Interest Capitalization for Self-Constructed Assets, Slides of Business

Download Interest Capitalization for Self-Constructed Assets and more Slides Business in PDF only on Docsity! LB&I Process Unit Unit Name Interest Capitalization for Self-Constructed Assets Primary UIL Code 0263A.08-00 Interest Capitalization Library Level Title Knowledge Base Corporate/Business Issues & Credits Shelf Accounting Issues Book Interest Capitalization 263A Chapter Overview Document Control Number (DCN) COR-P-006 (formerly INV/P/203_01_01-01) Date of Last Update Revised: 02/01/21 Note: This document is not an official pronouncement of law, and cannot be used, cited or relied upon as such. Further, this document may not contain a comprehensive discussion of all pertinent issues or law or the IRS's interpretation of current law. DRAFT 2 Table of Contents (View this PowerPoint in “Presentation View” to click on the links below) Process Overview Detailed Explanation of the Process Process Applicability Summary of Process Steps Step 1 – Determine the Unit of Property Step 2 – Determine the Production Period Step 3 – Determine the Computation Period Step 4 – Determine the Measurement Dates Step 5 – Calculate the Accumulated Production Expenditures Step 6 – Apply the Avoided Cost Method Step 7 – Impose a Change in Accounting Method DRAFT 5 Process Overview (cont’d) Interest Capitalization for Self-Constructed Assets This Practice Unit identifies taxpayers subject to IRC 263A(f) and covers the steps involved in determining how much interest must be capitalized to the basis of designated property. The method used to determine the amount of interest to capitalize is called the avoided cost method. This Practice Unit walks the user through steps to assist in determining the information needed to apply the avoided cost method. It assists the user in finding the pieces needed in order to make the computation. It includes a step for a Service-imposed change in accounting method and the calculation of an IRC 481(a) adjustment. It also covers elections a taxpayer may adopt. The unit includes a comprehensive example walking the user through all the steps in computing capitalizable interest. Back to Table of Contents DRAFT 6 Detailed Explanation of the Process Interest Capitalization for Self-Constructed Assets Analysis This process unit refers to related parties at various times to alert the user to consider related parties when applying the interest capitalization rules. The Treasury regulations covering interest capitalization refer to related parties when applying certain aspects of the interest capitalization rules. For example, when considering if there is production of designated property, activities and costs of related persons must be considered when applying the designated property requirements. The regulations also contain anti-abuse rules that refer to related parties. This anti-abuse regulation requires the application of the interest capitalization rules in a manner that is consistent with IRC section 263A(f) and reasonably carries out the purposes of IRC section 263A(f). For example, the regulations indicate the taxpayer may not use certain loans or loan structuring arrangements or other uses of related parties to facilitate the avoidance of interest capitalization. When considering requirements, and making the computations contained in this Practice Unit, keep in mind the anti-avoidance and related party rules. Back to Table of Contents DRAFT 7 Process Applicability Interest Capitalization for Self-Constructed Assets If a taxpayer meets the criteria of “producing designated property” and is subject to interest capitalization under IRC 263A(f), then use the steps described in this Practice Unit to determine the amount of interest required to be capitalized. Criteria Resources Producing Designated Property The term “produce” includes construct, build, install, manufacture, develop, improve, create, raise, or grow. A taxpayer is treated as producing any property that another party produces for the taxpayer under a contract with the taxpayer or with an intermediary. Designated property includes all real property and three categories of tangible property. 1. Property that has a long useful life (depreciable class life of 20 years or more), or 2. Property with an estimated production period exceeding two years, or 3. Property with an estimated production period exceeding one year and estimated costs exceeding $1,000,000. The thresholds for tangible personal property are applied separately for each unit of property. Costs and Activities to Consider For purposes of determining whether property is designated property, identify activities and costs arising from the production of the property. Included are all activities and costs if they are performed or incurred by or for the taxpayer or any related person; and all the costs that directly benefit or are incurred to produce the property.  IRC 263A(g)  Treas. Reg. 1.263A-2(a)(1)(i)  Treas. Reg. 1.263A-8(d)(2)  IRC 263A(f)  Treas. Reg. 1.263A-8(b)(1)  Treas. Reg. 1.263A-8(b)(2)  Treas. Reg. 1.263A-10 Back to Table of Contents DRAFT 10 Summary of Process Steps Interest Capitalization for Self-Constructed Assets Process Steps The steps below explain the process to apply the interest capitalization rules under IRC 263A(f). Step 1 Determine the Unit of Property Step 2 Determine the Production Period Step 3 Determine the Computation Period Step 4 Determine the Measurement Dates Back to Table of Contents DRAFT 11 Summary of Process Steps (cont’d) Interest Capitalization for Self-Constructed Assets Process Steps The steps below explain the process to apply the interest capitalization rules under IRC 263A(f). Step 5 Calculate the Accumulated Production Expenditures Step 6 Apply the Avoided Cost Method Step 7 Impose a Change in Accounting Method Back to Table of Contents DRAFT 12 Step 1: Determine the Unit of Property Interest Capitalization for Self-Constructed Assets Step 1 Determine the unit of property. Each unit of designated property must include all components of the property. Considerations Resources Unit of Property It is critical to determine the unit of property (real or tangible) because it is the basis for the rest of the interest capitalization process. The computation of accumulated production expenditures (APEs) and the determination of the production period is based on each unit of property. Unit of “Real Property” Each unit of real property includes components of real property a taxpayer or related person owns that are functionally interdependent (explained on next slide); and an allocable share of any common features (explained on next slide) a taxpayer or related person owns that is real property even though the common feature does not meet the functional interdependence test; and land on which the real property (including any common features) is situated, land subject to setback restrictions for such property, and any other contiguous portion of the tract of land other than land that a taxpayer holds for a purpose unrelated to the unit of property being produced.  Treas. Reg. 1.263A-10(b)(1)  Treas. Reg. 1.263A-10(b)(6), Examples Back to Table of Contents DRAFT 15 Step 2: Determine the Production Period Interest Capitalization for Self-Constructed Assets Step 2 Determine the production period. Capitalization of interest is required during the production period of a unit of designated property. Considerations Resources Periodic interest computations are made during the production period of the designated property. The period of time for these interest computations is called the computation period. The computation period is the period during which the avoided cost method is used to compute capitalizable interest. Interest is capitalized during each computation period. Real Property Production Period For a unit of real property, production begins on the first date the taxpayer performs any physical activity. The activity must be a physical activity; planning and design are not considered to be physical activities. Additionally, incidental repairs are not activities that start a production period. Physical activities undertaken to prepare for constructing or improving real property start the production period. Examples include clearing, grading, or excavating raw land; demolishing a building or gutting a standing building; engaging in the construction of infrastructure, such as roads, sewers, sidewalks, cables, and wiring; undertaking structural, mechanical, or electrical activities to a building or other structures; and engaging in landscaping activities.  Treas. Reg. 1.263A-8(d)(1)  Treas. Reg. 1.263A-12(c)(2)  Treas. Reg. 1.263A-12(e)(1) Back to Table of Contents DRAFT 16 Step 2: Determine the Production Period (cont’d) Interest Capitalization for Self-Constructed Assets Step 2 Considerations Resources Tangible Property Production Period For a unit of tangible personal property, production begins on the first date in which a taxpayer’s accumulated production expenditures, including planning and design expenditures, are at least 5% of the total estimated production expenditures for the unit of property. End of Production Period The end of the production period depends on how a taxpayer will use the unit of property (whether real property or tangible personal property). If a taxpayer produces the unit of property for self-use, the production period ends on the date the taxpayer places the unit in service and all production activities reasonably expected to be undertaken are completed. If a taxpayer produces the unit of property for sale, the production period ends on the date the taxpayer is ready to hold the unit for sale and all production activities reasonably expected to be undertaken are completed. If another party produces the unit of property for the taxpayer under a contract, the production period ends when the taxpayer places the property in service and all production activities reasonably expected to be undertaken are completed. In the case of property that is customarily aged before a taxpayer sells it (such as tobacco, wine, or whiskey), the production period includes the aging period.  Treas. Reg. 1.263A-8(d)(1)  Treas. Reg. 1.263A-12(c)(3)  Treas. Reg. 1.263A-12(d)(1) Back to Table of Contents DRAFT 17 Step 2: Determine the Production Period (cont’d) 2 Interest Capitalization for Self-Constructed Assets Step 2 Considerations Resources End of Production Period (cont’d) Note that under the Tax Cuts and Jobs Act, Public Law 115-97 Act, Section 13801 and Public Law 116-94 the production period for interest capitalization will not include the aging period for beer, wine, and distilled spirits and applies to interest costs paid or accrued in calendar years beginning after December 31, 2017, but only if paid or accrued on or before December 31, 2020. In addition, Act Section 106 of Public Law 116-260, Consolidated Appropriations Act, 2021, changed the ending production period of the aging process of beer, wine, and distilled spirits in Section 263A(f)(4)(B) from December 31, 2020, to indefinitely. If the taxpayer has a large project with several different units of property, then the production period will end for each unit as each separate unit of property is completed. The production period does not wait for the entire project to complete. For example, if there are separate apartments in a multi-unit building and each is a separate unit of property, the production period ends for each separate apartment when the taxpayer is ready to sell or place each unit in service. However, in the case of a single unit of property, which merely undergoes separate and distinct stages of production, the production period ends at the same time (when all separate stages of production are completed).  Treas. Reg. 1.263A-12(d)(3)  Treas. Reg. 1.263A-12(d)(4)  Treas. Reg. 1.263A-12(b)  Treas. Reg. 1.263A-8(b)(1)(ii)(B) and (C)  Tax Cuts and Jobs Act, Public Law 115-97, Act Section 13801  Further Consolidated Appropriations Act, 2020, Public Law 116-94, Act Section 144  Consolidated Appropriations Act, 2021, Public Law 116-260, Act Section 106 Back to Table of Contents DRAFT 20 Step 2: Determine the Production Period (cont’d) 5 Interest Capitalization for Self-Constructed Assets Step 2 Considerations Resources  Treas. Reg. 1.263A-12(g)(4), Example  Treas. Reg. 1.263A-12(g)(1) Back to Table of Contents DRAFT 21 Step 3: Determine the Computation Period Interest Capitalization for Self-Constructed Assets Step 3 Determine the computation period needed to make the avoided cost calculation. Considerations Resources Use of the Computation Period The avoided cost method is the method used to determine the amount of interest to capitalize to designated property. The computation period is the time-frame used to compute the interest to capitalize. If a taxpayer chooses the taxable year as the computation period, the taxpayer makes a single avoided cost method calculation for each unit of property for the entire taxable year. See Diagram 1 (on slide 23) for an illustration of the taxable year used as the computation period. If a shorter computation period is used, the taxpayer must make separate avoided cost method calculations for each unit of property for each computation period within the taxable year. See Treas. Reg. 1.263A-9(f)(3), Example 2. Computation periods cannot include portions of more than one taxable year. Except in the case of a short taxable year, each computation period within a taxable year must be the same length. In the case of a short taxable year, see Treas. Reg. see Treas. Reg. 1.263A-9(f)(1)(i). The same computation period(s) must be used for all designated property produced during a single taxable year. The choice of a computation period is a method of accounting and a change requires consent of the Commissioner under IRC 446(e).  Treas. Reg. 1.263A-9(f)(3)  Treas. Reg. 1.263A-9(f)(1)(i)  IRC 446(e) Back to Table of Contents DRAFT 22 Step 4: Determine the Measurement Dates Interest Capitalization for Self-Constructed Assets Step 4 Determine the measurement dates used in the determination of capitalized interest. Considerations Resources Determine the Measurement Dates The avoided cost method calculation requires a minimum number of measurement dates. The measurement dates depend on the length of the computation period. If a taxpayer uses the taxable year as the computation period, then the measurement dates must be at least quarterly, but can be more frequent. See Diagram 2 (on slide 23) for an illustration of quarterly measurement dates. If a taxpayer uses a computation period shorter than the taxable year, then measurement dates must occur at least twice during each computation period and measurement dates must occur at least four times during the taxable year (or consecutive 12 months in the case of a short taxable year). Measurement dates must occur at equal intervals during each computation period, except in the case of a short taxable year. In the case of a short taxable year, the taxpayer may treat a period shorter than the regular computation period as the first or last computation period or as the only computation period if the year is shorter than the regular computation period. The same measurement dates must be used for all designated property produced during the computation period.  Treas. Reg. 1.263A-9(f)(2)(i) Back to Table of Contents DRAFT 25 Step 4: Determine the Measurement Dates (cont’d) 3 Interest Capitalization for Self-Constructed Assets Step 4 Considerations Resources Measurement Period (cont’d) The first measurement date on which a taxpayer must take accumulated production expenditures into account for a unit of property is the first measurement date following the beginning of the production period for the unit of property. For example, a taxpayer uses quarterly measurement dates based on a calendar year computation period. The taxpayer begins production on a unit of designated property on 01/13. The first measurement date to consider accumulated production expenditures is 03/31. See Diagram 2 on the next slide. The final measurement date on which a taxpayer must take accumulated production expenditures into account for a unit of property is the first measurement date following the end of the production period for the unit of property. Using the same facts as above, the production ends on 08/06, therefore the final measurement date to consider accumulated production expenditures is 09/30. See Diagram 2 on the next slide. A taxpayer must take accumulated production expenditures into account for a unit of property on all intervening measurement dates. See Diagram 2 on the next slide.  Treas. Reg. 1.263A-9(f)(2)(iii) Back to Table of Contents DRAFT 26 Step 4: Determine the Measurement Dates (cont’d) 4 Interest Capitalization for Self-Constructed Assets Step 4 Considerations Resources  Diagram 2: Illustration of measurement dates taking accumulated production expenditures into account. Assume quarterly measurement dates are used and the production period for the unit of property begins January 13 and ends August 6.  Treas. Reg. 1.263A-9(f)(2)(iii) Back to Table of Contents DRAFT 27 Step 5: Calculate Accumulated Production Expenditures Interest Capitalization for Self-Constructed Assets Step 5 Calculate the accumulated production expenditures related to a unit of property. Considerations Resources Accumulated Production Expenditures Direct costs and a share of indirect costs are capitalized to each unit of property. These costs are referred as accumulated production expenditures. Included are costs incurred and capitalized to the unit of property prior to the beginning of the production period, including the cost of planning and design activities, the cost of raw land acquired for development, and the cost of a leasehold in mineral properties acquired for development. Also included are costs (other than interest) incurred with respect to the unit of property during each measurement period that includes the production period. It also includes any interest capitalized after prior computation periods. Finally, included is the adjusted basis of certain assets used to produce the unit of property when used during production. For example, a crane used to build large buildings or a heavy equipment used to clear land. See Treas. Reg. 1.263A-11(d)(2) for an example of allocating the adjusted basis of a bulldozer among different projects based on time.  IRC 263A(a)  Treas. Reg. 1.263A-10(b)(1)  Treas. Reg. 1.263A-11(d)  Treas. Reg. 1.263A-11(d)(2) Back to Table of Contents DRAFT 30 Step 6: Apply the Avoided Cost Method (cont’d) Interest Capitalization for Self-Constructed Assets Step 6 Considerations Resources Types of Debt The avoided cost method requires the capitalization of the traced debt amount and the excess expenditure amount for each unit of property’s computation period that includes the production period. The excess expenditure amount is a computation and will be explained in sub-step C. The avoided cost method involves three categories of debt: 1. Eligible debt 2. Traced debt 3. Nontraced debt Diagram 3 on the next slide illustrates the relationship between the three categories.  Treas. Reg. 1.263A-9 Back to Table of Contents DRAFT 31 Step 6: Apply the Avoided Cost Method (cont’d) 2 Interest Capitalization for Self-Constructed Assets Step 6 Considerations Resources  Diagram 3: Relationship Between Eligible Debt, Traced Debt, and Nontraced Debt  Treas. Reg. 1.263A-9(a)(4)  Treas. Reg. 1.263A-9(b) Back to Table of Contents DRAFT 32 Step 6: Apply the Avoided Cost Method (cont’d) 3 Interest Capitalization for Self-Constructed Assets Step 6 Considerations Resources There are several steps when considering the amount of interest to capitalize. They are broken into sub-steps to guide the computation from start to finish. Sub-step C, contains several computations and it is broken down further into five parts to aid in making the computation. The sub-steps are as follows: 1. Sub-step A: Identify eligible debt 2. Sub-step B: Compute the traced debt amount 3. Sub-step C: Compute the excess expenditure amount for each unit of property i. Subpart 1: Calculate the average excess expenditures for each unit of property ii. Subpart 2: Calculate interest incurred on nontraced debt during the computation period iii. Subpart 3: Calculate average nontraced debt for the computation period iv. Subpart 4: Calculate the weighted average interest rate v. Subpart 5: Calculate the excess expenditure amount for each unit of property 4. Sub-step D: Compute the total interest available to be capitalized 5. Sub-step E: Compare the sum of excess expenditure amounts for all units of property to the total interest available to be capitalized and determine the amount to capitalize Each sub-step and subpart will be discussed next in greater detail. Back to Table of Contents DRAFT 35 Step 6: Apply the Avoided Cost Method (cont’d) 6 Interest Capitalization for Self-Constructed Assets Step 6 Considerations Resources Sub-step B: Compute the Traced Debt Amount Traced debt is outstanding eligible debt that is allocated to the accumulated production expenditures for the unit of property being produced. In other words, the proceeds from the debt is used to pay for the expenses of producing the designated property. The traced debt must be identified on each measurement date. See Treas. Reg. 1.263A-9(b)(2) for additional information. Debt is allocated to expenditures based on how the debt is used. (referring to the allocation rules under Treas. Reg. 1.163- 8T). See Diagram 3 (on slide 30) illustrating the relationship between eligible debt, traced debt, and nontraced debt. Also, see comprehensive example, Step 6 (starting on slide 59) illustrating the avoided cost method calculations. Traced Debt Capitalization A taxpayer must capitalize total interest incurred on traced debt during each measurement period. Treas. Reg. 1.263A-9(b)(3) provides an example of traced debt capitalization: Taxpayer Z, a calendar year taxpayer is engaged in the production of a unit of designated property during 20X5. The taxpayer choses the taxable year as the computation period with quarterly measurement dates. The production starts on 01/14/X5 and ends on 06/16/X5. On 03/31/X5 and 06/30/X5, the taxpayer has a $1,000,000 loan allocated to the production expenditures of the designated property. During the period 01/01/X5 through 06/30/X5, the taxpayer incurs $50,000 of interest on the loan. The taxpayer must capitalize the $50,000 of interest to the designated property.  Treas. Reg. 1.263A-9(b)(2)  Treas. Reg. 1.163A-8T  Treas. Reg. 1.263A-9(b)(3), example Back to Table of Contents DRAFT 36 Step 6: Apply the Avoided Cost Method (cont’d) 7 Interest Capitalization for Self-Constructed Assets Step 6 Considerations Resources Sub-step B: Compute the Traced Debt Amount (cont’d) Election to Not Trace Debt A taxpayer may elect not to trace debt. Treas. Reg. 1.263A-9(d). If a taxpayer makes this election, the average excess expenditures and weighted average interest rate are determined by treating all eligible debt as nontraced debt. Treas. Reg. 1.263A-9(d)(2) provides the following example: a calendar year corporation is engaged in the production of a single unit of designated property during 20X5. The taxpayer adopts the taxable year as the computation period and quarterly measurement dates. At each measurement (03/31, 06/30, 09/30, and 12/31) the taxpayer has the following outstanding debt:  Treas. Reg. 1.263A-9(d)  Treas. Reg. 1.263A-9(d)(2), example Type of Outstanding Debt Amount Noninterest-bearing accounts payable traced to the designated property $100,000 Noninterest-bearing accounts payable not traced $300,000 Interest bearing loans that are eligible debt $900,000 The taxpayer elects to not trace debt. For purposes of calculating the weighted average interest rate, eligible debt at each measurement date is $1,000,000 ($100,000 + $900,000). Back to Table of Contents DRAFT 37 Step 6: Apply the Avoided Cost Method (cont’d) 8 Interest Capitalization for Self-Constructed Assets Step 6 Considerations Resources Sub-step B: Compute the Traced Debt Amount (cont’d) The election not to trace debt is a method of accounting. It applies to the determination of capitalized interest for all designated property. The election to use or revoke this method requires consent from the Commissioner under IRC 446(e). Sub-step C: Compute the Excess Expenditure Amount for Each Unit of Property  IRC 446(e)  Treas. Reg. 1.263A-9(c)  Treas. Reg. 1.263A-9(b)(5)(ii) Back to Table of Contents DRAFT 40 Step 6: Apply the Avoided Cost Method (cont’d) 11 Interest Capitalization for Self-Constructed Assets Step 6 Considerations Resources Sub-step C: Compute the Excess Expenditure Amount for Each Unit of Property (cont’d) See Comprehensive Example, Sub-step C. Also see Treas. Reg. 1.263A-9(c)(6), Examples. The components of the computation will be explained after the following elections which can affect this computation. Eligible Taxpayer’s Election to Use External Interest Rate Eligible taxpayers may elect to use an external interest rate instead of computing the weighted average interest rate. See Treas. Reg. 1.263A-9(e) for additional information. A taxpayer is an eligible taxpayer for the taxable year 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. The principles of IRC 263A(b)(2)(B) and(C) and Treas. Reg. 1.263A-3(b) apply in determining whether a taxpayer is an eligible taxpayer for a taxable year. If elected, the eligible taxpayer must use the highest Applicable Federal Rate (AFR) under IRC 1274(d) in effect during the computation.  Treas. Reg. 1.263A-9(c)(6), Examples 1 & 2  Treas. Reg. 1.263A-9(c)(5)(D)  Treas. Reg. 1.263A-9(e)  IRC 263A(b)(2)(B) and (C)  Treas. Reg. 1.263A-3(b)  IRC 1274(d) Back to Table of Contents DRAFT 41 Step 6: Apply the Avoided Cost Method (cont’d) 12 Interest Capitalization for Self-Constructed Assets Step 6 Considerations Resources Eligible Taxpayer’s Election to Use External Interest Rate (cont’d) The use of the AFR-plus-3 method is a method of accounting. The eligible taxpayer makes the election to use the AFR-plus-3 method by using the AFR-plus-3 as the taxpayer’s weighted average interest rate. Any change to the AFR-plus-3 method by an eligible taxpayer that has never previously used the method does not require Commissioner consent. Subsequent changes to or from the AFR-plus-3 method requires the Commissioner’s consent under IRC 446(e). All changes to or from the AFR-plus-3 method are made on a cut-off basis (i.e. an IRC 481(a) adjustment is not allowed. Election to Treat Eligible Debt as Outstanding in Certain Circumstances A taxpayer may elect to treat eligible debt that it repays within the 15-day period immediately preceding a quarterly measurement date as outstanding on that measurement date, see Treas. Reg. 1.263A-9(g)(7). When computing the denominator for the weighted average interest rate, any nontraced debt repaid during the computation period will be excluded from nontraced debt outstanding for measurement dates after repayment. Nevertheless, the numerator includes all interest incurred on nontraced debt during the computation period. If nontraced debt is repaid close in time to a measurement date, the numerator will include all interest that accrued on the debt during that measurement period, yet the debt will be wholly excluded from the denominator on the measurement date.  IRC 446(e)  Treas. Reg. 1.263A-9(g)(7) Back to Table of Contents DRAFT 42 Step 6: Apply the Avoided Cost Method (cont’d) 13 Interest Capitalization for Self-Constructed Assets Step 6 Considerations Resources Election to Treat Eligible Debt as Outstanding in Certain Circumstances (cont’d) This “mismatch” could inflate the weighted average interest rate. If a taxpayer satisfies the terms for the election, they may continue to include the underlying nontraced debt in the denominator on the first measurement date after repayment. A taxpayer may make this election or discontinue the election for any computation period and it is not a method of accounting. CAUTION: Special rules apply if a taxpayer has no nontraced debt or if it incurs interest at a rate that is contingent. If the taxpayer does not have traced debt then the weighted average interest rate is the highest applicable Federal rate in effect under IRC 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.  Treas. Reg. 1.263A-9(g)(7)  IRC 1274(d) ! Back to Table of Contents DRAFT 45 Step 6: Apply the Avoided Cost Method (cont’d) 16 Interest Capitalization for Self-Constructed Assets Step 6 Considerations Resources Sub-step C: Compute the Excess Expenditure Amount for Each Unit of Property (cont’d) The portion of the $2,500,000 loan allocated to the accumulated production expenditures for Property D is treated as traced debt for each measurement date in 20X5. Any excess of the $2,500,000 loan that is treated as traced debt on each measurement date during 20X5 is treated as nontraced debt for that measurement date, even though the taxpayer expects the entire $2,500,000 will be treated as traced debt for Property D on subsequent measurement dates as more of the proceeds are used to finance additional production expenditures. In addition, the $2,000,000 loan is treated as nontraced debt for 20X5, even though it was treated as traced debt with respect to Property C in a prior period.  Treas. Reg. 1.263A-9(c)(5)(i)(B), Example Back to Table of Contents DRAFT 46 Step 6: Apply the Avoided Cost Method (cont’d) 17 Interest Capitalization for Self-Constructed Assets Step 6 Considerations Resources Subpart 4: Calculate the Weighted Average Interest Rate If the interest incurred on nontraced debt was $50,000 and the average nontraced debt for the computation period was $1,000,000 then weighted average interest rate:  Treas. Reg. 1.263A-9(c)(5)(iii)  Treas. Reg. 1.263A-9(c)  Treas. Reg. 1.263A-9(c)(3), Example Back to Table of Contents DRAFT 47 Step 6: Apply the Avoided Cost Method (cont’d) 18 Interest Capitalization for Self-Constructed Assets Step 6 Considerations Resources Sub-step D: Calculate the Total Interest Available to Be Capitalized A taxpayer must compute the total interest available to be capitalized by adding certain interest incurred during the computation period. Included is interest on nontraced debt, plus interest on debt that is borrowed directly or indirectly from a person related to the taxpayer that bears a rate of interest that is less than the federal rate in effect under IRC 1274(d) on the date of issuance. Plus, in the case of a partnership, guaranteed payments for the use of capital (within the meaning of IRC 707(c)), that would be deductible by the partnership if IRC 263A(f) did not apply.  IRC 1274(d)  IRC 707(c)  Treas. Reg. 1.263A-9(c)(2) Back to Table of Contents DRAFT 50 Step 6: Apply the Avoided Cost Method (cont’d) 21 Interest Capitalization for Self-Constructed Assets Step 6 Considerations Resources Sub-step E: Compare the Sum of the Excess Expenditure Amounts for All Units of Property to the Total Interest Available to Be Capitalized (cont’d) CAUTION: In this case, related persons may be required to capitalize interest as well. The sum of the excess expenditures exceeds interest available; therefore, the related person must take the excess expenditures into account when computing capitalized interest for each unit of property. In addition, if the taxpayer is a corporation related to another person for the purposes of the applicable related party rules, then the Service may require in this instance that the deferred interest be excluded from the total interest available for capitalization. ! Back to Table of Contents DRAFT 51 Step 7: Impose a Change in Accounting Method Interest Capitalization for Self-Constructed Assets Step 7 Impose a change in accounting method and compute the required IRC 481(a) adjustment. Considerations Resources Accounting Method Neither the Code nor the Regulations define the term “method of accounting.” In general, an accounting method is a set of rules under which a taxpayer ascertains when to recognize income and expenses to determine taxable income. The term “method of accounting” includes not only a taxpayer’s overall method of accounting, but also the accounting treatment of any material item. An overall method is a general method of accounting, such as the cash method or the accrual method. A material item refers to any specific item that involves the proper time to include income or deduct expenses. A method of accounting must involve timing. If an accounting practice for an item does not permanently affect the taxpayer’s lifetime taxable income, but does or could change the year in which taxable income is reported (or in which deductions are claimed), the accounting practice for the item involves timing and is therefore considered a method of accounting. A method of accounting that complies with the tax rules and regulations is a permissible method of accounting (i.e., clearly reflects income). An impermissible method of accounting does not comply with the tax rules and regulations. A taxpayer adopts a method of accounting by a consistent pattern of treatment.  IRC 446  Treas. Reg. 1.446-1  Rev. Proc. 2002-18  Issue Snapshot - Basic Method of Accounting Concepts Back to Table of Contents DRAFT 52 Step 7: Impose a Change in Accounting Method (cont’d) Interest Capitalization for Self-Constructed Assets Step 7 Considerations Resources Accounting Method (cont’d) A taxpayer adopts a permissible method of accounting by using it on the first return that reflects the overall method or material item. A taxpayer adopts an impermissible method of accounting by using it on two or more consecutively filed returns. Once a taxpayer adopts a method of accounting, a taxpayer cannot change the method, even an impermissible one, without the Commissioner’s consent. Capitalization of interest, under IRC 263A, represents a method of accounting. See Treas. Reg. 1.263A-8(a)(3). Change in Accounting Method A change in treatment of interest from deductible to capitalizable or vice versa is a change in accounting method. When the Service determines a taxpayer’s method of accounting for its interest deduction does not clearly reflect income (i.e., the method is impermissible), the Service can change the taxpayer’s method to a permissible method (i.e., capitalization under IRC 263A(f)). This is a Service-imposed or involuntary method change. The Service generally makes the change in accounting method in the earliest year under examination. The new method is effective as of the beginning of the year of change.  Treas. Reg. 1.263A-8(a)(3)  IRC 263A(f)  Issue Snapshot - Involuntary (Service-Initiated) Method Change Back to Table of Contents DRAFT 55 Step 7: Impose a Change in Accounting Method (cont’d) 4 Interest Capitalization for Self-Constructed Assets Step 7 Considerations Resources Unauthorized Change in Accounting Method As provided previously, once a taxpayer adopts a method of accounting, consent is required to change a method of accounting. A taxpayer requests consent by following the general method change procedures (currently Rev. Proc. 2015-13) and files a Form 3115, Application for Change in Accounting Method. If a taxpayer has adopted a method of accounting for its interest under IRC 263A, and has changed its method of accounting without obtaining consent, the taxpayer has made an unauthorized change in accounting method. This would include a change to the computation period, to or from tracing to not tracing debt, or to or from the weighted average interest rate to or from the AFR-plus-3 interest rate. If a taxpayer has made an unauthorized change in method, an examiner may make any adjustments that are necessary to bring the change in accounting method into compliance (including any IRC 481(a) adjustment), deny the change in accounting method, and place the taxpayer back on its prior method, or deny the change in accounting method and place the taxpayer on any permissible method of accounting. An examiner can adapt the Pro Forma Unauthorized Method Change Issue Notice of Proposed Adjustment.  IRC 263A  IRC 481(a)  Pro Forma - Unauthorized Method Change Issue Notice of Proposed Adjustment Back to Table of Contents DRAFT 56 Definitions Interest Capitalization for Self-Constructed Assets Description  Accumulated production expenditures – the cumulative amount of direct and indirect costs that a taxpayer is required to capitalize to a unit of property under IRC 263A(f). See Step 5 for further explanation.  Avoided cost method – the method a taxpayer uses to compute the amount of interest to capitalize under IRC 263A(f). See Step 6 for additional information.  Computation period – the avoided cost method computes interest capitalization for each computation period (generally, the taxable year). See Step 3 for further information.  Designated property – all real property, or tangible personal property satisfying specific requirements that the taxpayer produced. A full discussion is found in Step 1.  Eligible debt – all of a taxpayer’s outstanding debt, except certain categories of debt. See Step 6 for a full discussion and explanation.  Measurement date – the avoided cost method computes interest capitalization based on “snapshots” of a taxpayer’s accumulated production expenditures, traced debt, and nontraced debt at various times throughout the computation period. The taxpayer takes these “snapshots” on the measurement dates. See Step 4 for additional discussion.  Measurement period – begins on the first day following the preceding measurement date and ends on the measurement date (e.g., if quarterly measurement dates are used, April 1 – June 30 is a measurement period). See Step 4 for additional discussion.  Nontraced debt – Eligible debt not treated as traced debt. See Step 6 for further discussion.  Traced debt – Eligible debt allocable under the rules of Treas. Reg. 1.163-8T to the accumulated production expenditures of a unit of property on one or more measurement dates. See Step 6 for further discussion.  Unit of property – used as a basis to determine the accumulated production expenditures of the designated property and to determine the beginning and ending of the production period. See Step 1 for additional information. Back to Table of Contents DRAFT 57 Examples of the Process Interest Capitalization for Self-Constructed Assets Description Based on Treas. Reg. 1.263A-9(f)(3), Example 3 Key Facts: 1. Corporation X is a calendar year taxpayer. 2. Corporation X engaged in the production of two units of designated property during 2015. Unit A: production started on 06/01/2014 and ended on 6/20/2015 Unit B: production started on 4/15/2015, but does not end until 07/31/2016 3. Corporation X adopted the taxable year as its computation period and did not elect not to trace debt. 4. Corporation X uses quarterly measurement dates and pays all interest on Eligible Debt in the quarter incurred. 5. During 2015, Corporation X had two items of Eligible Debt. The debt and the manner in which it is used are as follows: Loan # Principal Annual Rate (Percent) Period Outstanding Use of Proceeds 1 $ 1,000,000 9% 01/01/2015-09/01/2015 Unit A 2 $ 2,000,000 11% 06/01/2015-12/31/2015 Nontraced Accumulated production expenditures at the end of each quarter during 2015 are as follows: Measurement Date Unit A Unit B 03/31/2015 $ 1,200,000 $ 0 06/30/2015 $ 1,800,000 $ 500,000 09/30/2015 $ 0 $ 1,000,000 12/31/2015 $ 0 $ 1,600,000 Back to Table of Contents DRAFT 60 Examples of the Process (cont’d) 3 Interest Capitalization for Self-Constructed Assets Description Step 6: Apply the Avoided Cost Method Sub-step A: Identify eligible debt Loan #1 and Loan #2 do not meet any of the exceptions in Treas. Reg. 1.263A-9(a)(4). Therefore, Loan #1 and Loan #2 are both eligible debt. Back to Table of Contents DRAFT 61 Examples of the Process (cont’d) 4 Interest Capitalization for Self-Constructed Assets Description Step 6: Apply the Avoided Cost Method (cont’d) Sub-step B: Compute the traced debt amount Trace the use of the proceeds of Loan #1 and Loan #2 On 3/31 and 6/30, the proceeds of Loan #1 are traceable under Treas. Reg. 1.163-8T to Unit A. Therefore, Loan #1 is treated as traced debt to Unit A for the Measurement Periods 1/1 to 3/31 and 4/1 to 6/30, or 6 months. Loan # Principal Annual Rate Monthly Interest # Months as Traced Debt Traced Debt Amount 1 $ 1,000,000 9% $ 7,500 6 $ 45,000 Based on an annual 9 percent rate of interest, Corporation X incurs $7,500 of interest each month that Loan #1 is outstanding. The interest incurred on Loan #1 from 1/1 to 6/30 ($7,500/month x 6 months = $45,000) must be capitalized to Unit A. Back to Table of Contents DRAFT 62 Examples of the Process (cont’d) 5 Interest Capitalization for Self-Constructed Assets Description Step 6: Apply the Avoided Cost Method (cont’d) Sub-step C: Compute the excess expenditure amount for each unit of property Calculate average excess expenditures for Unit A: Calculate average excess expenditures for Unit B: Back to Table of Contents DRAFT 65 Examples of the Process (cont’d) 8 Interest Capitalization for Self-Constructed Assets Description Step 6: Apply the Avoided Cost Method (cont’d) Sub-step E: Compare sum of excess expenditure amounts for all units of property to total interest available to be capitalized: Back to Table of Contents DRAFT 66 Examples of the Process (cont’d) 9 Interest Capitalization for Self-Constructed Assets Description Step 7: Impose a Change of Accounting Method If the taxpayer’s current method of accounting for interest does not comply with IRC 263A(f) either by failing to capitalize any interest for Unit A and Unit B or by under capitalizing the interest amount, the taxpayer is using an impermissible method of accounting. Therefore, impose an accounting method change as described in Step 7 of this Practice Unit. Back to Table of Contents DRAFT 67 Other Considerations / Impact to Audit Interest Capitalization for Self-Constructed Assets Considerations Resources  Consider the proper capitalization of other IRC 263A costs to the property; e.g., direct production costs of the asset, indirect costs (such as employee benefits), engineering and design costs, officer compensation, other mixed and administrative costs.  Issue Snapshot - Identifying and Allocating the Costs of Self- Constructed Assets under IRC 263A  Issue Snapshot - 263A Costs and Allocation Methods  Custom homebuilder costs require capitalization, e.g., indirect costs such as officer compensation, insurance or employee benefits.  Issue Snapshot - 263A Custom Homebuilders  Once interest capitalization applies, depreciation should be updated due to the change in the basis of the asset. Back to Table of Contents DRAFT 70 Training and Additional Resources Interest Capitalization for Self-Constructed Assets Type of Resource Description(s) Saba Meeting Sessions  Basic Concepts of UNICAP and Self-Constructed Assets PPT - 2015-07 Issue Toolkits  Issue Snapshot - Capitalizable Interest  Issue Snapshot - Partnership Interest Capitalization Other Training Materials  Job Aid - IRC 263A Uniform Capitalization Reference Guide Back to Table of Contents DRAFT 71 Glossary of Terms and Acronyms Term/Acronym Definition AFR Applicable Federal Rate APEs Accumulated Production Expenditures CAM Change in Accounting Method Excess Exps Excess Expenditures IRC Internal Revenue Code Rev. Proc. Revenue Procedure Treas. Reg. Treasury Regulation UNICAP Uniform Capitalization Back to Table of Contents 72 Index of Related Practice Units Associated UIL(s) Related Practice Unit None at this time. Back to Table of Contents