Capitalization and Accounting Methods Update

Presented by:

► Sharon Kay – Washington National Tax: 202 327 6556

► Kristine Mora – Washington National Tax: 202 327 6092

Page 21105-1260385

Notice

► Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code, or applicable state or local tax law provisions

► These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice

Page 31105-1260385

Agenda

► Accounting method changes trends► Tangible property regulations► Inventory update

Accounting method changes trends

Page 5

Accounting method timeline and procedural considerations

2012

au

tom

atic

3115

due

1

1 For properly extended corporate and partnership tax returns.

03/3

1/20

13

01/0

1/20

13

12/3

1/20

12

11/1

3/20

12

90 day window period

Typical timeline for calendar-year taxpayers20

12 n

on-

auto

mat

ic

3115

due

09/1

5/20

13

2013

non

-

auto

mat

ic

3115

due

1

12/3

1/20

13

Automatic Accounting Method Changes Non-automatic Accounting Method Changes

Filing Deadline Due date of tax return for year of change Last day of tax year of change

Implementation of Change

Implement on tax return for year of change; no user fees

May not implement on tax return until consent received; user fee required

Taxpayers Under Examination may only file

(1) Within first 90 days of a tax year if taxpayer has been under examination for at least 12 months;(2) Within 120 days of an examination ending; or(3) With the consent of the Director(4) For automatic changes, taxpayer may file method change if automatic change procedure

specifies the change is not subject to audit protection.

Page 61105-1260385

Accounting method changes trends

► Top 5 method changes we’ve filed in the past year► Accrued bonus liability – typically unfavorable adjustment► Depreciation – typically favorable adjustment► UNICAP – both favorable and unfavorable adjustments► Deferral of advance payments – typically favorable adjustments► Repairs – typically favorable adjustments

► Latest trends ► Changes for earnings and profits of CFCs► Computer software development and ERP implementations► Opportunity if there is corporate tax reform

► Crystal ball for the next year► Predict that 9 out of top 10 most commonly filed will be from the 19 tangibles

regulations method changes, if IRS does not delay effective date ► The 10th will be UNICAP

Tangible property regulations

Page 8

Materials and supplies

Acquisitions Improvements Depreciation and dispositions

§1.162-3T §1.263(a)-2T §1.263(a)-3T §§1.168(i)-1T, -7T, -8T§1.263(a)-1T

• Definition of material and supply

• Three categories that determine when deductible:• Incidental supply• Non-incidental supply• Rotable spare parts

• Election to deduct under de minimis rule in acquisition regulations

• Election to capitalize and depreciate

• De minimis expensing used for AFS allowed if less than ceiling (applied to each regarded entity)• Election to capitalize

and depreciate• Capitalize costs that

facilitate acquisition of property • Whether and which

test for real property• Expense employee

compensation and overhead, but may elect to capitalize

• Capitalize costs to defend or perfect title to property

• Definition of unit of property is generally functional interdependence except for:• Buildings• Plant property• Leased property

• Improvement defined:• Betterment• Restoration• New or different use

• Safe harbor for routine maintenance on property other than buildings

• Safe harbor for certain regulated entities

• No plan of rehabilitation

• Leased property • Depreciation accounts• Single asset accounts • Mass asset accounts• General asset

accounts• Dispositions• General rules • Required to recognize

disposition of structural components

• Reasonable identification methods

• Capitalize facilitative costs for sales of property by non-dealers

• Deduct dealer expenses for sales

• Other issues include: coordination with section 263A, mass asset accounting

Overview - tangible property regulations

Page 9

Transition rules

► Revenue Procedures 2012-19 and 2012-20► What does compliance with Section 263A (UNICAP) mean?

► Improvements and other self-constructed property► Improvement includes capitalized repairs and is subject to Section 263A► Must allocate costs in addition to invoice price such as

► Allocable portion of the department that negotiates with repairmen and supervises the work performed

► Allocable portion of support departments such as payroll, HR, legal, etc. that support the above department

► Probably not eligible under the automatic procedures due to methods typically used

► Therefore, must file by the last day of the tax year to request advance consent

► Scope is not waived► Inventory

► May be eligible to file under the automatic procedures, but for now scope is not waived

► IRS is considering making selected methods automatic and waiving scope

Page 10

Developing an implementation plan

Assess current stateAssess current state of accounting methods and elections as well as the current

processes and available data and systems that support them

Understand required/allowed stateUnderstand required state under new regulations as well as elections/optional

methods for potential opportunities and how these differ from current state

Determine impact on other areas Model requirements/opportunities to determine impact on other federal tax items (e.g.,

§199 deduction, inventory and PCM computations), state taxable income, E&P, etc., and to evaluate financial statement considerations

Develop solutions for implementing changesPrioritize issues and develop solutions for changes to data tracking and business

processes/systems, computations and documentation of compliance

Determine resources needed to implementDevelop workplan for implementation of new methods/elections, computation of

§481(a) adjustments, tax return reporting (including Forms 3115 and elections), documentation for potential IRS exam, and financial statement considerations

Inventory update

Page 121105-1260385

Inventory Agenda:

► Legislative / Regulatory Update► Section 263A (UNICAP)

► Overview► Proposed regulations for negative Section 263A

costs► Self-constructed assets► Other inventory planning

Page 131105-1260385

Inventory accounting — legislative / regulatory update

► Proposed regulations

► Sales-based royalties

► Vendor allowances

► Retail inventory method

► Negative 263A costs

► President's Fiscal 2013 budget proposals:

► Last in, first out (LIFO) repeal

► Lower of cost or market (LCM) repeal

► Subnormal goods write-downs repeal

Page 141105-1260385

Uniform Capitalization (UNICAP) planning: Why now?

► Mandatory compliance in order to fall within automatic change procedures for the tangible property regulations

► Other considerations:

► Bonus depreciation

► Reduce taxable income

► Remediate potential exposure

► Net operating loss (NOL) companies

► Newly acquired entities

► Changes to book inventory costing methods

Page 151105-1260385

UNICAP planning: Common opportunities

► Opportunities:► Adopt a burden rate method or new proposed modified simplified

production method (if finalized)

► Embedded costs

► R&D

► Deprecation on temporarily idle facilities

► Warranty and product liability

► Policy-making/budgeting

► Elect the historic absorption ratio

► Lock in a low rate

► Reduce administrative effort

Page 161105-1260385

UNICAP planning: Potential exposures

► Common exposure areas► Book/tax differences are not allocated

► Absorption ratio has not been updated

► Operations have changes since last UNICAP study

► Contract manufacturing for retailers or distributors

► Service providers (e.g., restaurants) should be treated as producers

► Following book capitalization for self-constructed assets

Page 171105-1260385

Other 263A Considerations – Self-constructed assets

► Applies to real or tangible personal property produced by the taxpayer and applies to property produced by a company for use in its trade or business (“self- constructed asset”). ► Definition includes construct, build, install, manufacture, develop, improve

► Includes capitalizable improvements

► Applies to taxpayers that have property produced by a contractor► The company that contracts to have property constructed for it is treated

as self-constructing the asset to the extent it makes progress payments or otherwise incurs cost with respect to the property.

► Indirect costs incurred by the company (e.g., construction period interest, oversight and general and administrative expenses) for which the property is being produced must be capitalized by that company as a cost of the property

► Currently most self-constructed asset Section 263A changes are non-automatic and must be filed by the last day of the tax year

Page 181105-1260385

UNICAP: Negative 263A costsProposed Regulations

► A negative amount generally occurs when a taxpayer capitalizes a cost as a Section 471 cost that is greater than the amount required to be capitalized for tax purposes, which the taxpayer seeks to remove from inventory cost using its 263A formula.

► In Notice 2007-29, the IRS stated that, pending the issuance of additional guidance, it would not challenge the inclusion of negative amounts in calculating additional costs under Section 263A or the permissibility of aggregate negative additional Section 263A costs.

Page 191105-1260385

UNICAP: Negative 263A costsProposed Regulations► Proposed regulations that generally prohibit the inclusion of negative

additional 263A costs subject to a few exceptions:► Small taxpayers

► Simplified resale method

► Modified simplified production method (discussed on next slide)

► All other taxpayers must reduce 471 costs using a method that approximates the manner in which the taxpayer originally capitalized the costs

► The proposed regulations would generally prohibit treating cash or trade discounts under Reg. Section 1.471-3(b) as negative amounts under either simplified method.

Page 201105-1260385

UNICAP: Negative 263A costsProposed Regulations► New modified simplified production method

► Two absorption ratios► Preproduction► Production

► Allows negative additional Section 263A treatment

► Reduce the distortions

► May be favorable but additional work if currently using SPM► Preproduction costs applied to raw material AND raw material content of WIP

and finished goods► Many of the benefits of burden rate methods but with less work

Page 211105-1260385

UNICAP: Negative 263A costsProposed Regulations► Adopt a new definition of Section 471 costs

► Applies to all taxpayers regardless methods used

► All costs, other than interest, that a taxpayer capitalizes to its inventory in its financial statements.

► Must include direct labor and direct material

► Consistent with what most taxpayers are currently doing in practice

Page 221105-1260385

Other inventory planning

► Reduce taxable income► LIFO

► Automate LIFO computations

► Adopt LIFO for additional inventory

► Change from internal to external inflation indexes or vice versa

► Terminate LIFO for deflationary goods (e.g., pools with debit LIFO reserve)

► Reconstruct base-year cost if inflationary; do not reconstruct if deflationary

► Inventory write-downs (non-LIFO taxpayers only)

► Lower of cost or market

► Subnormal goods (e.g., expired products, obsolete inventory)

► Retail inventory method

► Inventory shrink

► Charitable contributions of inventory

► Chargebacks

Page 231105-1260385

Questions and answers

?

Page 241105-1260385

Thanks for participating