) (ii) (B), the accumulated production expenditures
attributable to a benefitted property qualifying under this paragraph (b) (5)
(ii) (B) may be excluded from the accumulated production expenditures of
the unit of real property even though production continues on a common
feature allocable to the unit. For purposes of this paragraph (b) (5) (ii) (B),
production activity is considered to occur during any time which would not
qualify as a cessation of production activities under the suspension period
rules of § 1.263A-12 (g).
(2) Accumulated production expenditures. If this paragraph (b) (5) (ii) (B)
applies, accumulated production expenditures attributable to the benefitted
property of the unit of real property [*129] may be treated as not
included in the accumulated production expenditures for the unit starting
with the first measurement period beginning after the first day of the 120
consecutive day period, but must be included in the accumulated production
expenditures for the unit beginning in the measurement period in which
direct production activity has resumed on the benefitted property.
Accumulated production expenditures with respect to common features
allocable to the unit of real property may not be excluded under this
paragraph (b) (5) (ii) (B).
(iii) Common feature placed in service before the end of production of a
benefitted property. To the extent that a common feature with respect to
which all production activities to be undertaken by, or for, a taxpayer or a
related person are completed is placed in service before the end of the
production period of a unit that includes an allocable share of the costs of
the common feature, the costs of the common feature are not treated as
included in accumulated production expenditures of the unit for
measurement periods beginning after the date the common feature is placed
in service.
(iv) Benefitted property sold before production completed on [*130]
common feature. If a unit of real property is sold before common features

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 53 of 70

included in the unit are completed, the production period of the unit ends on
the date of sale. Thus, common feature costs actually incurred and properly
allocable to the unit as of the date of sale are excluded from accumulated
production expenditures for measurement periods beginning after the date
of sale. Common feature costs properly allocable to the unit and actually
incurred after the sale are not taken into account in determining
accumulated production expenditures.
(v) Benefitted property placed in service before production completed on
common feature. Where production activities remain to be undertaken on a
common feature allocable to a unit of real property that includes benefitted
property, the costs of the benefitted property are not treated as included in
the accumulated production expenditures for the unit for measurement
periods beginning after the date the benefitted property is placed in service
and all production activities reasonably expected to be undertaken by, or for,
the taxpayer or a related person with respect to the benefitted property are
completed.
(6) Examples. The principles of paragraph [*131] (b) of this section are
illustrated by the following examples:

Example 1. B, an individual, is in the trade or business of
constructing custom-built houses for sale. B owns a 10-acre tract
upon which B intends to build four houses on 2-acre lots. In
addition, on the remaining 2 acres B plans to construct a
perimeter road that benefits the four houses and is not held for
the production of income separately from the sale of the houses.
In 1995, B begins constructing the perimeter road and clears the
land for one house. Under the principles of paragraph (b) (1) of
this section, each planned house (including attributable land) is
part of a separate unit of real property (house unit). Under the
principles of paragraph (b) (3) of this section, the perimeter road
(including attributable land) constitutes a common feature with
respect to each planned house (i.e., benefitted property). In
accordance with paragraph (b) (1), the production period for all
four house units begins when production commences on the
perimeter road in 1995. In addition, under the principles of
paragraph (b) (4) of this section, the accumulated production
expenditures for the four house units include the allocable costs
[*132] of the road. In addition, for the house with respect to
which B has cleared the land, the accumulated production
expenditures for the house unit include the land costs
attributable to the house. See paragraph (b) (5) (i) of this
section. However, the accumulated production expenditures for
each of the three house units that include a house for which B
has not yet undertaken a direct production activity do not
include the land costs attributable to the house. See paragraph
(b) (5) (ii) of this section.
Example 2. Assume the same facts as Example 1, except that B
undertakes no further direct production activity with respect to
the house for which the land was cleared for a period of at least
120 days but continues constructing the perimeter road during
this period. In accordance with paragraph (b) (5) (ii) (B) of this
section, B may exclude the accumulated production expenditures
attributable to the benefitted property from the accumulated
production expenditures of the house unit starting with the first

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 54 of 70

measurement period that begins after the first day of the 120
consecutive day period. B must include the accumulated
production expenditures attributable to the benefitted property
in [*133] the accumulated production expenditures for the
house unit beginning with the measurement period in which
direct production resumes on the benefitted property. The house
unit will continue to include the accumulated production
expenditures attributable to the perimeter road during the period
in which direct production activity was suspended on the
benefitted property.
Example 3. (i) D, a corporation, is in the trade or business of
developing commercial real property. D owns a 20-acre tract
upon which D intends to build a shopping center with 150 stores.
D intends to lease the stores. D will also provide on the 20 acres
a 1500-car parking lot, which is not held by D for the production
of income separately from the stores in the shopping center.
Additionally, D will not produce any other common features as
part of the project. D intends to complete the shopping center in
phases and expects that each store will be placed in service
independently of any other store.
(ii) Under paragraphs (b) (1) and (b) (2) of this section, each
store (including attributable land) is part of a separate unit of
real property (store unit). The 1500-car parking lot is a common
feature benefitting each store, [*134] and D must include an
allocable share of the parking lot in each store unit. See
paragraphs (b) (1) and (b) (3). In accordance with paragraph
(b) (5) (i), D includes in the accumulated production
expenditures for each store unit during each store unit's
production period: the costs capitalized with respect to the store
(including attributable land costs in accordance with paragraph
(b) (5) of this section) and an allocable share of the parking lot
costs (including attributable land costs in accordance with
paragraph (b) (5) of this section). Under paragraph (b) (4), the
portion of the parking lot costs that is included in the
accumulated production expenditures of a store unit is
determined using a reasonable method of allocation.
Example 4. X, a real estate developer, begins a project to
construct a condominium building and a convenience store for
the benefit of the condominium. X intends to separately lease
the convenience store. Because the convenience store is held for
the production of income separately from the condominium units
that it benefits, the convenience store is not a common feature
with respect to the condominium building. Instead, the
convenience store is a separate [*135] unit of property with a
separate production period and for which a separate
determination of accumulated production expenditures must be
made.
Example 5. (i) In 1995, X, a real estate developer, begins a
project consisting of a condominium building and a common
swimming pool that is not held for the production of income
separately from the condominium sales. The condominium
building consists of 10 stories, and each story is occupied by a
single condominium. Production of the swimming pool begins in
January. No direct production activity is undertaken on any
condominium until September, when direct production activity

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 55 of 70

commences on each condominium. On December 31, 1995, 1
condominium that was completed in December has been sold, 3
condominiums that were completed in December have not been
sold, and 6 condominiums are only partially complete;
additionally, the swimming pool is completed. X is a calendar
year taxpayer that uses a full taxable year as the computation
period, and quarterly measurement dates.
(ii) Under paragraphs (b) (1) and (b) (2) of this section, each
condominium (including attributable land) is part of a separate
unit of real property. Under the principles of paragraph [*136]
(b) (3) of this section, the swimming pool is a common feature
with respect to each condominium and under paragraph (b) (4)
of this section the cost of the swimming pool is allocated equally
among the condominiums.
(iii) Under paragraph (b) (1) of this section, the production
period of each of the 10 condominium units begins in January
when production of the swimming pool begins. On X's March 31,
1995, and June 30, 1995, measurement dates, the accumulated
production expenditures for each condominium unit include the
allocable costs of the swimming pool, but not the land costs
attributable to the condominium because no direct production
activity has been undertaken on the condominium. See
paragraph (b) (5) (ii) (A) of this section. On X's September 30,
1995, and December 31, 1995, measurement dates, the
accumulated production expenditures for each unit include the
allocable costs of the swimming pool, and the costs of the
condominium (including attributable land costs) because a direct
production activity has commenced on the condominium.
See paragraph (b) (5) (i) of this section.
(iv) The production period for the condominium unit that
includes the condominium that is sold as of the end [*137] of
1995 ends on the date the condominium is sold. See paragraph
(b) (5) (iv) of this section. The production period of each unit
that is ready to be held for sale ends when all production
activities have been completed on the unit, in this case on
December 31, 1995, the date that the swimming pool included in
the unit is completed. See § 1.263A-12 (d). Accordingly, interest
capitalization ceases for each such unit that is sold or ready to
be held for sale as of the end of 1995 (including each unit's
allocable share of the completed swimming pool).
(v) The production periods for the condominium units that
include the condominiums that are only partially complete at the
end of 1995 continue after 1995. The accumulated production
expenditures for each partially completed condominium unit
continue to include the costs of the condominium (including
attributable land costs) in addition to the costs of an allocable
share of the completed swimming pool (including attributable
land costs).
Example 6. Assume the same facts as inExample 5, except that
the swimming pool is only partially complete as of the end of
1995. Under these facts, X capitalizes no interest during 1996
for the 1 unit that [*138] includes the condominium sold
during 1995 (including the costs of the allocable share of the

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 56 of 70

swimming pool). See paragraph (b) (5) (iv) of this section.
However, with respect to the 6 condominiums that are partially
complete and the 3 condominiums that are completed but
unsold, interest capitalization continues after the end of 1995.
The accumulated production expenditures for each of these 9
units include the costs of an allocable share of the swimming
pool. See paragraph (b) (5) (i) of this section. In determining
the costs of an allocable share of the swimming pool included in
the accumulated production expenditures for each of the 9 units,
X includes all costs of the swimming pool properly allocable to
each unit, including those costs incurred as of the date of the
sale of unit 1 that may have been used under applicable
administrative procedures (e.g., Rev. Proc. 92-29, 1992-1 C.B.
748) in determining the basis of unit 1 solely for purposes of
computing gain or loss on the sale of unit 1. See § 601.601 (d)
(2) (ii) (b) of this chapter.
Example 7. (i) Assume the same facts as inExample 5, except
that X intends to lease rather than sell the condominiums and
the completed swimming [*139] pool is placed in service for
depreciation purposes on December 31, 1995. Additionally,
assume that all 10 condominiums are partially completed at the
end of 1995.
(ii) Under these facts, because the swimming pool is a common
feature that is placed in service separately from the
condominiums that it benefits, under paragraph (b) (5) (iii) of
this section, the accumulated production expenditures of each of
the condominium units do not include the costs of the allocable
share of the swimming pool after 1995.

(c) Units of tangible personal property. Components of tangible personal
property are a single unit of property if the components are functionally
interdependent. Components of tangible personal property that are produced
by, or for, the taxpayer, for use by the taxpayer or a related person, are
functionally interdependent if the placing in service of one component is
dependent on the placing in service of the other component by the taxpayer
or a related person. In the case of tangible personal property produced for
sale, components of tangible personal property are functionally
interdependent if they are customarily sold as a single unit. For example, if
an aircraft manufacturer customarily [*140] sells completely assembled
aircraft, the unit of property includes all components of a completely
assembled aircraft. If the manufacturer also customarily sells aircraft
engines separately, any engines that are reasonably expected to be sold
separately are treated as single units of property.
(d) Treatment of installations. If the taxpayer produces or is treated as
producing any property that is installed on or in other property, the
production activity and installation activity relating to each unit of property
generally are not aggregated for purposes of this section. However, if the
taxpayer is treated as producing and installing any property for use by the
taxpayer or a related person or if the taxpayer enters into a contract
requiring the taxpayer to install property for use by a customer, the
production activity and installation activity are aggregated for purposes of
this section.

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 57 of 70

§ 1.263A-11 Accumulated production expenditures.
(a) General rule. Accumulated production expenditures generally means the
cumulative amount of direct and indirect costs described in section 263A (a)
that are required to be capitalized with respect to the unit of property (as
defined in § 1.263A-10), [*141] including interest capitalized in prior
computation periods, plus the adjusted bases of any assets described in
paragraph (d) of this section that are used to produce the unit of property
during the period of their use. Accumulated production expenditures may
also include the basis of any property received by the taxpayer in a
nontaxable transaction.
(b) When costs are first taken into account-(1) In general. Except as
provided in paragraph (c) (1) of this section, costs are taken into account in
the computation of accumulated production expenditures at the time and to
the extent they would otherwise be taken into account under the taxpayer's
method of accounting (e.g., after applying the requirements of section 461,
including the economic performance requirement of section 461 (h)). Costs
that have been incurred and capitalized with respect to a unit of property
prior to the beginning of the production period are taken into account as
accumulated production expenditures beginning on the date on which the
production period of the property begins (as defined in § 1.263A-12 (c)).
Thus, for example, the cost of raw land acquired for development, the cost
of a leasehold in mineral properties [*142] acquired for development, and
the capitalized cost of planning and design activities are taken into account
as accumulated production expenditures beginning on the first day of the
production period. For purposes of determining accumulated production
expenditures on any measurement date during a computation period, the
interest required to be capitalized for the computation period is deemed to
be capitalized on the day immediately following the end of the computation
period. For any subsequent measurement dates and computation periods,
that interest is included in accumulated production expenditures. If the cost
of land or common features is allocated among planned units of property
that are completed in phases, any portion of the cost properly allocated to
completed units is not reallocated to any incomplete units of property.
(2) Dedication rule for materials and supplies. The costs of raw materials,
supplies, or similar items are taken into account as accumulated production
expenditures when they are incurred and dedicated to production of a unit of
property. Dedicated means the first date on which the raw materials,
supplies, or similar items are specifically associated with the [*143]
production of any unit of property, including by record, assignment to the
specific job site, or physical incorporation. In contrast, in the case of a
component or subassembly that is reasonably expected to be become a part
of (e.g., be incorporated into) any unit of property, costs incurred (including
dedicated raw materials) for the component or subassembly are taken into
account as accumulated production expenditures during the production of
any portion of the component or subassembly and prior to its connection
with (e.g., incorporation into) any specific unit of property. For purposes of
the preceding sentence, components and subassemblies must be aggregated
at each measurement date in a reasonable manner that is consistent with
the purposes of section 263A (f).
(c) Property produced under a contract -(1) Customer. If a unit of property
produced under a contract is designated property under § 1.263A-8 (d) (2)
(i) with respect to the customer, the customer's accumulated production
expenditures include any payments under the contract that represent part of
the purchase price of the unit of designated property or, to the extent costs
are incurred earlier than payments are made (determined [*144] on a

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 58 of 70

cumulative basis for each unit of designated property), any part of such
price for which the requirements of section 461 have been satisfied. The
customer has made a payment under this section if the transaction would be
considered a payment by a taxpayer using the cash receipts and
disbursements method of accounting. The customer's accumulated
production expenditures also include any other costs incurred by the
customer, such as interest, or any other direct or indirect costs that are
required to be capitalized under section 263A (a) and the regulations
thereunder with respect to the production of the unit of designated property.
(2) Contractor. If a unit of property produced under a contract is designated
property under § 1.263A-8 (d) (2) (ii) with respect to the contractor, the
contractor must treat the cumulative amount of payments made by the
customer under the contract attributable to the unit of property as a
reduction in the contractor's accumulated production expenditures. The
customer has made a payment under this section if the transaction would be
considered a payment by a taxpayer using the cash receipts and
disbursements method of accounting.
(d) Property used to produce [*145] designated property -(1) In general.
Accumulated production expenditures include the adjusted bases (or portion
thereof) of any equipment, facilities, or other similar assets, used in a
reasonably proximate manner for the production of a unit of designated
property during any measurement period in which the asset is so used.
Examples of assets used in a reasonably proximate manner include
machinery and equipment used directly or indirectly in the production
process, such as assembly-line structures, cranes, bulldozers, and buildings.
A taxpayer apportions the adjusted basis of an asset used in the production
of more than one unit of designated property in a measurement period
among such units of designated property using reasonable criteria
corresponding to the use of the asset, such as machine hours, mileage, or
units of production. If an asset used in a reasonably proximate manner for
the production of a unit of designated property is temporarily idle (within the
meaning of § 1.263A-1 (e) (3) (iii) (E)) for an entire measurement period,
the adjusted basis of the asset is excluded from the accumulated production
expenditures for the unit during that measurement period. Notwithstanding
[*146] this paragraph (d) (1), the portion of the depreciation allowance
for equipment, facilities, or any other asset that is capitalized with respect to
a unit of designated property in accordance with § 1.263A-1 (e) (3) (ii) (I) is
included in accumulated production expenditures without regard to the
extent of use under this paragraph (d) (1) (i.e., without regard to whether
the asset is used in a reasonably proximate manner for the production of the
unit of designated property).
(2) Example. The following example illustrates how the basis of an asset is
allocated on the basis of time:

Example. In 1995, X uses a bulldozer exclusively to clear the
land on several adjacent real estate development projects, A, B,
and C. A, B, and C are treated as separate units of property
under the principles of § 1.263A-10. X decides to allocate the
basis of the bulldozer among the three projects on the basis of
time. At the end of the first quarter of 1995, the production
period has commenced for all three projects. The bulldozer was
operated for 30 hours on project A, 80 hours on project B, and
10 hours on project C, for a total of 120 hours for the entire
period. For purposes of determining accumulated [*147]

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 59 of 70

production expenditures as of the end of the first quarter, 1/4 of
the adjusted basis of the bulldozer is allocated to project A, 2/3
to project B, and 1/12 to project C. Nonworking hours, regularly
scheduled nonworking days, or other periods in which the
bulldozer is temporarily idle (within the meaning of § 1.263A-1
(e) (3) (iii) (E)) during the measurement period are not taken
into account in allocating the basis of the bulldozer.

(3) Excluded equipment and facilities. The adjusted bases of equipment,
facilities, or other assets that are not used in a reasonably proximate
manner to produce a unit of property are not included in the computation of
accumulated production expenditures. For example, the adjusted bases of
equipment and facilities, including buildings and other structures, used in
service departments performing administrative, purchasing, personnel, legal,
accounting, or similar functions, are excluded from the computation of
accumulated production expenditures under this paragraph (d) (3).
(e) Improvements -(1) General rule. If an improvement constitutes the
production of designated property under § 1.263A-8 (d) (3), accumulated
production expenditures with respect to the [*148] improvement consist
of-

(i) All direct and indirect costs required to be capitalized with respect
to the improvement,

(ii) In the case of an improvement to a unit of real property(A) An allocable portion of the cost of land, and
(B) For any measurement period, the adjusted basis of any
existing structure, common feature, or other property
that is not placed in service or must be temporarily
withdrawn from service to complete the improvement
(associated property) during any part of the
measurement period if the associated property directly
benefits the property being improved, the associated
property directly benefits from the improvement, or the
improvement was incurred by reason of the associated
property. See, however, the de minimis rule under
paragraph (e) (2) of this section that applies in the case
of associated property.

(iii) In the case of an improvement to a unit of tangible personal
property, the adjusted basis of the asset being improved if that
asset either is not placed in service or must be temporarily
withdrawn from service to complete the improvement.

(2) De minimis rule. For purposes of paragraph (e) (1) (ii) of this section,

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 60 of 70

the total costs of all associated property for [*149] an improvement unit
(associated property costs) are excluded from the accumulated production
expenditures for the improvement unit during its production period if, on the
date the production period of the unit begins, the taxpayer reasonably
expects that at no time during the production period of the unit will the
accumulated production expenditures for the unit, determined without
regard to the associated property costs, exceed 5 percent of the associated
property costs.
(f) Mid-production purchases. If a taxpayer purchases a unit of property for
further production, the taxpayer's accumulated production expenditures
include the full purchase price of the property plus, in accordance with the
principles of paragraph (e) of this section, additional direct and indirect costs
incurred by the taxpayer.
(g) Related person costs. The activities of a related person are taken into
account in applying the classification thresholds under § 1.263A-8 (b) (1) (ii)
(B) and (C), and in determining the production period of a unit of designated
property under § 1.263A-12. However, only those costs incurred by the
taxpayer are taken into account in the taxpayer's accumulated production
expenditures under [*150] this section because the related person
includes its own capitalized costs in the related person's accumulated
production expenditures with respect to any unit of designated property
upon which the parties engage in mutual production activities. For purposes
of the preceding sentence, the accumulated production expenditures of any
property transferred to a taxpayer in a nontaxable transaction are treated as
accumulated production expenditures incurred by the taxpayer.
(h) Installation. If the taxpayer installs property that is purchased by the
taxpayer, accumulated production expenditures include the cost of the
property that is installed in addition to the direct and indirect costs of
installation.
§ 1.263A-12 Production period.
(a) In general. Capitalization of interest is required under § 1.263A-9 for
computation periods (within the meaning of § 1.263A-9 (f) (1)) that include
the production period of a unit of designated property. In contrast, section
263A (a) requires the capitalization of all other direct or indirect costs, such
as insurance, taxes, and storage, that directly benefit or are incurred by
reason of the production of property without regard to whether they are
incurred [*151] during a period in which production activity occurs.
(b) Related person activities. Activities performed and costs incurred by a
person related to the taxpayer that directly benefit or are incurred by reason
of the taxpayer's production of designated property are taken into account in
determining the taxpayer's production period (regardless of whether the
related person is performing only a service or is producing a subassembly or
component that the related person is required to treat as an item of
designated property). These activities and the related person's costs are also
taken into account in determining whether tangible personal property
produced by the taxpayer is 1-year or 2-year property under § 1.263A-8 (b)
(1) (ii) (B) and (C).
(c) Beginning of production period -(1) In general. A separate production
period is determined for each unit of property defined in § 1.263A-10. The
production period begins on the date that production of the unit of property
begins.

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 61 of 70

(2) Real property. The production period of a unit of real property begins on
the first date that any physical production activity (as defined in paragraph
(e) of this section) is performed with respect to a unit of real [*152]
property. See § 1.263A-10 (b) (1). The production period of a unit of real
property produced under a contract begins for the contractor on the date the
contractor begins physical production activity on the property. The
production period of a unit of real property produced under a contract begins
for the customer on the date either the customer or the contractor begins
physical production activity on the property.
(3) Tangible personal property. The production period of a unit of tangible
personal property begins on the first date by which the taxpayer's
accumulated production expenditures, including planning and design
expenditures, are at least 5 percent of the taxpayer's total estimated
accumulated production expenditures for the property unit. Thus, the
beginning of the production period is determined without regard to whether
physical production activity has commenced. The production period of a unit
of tangible personal property produced under a contract begins for the
contractor when the contractor's accumulated production expenditures,
without any reduction for payments from the customer, are at least 5
percent of the contractor's total estimated accumulated production
expenditures. [*153] The production period for a unit of tangible personal
property produced under a contract begins for the customer when the
customer's accumulated production expenditures are at least 5 percent of
the customer's total estimated accumulated production expenditures.
(d) End of production period-(1) In general. The production period for a unit
of property produced for self use ends on the date that the unit is placed in
service and all production activities reasonably expected to be undertaken
by, or for, the taxpayer or a related person are completed. The production
period for a unit of property produced for sale ends on the date that the unit
is ready to be held for sale and all production activities reasonably expected
to be undertaken by, or for, the taxpayer or a related person are completed.
See, however, § 1.263A-10 (b) (5) (iv) providing an exception for common
features in the case of a benefitted property that is sold. In the case of a
unit of property produced under a contract, the production period for the
customer ends when the property is placed in service by the customer and
all production activities reasonably expected to be undertaken are complete
(i.e., generally, no earlier [*154] than when the customer takes delivery).
In the case of property that is customarily aged (such as tobacco, wine, or
whiskey) before it is sold, the production period includes the aging period.
(2) Special rules. The production period does not end for a unit of property
prior to the completion of physical production activities by the taxpayer even
though the property is held for sale or lease, since all production activities
reasonably expected to be undertaken by the taxpayer with respect to such
property have not in fact been completed. See, however, § 1.263A-10 (b)
(5) regarding separation of certain common features.
(3) Sequential production or delivery. The production period ends with
respect to each unit of property (as defined in § 1.263A-10) and its
associated accumulated production expenditures as the unit of property is
completed within the meaning of paragraph (d) (1) of this section, without
regard to the production activities or costs of any other units of property.
Thus, for example, in the case of separate apartments in a multi-unit
building, each of which is a separate unit of property within the meaning of §
1.263A-10, the production period ends for each separate apartment
[*155] when it is ready to be held for sale or placed in service within the

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 62 of 70

meaning of paragraph (d) (1) of this section. In the case of a single unit of
property that merely undergoes separate and distinct stages of production,
the production period ends at the same time (i.e., when all separate stages
of production are completed with respect to the entire amount of
accumulated production expenditures for the property).
(4) Examples. The provisions of paragraph (d) of this section are illustrated
by the following examples:

Example 1. E is engaged in the original construction of a highrise office building with two wings. At the end of 1995, Wing #1,
but not Wing #2, is placed in service. Moreover, at the end of
1995, all production activities reasonably expected to be
undertaken on Wing #1 are completed. In accordance with §
1.263A-10 (b) (1), Wing #1 and Wing #2 are separate units of
designated property. E may stop capitalizing interest on Wing #1
but not on Wing #2.
Example 2. F is in the business of constructing finished houses. F
generally paints and finishes the interior of the house, although
this does not occur until a potential buyer is located. Because F
reasonably expects to undertake [*156] production activity
(painting and finishing), the production period of each house
does not end until these activities are completed.

(e) Physical production activities -(1) In general. The term physical
production activities includes any physical activity that constitutes
production within the meaning of § 1.263A-8 (d) (1). The production period
begins and interest must be capitalized with respect to real property if any
physical production activities are undertaken, whether alone or in
preparation for the construction of buildings or other structures, or with
respect to the improvement of existing structures. For example, the clearing
of raw land constitutes the production of designated property, even if only
cleared prior to resale.
(2) Illustrations. The following is a partial list of activities any one of which
constitutes a physical production activity with respect to the production of
real property:

(i) Clearing, grading, or excavating of raw land;
(ii) Demolishing a building or gutting a standing building;
(iii) Engaging in the construction of infrastructure, such as roads,
sewers, sidewalks, cables, and wiring;
(iv) Undertaking structural, mechanical, or electrical activities with
respect [*157] to a building or other structure; or

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 63 of 70

(v) Engaging in landscaping activities.

(f) Activities not considered physical production. The activities described in
paragraphs (f) (1) and (f) (2) of this section are not considered physical
production activities:

(1) Planning and design. Soil testing, preparing architectural blueprints
or models, or obtaining building permits.

(2) Incidental repairs. Physical activities of an incidental nature that
may be treated as repairs under § 1.162-4.

(g) Suspension of production period -(1) In general. If production activities
related to the production of a unit of designated property cease for at least
120 consecutive days (cessation period), a taxpayer may suspend the
capitalization of interest with respect to the unit of designated property
starting with the first measurement period that begins after the first day in
which production ceases. The taxpayer must resume the capitalization of
interest with respect to a unit beginning with the measurement period during
which production activities resume. In addition, production activities are not
considered to have ceased if they cease because of circumstances inherent
in the production process, such as normal adverse [*158] weather
conditions, scheduled plant shut-downs, or delays due to design or
construction flaws, the obtaining of a permit or license, or the settlement of
groundfill to construct property. Interest incurred on debt that is traced debt
with respect to a unit of designated property during the suspension period is
subject to capitalization with respect to the production of other units of
designated property as interest on nontraced debt. See § 1.263A-9 (c) (5)
(i) of this section. For applications of the avoided cost method after the end
of the suspension period, the accumulated production expenditures for the
unit include the balance of accumulated production expenditures as of the
beginning of the suspension period, plus any additional capitalized costs
incurred during the suspension period. No further suspension of interest
capitalization may occur unless the requirements for a new suspension
period are satisfied.
(2) Special rule. If a cessation period spans more than one taxable year, the
taxpayer may suspend the capitalization of interest with respect to a unit
beginning with the first measurement period of the taxable year in which the
120-day period is satisfied.
(3) Method [*159] of accounting. An election to suspend interest
capitalization under paragraph (g) (1) of this section is a method of
accounting that must be consistently applied to all units that satisfy the
requirements of paragraph (g) (1) of this section. However, the special rule
in paragraph (g) (2) of this section is applied on an annual basis to all units
of an electing taxpayer that satisfy the requirements of paragraph (g) (2) of
this section.
(4) Example. The provisions of paragraph (g) (1) of this section are

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 64 of 70

illustrated by the following example.
Example. (i) D, a calendar-year taxpayer, began production of a residential
housing development on January 1, 1995. D, in applying the avoided cost
method, chose a taxable year computation period and quarterly
measurement dates. On April 10, 1995, all production activities ceased with
respect to the units in the development until December 1, 1996. The
cessation, which occurred for a period of at least 120 consecutive days, was
not attributable to circumstances inherent in the production process. With
respect to the units in the development, D incurred production expenditures
of $2,000,000 from January 1, 1995 through April 10, 1995. D incurred
interest [*160] of $100,000 on traced debt with respect to the units for
the period beginning January 1, 1995, and ending June 30, 1995. D did not
incur any production expenditures for the more than 20-month cessation
beginning April 10, 1995, and ending December 1, 1996, but incurred
$200,000 of production expenditures from December 1, 1996, through
December 31, 1996.
(ii) D is required to capitalize the $100,000 interest on traced debt incurred
during the two measurement periods beginning January 1, 1995, and ending
June 30, 1995. Because D satisfied the 120-day rule under this paragraph
(g), D is not required to capitalize interest with respect to the accumulated
production expenditures for the units for the measurement period beginning
July 1, 1995, and ending September 30, 1995, which is the first
measurement period that begins after the date production activities ceased.
D is required to resume interest capitalization with respect to the $
2,300,000 (2,000,000 + 100,000 + 200,000) of accumulated
production expenditures for the units for the measurement period beginning
October 1, 1996, and ending December 31, 1996 (the measurement period
during which production activities resume). Accordingly, [*161] D may
suspend the capitalization of interest with respect to the units from July 1,
1995, through September 30, 1996.
§ 1.263A-13 Oil and gas activities.
(a) In general. This section provides rules that are to be applied in tandem
with §§ 1.263A-8 through 1.263A-12, 1.263A-14, and 1.263A-15 in
capitalizing interest with respect to the development (within the meaning of
section 263A (g)) of oil or gas property. For this purpose, oil or gas property
consists of each separate operating mineral interest in oil or gas as defined
in section 614 (a), or, if a taxpayer makes an election under section 614 (b),
the aggregate of two or more separate operating mineral interests in oil or
gas as described in section 614 (b) (section 614 property). Thus, an oil or
gas property is designated property unless the de minimis rule applies. A
taxpayer must apply the rules in paragraph (c) of this section if the taxpayer
cannot establish, at the beginning of the production period of the first well
drilled on the property, a definite plan that identifies the number and
location of other wells planned with respect to the property. If a taxpayer
can establish such a plan at the beginning of the production period [*162]
of the first well drilled on the property, the taxpayer may either apply the
rules of paragraph (c) of this section or treat each of the planned wells as a
separate unit and partition the leasehold acquisition costs and costs of
common features based on the number of planned well units.
(b) Generally applicable rules -(1) Beginning of production period -(i)
Onshore activities. In the case of onshore oil or gas development activities,
the production period for a unit begins on the first date physical site
preparation activities (such as building an access road, leveling a site for a

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 65 of 70

drilling rig, or excavating a mud pit) are undertaken with respect to the unit.
(ii) Offshore activities. In the case of offshore development activities, the
production period for a unit begins on the first date physical site preparation
activities, other than activities undertaken with respect to expendable wells,
are undertaken with respect to the unit. For purposes of the preceding
sentence, the first physical site preparation activity undertaken with respect
to a section 614 property is generally the first activity undertaken with
respect to the anchoring of a platform (e.g., drilling to drive the piles).
[*163] For purposes of this section, an expendable well is a well drilled
solely to determine the location and delineation of offshore hydrocarbon
deposits.
(2) End of production period. The production period ends for a productive
well unit on the date the well is placed in service and all production activities
reasonably expected to be undertaken by, or for, the taxpayer or a related
person are completed. See § 1.263A-12 (d).
(3) Accumulated production expenditures -(i) Costs included. Accumulated
production expenditures for a well unit include the following costs (to the
extent they are not intangible drilling and development costs allowable as a
deduction under section 263 (c), 263 (i), or 291 (b) (2)): the costs of
acquiring the section 614 leasehold and the costs of taxes and similar items
that are required to be capitalized under section 263A (a) with respect to the
section 614 leasehold; the costs of real property associated with developing
the section 614 property (e.g., casing); the basis of real property that
constitutes a common feature within the meaning of § 1.263A-10 (b) (3);
and the adjusted basis of property used to produce property (such as a
mobile rig, drilling ship, or an [*164] offshore drilling platform).
(ii) Improvement unit. To the extent section 614 costs are allocated to a well
unit, the undepleted portion of those section 614 costs must also be included
in the accumulated production expenditures for any improvement unit
(within the meaning of § 1.263A-8 (d) (3)) with respect to that well unit.
(c) Special rules when definite plan not established-(1) In general. The
special rules of this paragraph (c) must be applied by a taxpayer that cannot
establish, at the beginning of the production period of the first well drilled on
the property, a definite plan that identifies the number and location of the
wells planned with respect to the property. A taxpayer that can establish
such a plan is permitted, but not required, to apply the rules of this
paragraph (c), provided the rules of this paragraph (c) are consistently
applied for all the taxpayer's oil or gas properties for which a definite plan
can be established.
(2) Oil and gas units -(i) First productive well unit. Until the first productive
well is placed in service and all production activities reasonably expected to
be undertaken by, or for, the taxpayer or a related person are completed, a
first productive [*165] well unit includes the section 614 property and all
real property associated with the development of the section 614 property.
Thus, for example, a first productive well unit includes the section 614
property and real property associated with any nonproductive well drilled on
the section 614 property on or before the date the first productive well is
placed in service and all production activities reasonably expected to be
undertaken by, or for, the taxpayer or a related person are completed. For
purposes of this section, a productive well is a well that produces in
commercial quantities. See paragraph (c) (5) of this section, which provides
a special rule whereby the costs of a section 614 property and common
feature costs for a section 614 property generally are included only in the

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 66 of 70

accumulated production expenditures for the first productive well unit.
(ii) Subsequent units. Generally, real property associated with each
productive or nonproductive well with respect to which production activities
begin after the date the first productive well is placed in service and all
production activities reasonably expected to be undertaken by, or for, the
taxpayer or a related person are completed, [*166] constitutes a unit of
real property. Additionally, a productive or nonproductive well that is
included in a first productive well unit and for which development continues
after the date the first productive well is placed in service and all production
activities reasonably expected to be undertaken by, or for, the taxpayer or a
related person are completed, generally is treated as a separate unit of
property after that date. See, however, paragraph (c) (5) of this section,
which provides rules for the treatment of costs included in the accumulated
production expenditures of a first productive well unit.
(3) Beginning of production period -(i) First productive well unit. The
beginning of the production period of the first productive well unit is
determined as provided in paragraph (b) of this section.
(ii) Subsequent wells. In applying paragraph (b) of this section to
subsequent well units (as described in paragraph (c) (2) (ii) of this section),
any activities occurring prior to the date the production period ends for the
first productive well unit are not taken into account in determining the
beginning of the production period for the subsequent well units.
(4) End of production period. [*167] The end of the production period for
both the first productive well unit and subsequent productive well units is
determined as provided in paragraph (b) (2) of this section. See § 1.263A12 (d). Nonproductive wells included in the first productive well unit need
not be plugged and abandoned for the production period to end for a first
productive well unit.
(5) Accumulated production expenditures -(i) First productive well unit. The
accumulated production expenditures for a first productive well unit include
all costs incurred with respect to the section 614 property and associated
real property at any time through the end of the production period for the
first productive well unit. Thus, the costs of acquiring the section 614
property, the costs of taxes and similar items that are required to be
capitalized under section 263A (a) with respect to the section 614 property,
and the costs of common features, that are incurred at any time through the
end of the production period of the first productive well unit (section 614
costs) are included in the accumulated production expenditures for the first
productive well unit.
(ii) Subsequent well unit. The accumulated production expenditures
[*168] for a subsequent well do not include any costs included in the
accumulated production expenditures for a first productive well unit. In the
event that section 614 costs or common feature costs with respect to a
section 614 property are incurred subsequent to the end of the production
period of the first productive well unit, those common feature costs and
undepleted section 614 costs are allocated among the accumulated
production expenditures of wells being drilled as of the date such costs are
incurred.
(6) Allocation of interest capitalized with respect to first productive well unit.
Interest attributable to any productive or nonproductive well included in the
first productive well unit (within the meaning of paragraph (c) (2) (ii) of this
section) is allocated among and capitalized to the basis of the property

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 67 of 70

associated with the first productive well unit. See § 1.263A-8 (a) (2).
(7) Example. The provisions of this paragraph (c) are illustrated by the
following example.
Example. (i) Corporation Z, an oil company, acquired a section 614 property
in an onshore tract, Tract B, for development. In 1995, Corporation Z began
site preparation activities on Tract B and also commenced drilling [*169]
Well 1 on Tract B. Corporation Z was unable to establish, as provided in
paragraph (a) of this section, a definite plan identifying the number and
location of other wells planned on Tract B. In 1996, Corporation Z began
drilling Well 2. On May 1, 1997, Well 2, a productive well, was placed in
service and all production activities reasonably expected to be undertaken
with respect to Well 2 were completed. By that date, also, Well 1 was
abandoned.
(ii) Well 2 is a first productive well (within the meaning of paragraph (c) (2)
(i) of this section). Well 1 is a nonproductive well drilled prior to a first
productive well. Under paragraph (c) of this section, Corporation Z must
treat both Well 1 and Well 2 as part of the first productive well unit on the
section 614 property. In accordance with paragraphs (c) (3) and (c) (4) of
this section, the production period of the first productive well unit begins on
the date physical site preparation activities are undertaken with respect to
Well 1 in 1995 and ends on May 1, 1997, the date that Well 2 is placed in
service and all production activities reasonably expected to be undertaken
are completed. In accordance with paragraph (c) (5) of this section,
[*170] the accumulated production expenditures for the first productive
well unit include, among other capitalized costs, the entire section 614
property costs capitalized with respect to Tract B and all common feature
costs incurred with respect to the section 614 property through May 1, 1997.
(iii) Any well that Corporation Z begins after May 1, 1997, is a separate unit
of property. See paragraph (c) (2) (ii) of this section. Under paragraph (c)
(3) (ii) of this section, the production period for any such well unit begins on
the first day after May 1, 1997, on which Corporation Z undertakes physical
site preparation activities with respect to the well unit. Moreover,
Corporation Z does not include any of the section 614 property costs in the
accumulated production expenditures for any well unit begun after May 1,
1997.
§ 1.263A-14 Rules for related persons.
Taxpayers must account for average excess expenditures allocated to
related persons under applicable administrative pronouncements interpreting
section 263A (f). See § 601.601 (d) (2) (ii) (b) of this chapter.
§ 1.263A-15 Effective dates, transitional rules, and anti-abuse rule.
(a) Effective dates -(1) Sections 1.263A-8 through 1.263A-15 [*171]
generally apply to interest incurred in taxable years beginning on or after
January 1, 1995. In the case of property that is inventory in the hands of the
taxpayer, however, these sections are effective for taxable years beginning
on or after January 1, 1995. Changes in methods of accounting necessary as
a result of the rules in §§ 1.263A-8 through 1.263A-15 must be made under
the terms and conditions prescribed by the Commissioner. Under these
terms and conditions, the principles of § 1.263A-7T (e) generally must be
applied in revaluing inventory property.

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 68 of 70

(2) For taxable years beginning before January 1, 1995, taxpayers must
take reasonable positions on their federal income tax returns when applying
section 263A (f). For purposes of this paragraph (a) (2), a reasonable
position is a position consistent with the temporary regulations, revenue
rulings, revenue procedures, notices, and announcements concerning section
263A applicable in taxable years beginning before January 1, 1995. See §
601.601 (d) (2) (ii) (b) of this chapter. For this purpose, Notice 88-99,
1988-2 C.B. 422, applies to taxable years beginning after August 17, 1988,
in the case of inventory, and to interest incurred [*172] in taxable years
beginning after August 17, 1988, in all other cases. Finally, under
administrative procedures issued by the Commissioner, taxpayers may elect
early application of §§ 1.263A-8 through 1.263A-15 to taxable years
beginning on or after January 1, 1994, in the case of inventory property, and
to interest incurred in taxable years beginning on or after January 1, 1994,
in the case of property that is not inventory in the hands of the taxpayer.
(b) Transitional rule for accumulated production expenditures -(1) In
general. Except as provided in paragraph (b) (2) of this section, costs
incurred before the effective date of section 263A are included in
accumulated production expenditures (within the meaning of § 1.263A-11)
with respect to noninventory property only to the extent those costs were
required to be capitalized under section 263 when incurred and would have
been taken into account in determining the amount of interest required to be
capitalized under former section 189 (relating to the capitalization of real
property interest and taxes) or pursuant to an election that was in effect
under section 266 (relating to the election to capitalize certain carrying
charges).
(2) [*173] Property used to produce designated property. The basis of
property acquired prior to 1987 and used to produce designated
noninventory property after December 31, 1986, is included in accumulated
production expenditures in accordance with § 1.263A-11 (d) without regard
to whether the basis would have been taken into account under former
section 189 or section 266.
(c) Anti-abuse rule. The interest capitalization rules contained in §§ 1.263A8 through 1.263A-15 must be applied by the taxpayer in a manner that is
consistent with and reasonably carries out the purposes of section 263A (f).
For example, in applying § 1.263A-10, regarding the definition of a unit of
property, taxpayers may not divide a single unit of property to avoid
properly classifying the property as designated property. Similarly,
taxpayers may not use loans in lieu of advance payments, tax-exempt
parties, loan restructurings at measurement dates, or obligations bearing an
unreasonably low rate of interest (even if such rate equals or exceeds the
applicable Federal rate under section 1274 (d)) to avoid the purposes of
section 263A (f). For purposes of this paragraph (c), the presence of backto-back loans with different [*174] rates of interest, and other uses of
related parties to facilitate an avoidance of interest capitalization, evidences
abuse. In such cases, the District Director may, based upon all the facts and
circumstances, determine the amount of interest that must be capitalized in
a manner that is consistent with and reasonably carries out the purposes of
section 263A (f).

Par. 6. Section 1.266-1 (a) is redesignated as § 1.266-1 (a) (1) and § 1.266-1 (a) (2) is
added to read as follows:

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 69 of 70

§ 1.266-1 Taxes and carrying charges chargeable to capital account
and treated as capital items.
(a)
(1)
(2) See §§ 1.263A-8 through 1.263 A-15 for rules regarding the requirement
to capitalize interest, that apply prior to the application of this section. After
applying §§ 1.263A-8 through 1.263A-15, a taxpayer may elect to capitalize
interest under section 266 with respect to designated property within the
meaning of § 1.263A-8 (b), provided a computation under any provision of
the Internal Revenue Code is not thereby materially distorted, including
computations relating to the source of deductions.

Par. 7. Section 1.1502-13 is amended by adding a sentence to the end of paragraph (c)
(1) (i), and by adding [*175] a sentence to the end of paragraph (c) (2), to read as
follows:

§ 1.1502-13 Intercompany transactions.

(c)
(1)
(i)
See, however, paragraph (c) (2) of this section for
determining the amount of deferred gain or loss on a deferred intercompany
transaction that involves interest capitalized under section 263A (f) (2)
Additionally, see section 263A (f) and the regulations thereunder to
determine the amount of deferred gain or loss on a deferred intercompany
transaction that involves interest capitalized under section 263A (f).

PART 602-OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT
Par. 8. The authority citation for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805

Par. 9. Section 602.101 (c) is amended by adding entries in numerical order to the table
to read as follows:

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010

Search - 42 Results - td 8584

Page 70 of 70

§ 1.602.101 OMB Control numbers.

(c)
CRF part or section where identified and
described

Current OMB control No.

1.263A-8 (b) (2) (iii)

1545-1265

1.263A-9 (d) (1)

1545-1265

1.263A-9 (f) (1) (ii)

1545-1265

1.263A-9 (f) (2) (iv)

1545-1265

1.263A-9 (g) (2) (iv) (C)

1545-1265

1.263A-9 (g) (3) (iv)

1545-1265

Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved:
Leslie [*176] Samuels,
Assistant Secretary of the Treasury.
(Filed by the Office of the Federal Register on December 28, 1994, 8:45 a.m., and published in the
issue of the Federal Register for December 29, 1994, 59 F.R. 67187 as corrected by 60 F.R. 16573
and 60 F.R. 47053)

Source:
Terms:
View:
Date/Time:

Combined Source Set 1
- IRS Cumulative Bulletin and Internal Revenue Bulletin; Internal Revenue Man...
td 8584 (Edit Search)
Full
Friday, May 28, 2010 - 11:13 AM EDT

* Signal Legend:
- Warning: Negative treatment is indicated
- Questioned: Validity questioned by citing refs
- Caution: Possible negative treatment
- Positive treatment is indicated
- Citing Refs. With Analysis Available
- Citation information available
* Click on any Shepard's signal to Shepardize® that case.

About LexisNexis | Terms & Conditions | Contact Us
Copyright © 2010 LexisNexis, a division of Reed Elsevier Inc. All rights
reserved.

http://www.lexis.com/research/retrieve?_m=e6a5d43daab26d1be3161d6c76e68807&_browseTyp... 5/28/2010