Determination 200152014: Utility denied immediate deduction of coal handling costs

Plain-English summary

An electric utility asked to change its accounting method so it could deduct coal handling costs when incurred instead of capitalizing them until the coal was burned to produce electricity. The IRS denied that change. It viewed transportation to the power plant as part of acquiring the coal and other handling costs as costs that section 263A requires the utility to capitalize while the coal is held for future production. The IRS also denied the utility's proposed alternative allocation method because it would accelerate deductions for costs tied to electricity produced in a later tax year. The utility had to continue recognizing those costs when the associated coal was consumed and electricity produced.

Ruling snapshot

• Question: Could the utility currently deduct coal handling costs or use its proposed alternative allocation method?
• Outcome: Denied: both proposed accounting methods would fail to clearly reflect income.
• Key authorities: IRC §§ 162, 263A, and 446; Treas. Reg. §§ 1.162-3 and 1.263A-2.

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury

1111 Constitution Avenue NW
Number: 200152014
Washington DC 20224
Release Date: 12/28/2001
UIL: 9999.98-00
Person to Contact:

Telephone Number:
202-622-4970
Refer Reply To:
CC:ITA:B6/CAM-1117522-98
Date: September 25, 2001

Subject: Request Concerning Method of Accounting for Material Handling Costs Related to Coal Used to Produce Electric Energy

    We sent the following letter to                        , EIN:               ,

(hereinafter “the Taxpayer”) detailing our reasons for not granting it permission to change its accounting method. The Taxpayer had filed its Form 3115, Application for Change in Accounting Method, seeking permission to change its accounting method for certain coal handling costs for the tax year beginning

FACTS

The Taxpayer is the parent corporation of an affiliated group filing consolidated income tax returns on a calendar year basis. The Taxpayer in engaged in the generation, transmission, distribution and sale of electric energy. In connection with these activities, the Taxpayer uses coal as a fuel source. No other member of the Taxpayer’s affiliated group uses coal in this manner in their trades or businesses. Thus, the Form 3115 was filed solely to obtain permission to change the Taxpayer’s method of accounting.

To produce electric energy for sale, the Taxpayer burns coal at power generating plants. The Taxpayer seeks permission to change how it accounts for the costs of handling the coal once title to the coal is obtained, which ordinarily is at the mine itself. Examples of these costs include transporting, hauling, storage, insurance, sales tax, and handling. Alternatively, the Taxpayer requests approval to use a particular facts and circumstances allocation method as referenced by Treas. Reg. § 1.263A-1(f).1

Under the present accounting method, the Taxpayer capitalizes coal handling costs as part of the cost of the coal. Thus, these costs do not enter into the Taxpayer's computation of taxable income until the tax year in which the coal is actually burned to

1
The particular method proposed is as follows:

inventoriable costs X ending inventory = costs allocated to inventory kilowatt-hours produced

Inventoriable costs includes the cost of the coal consumed and all coal handling costs incurred in the year. Kilowatt-hours produced is the actual amount of kilowatt-hours of electric energy produced in the year. Ending inventory is the amount of kilowatt-hours of electric energy produced in the year that have yet to be sold and remain on hand at year end. Page 2

generate electric energy. Because of the nature of this energy, the burning of coal is almost simultaneous with the sale of the electric energy produced.

Under the proposed accounting method, the Taxpayer would deduct under IRC §§ 162 and 461 coal handling costs in the tax year in which the costs are incurred. None of these costs would be capitalized.

At the time the Taxpayer filed the Form 3115, the Taxpayer was under
examination for tax years through . The Form 3115 was filed with the consent of the director as specified in section 6.01(4) of Rev. Proc. 97-27, 1997-1 C.B.

680. The Taxpayer was also before an appeals office for tax years and
     through . The appeals office has agreed with the Taxpayer that the issue under consideration by that office is not the same method of accounting the Taxpayer is requesting to change. Section 6.02 of Rev. Proc. 97-27. Additionally, the Taxpayer was before a federal court when it filed its Form 3115. Counsel for the government has agreed with the Taxpayer that the issue under consideration by the court is not the same method of accounting the Taxpayer is requesting to change. Section 6.03 of Rev. Proc. 97-27.

                               DENIAL OF CONSENT
     
     The cost of transporting coal from the place where title is obtained to a power
     

     plant where it can be used in the production of electric energy is a cost of acquisition that is properly treated as part of the cost of the coal. See generally Rev. Rul. 72-113, 1972-1 C.B. 99; Maier Brewing Company v. Commissioner, T.C.M. 1987-385, aff’d, 916 F.2d 716 (9th Cir. 1990); Sears Oil Co., Inc. v. Commissioner, T.C.M. 1965-39; D. Loveman & Son Export Corporation v. Commissioner, 34 T.C. 776 (1960), aff’d, 296 F.2d 732 (6th Cir. 1961), cert. denied, 369 U.S. 860 (1962). Accordingly, the Taxpayer’s present method of capitalizing coal transportation costs is a correct method of accounting and not an incorrect method as asserted by the Taxpayer.

     As part of the cost of coal, these transportation costs would not enter into the
     computation of taxable income until the coal is consumed when electric energy is produced and sold. This would be the case regardless of whether the cost (including acquisition costs) of coal used to produce electric energy is deemed to be a direct or indirect material cost subject to IRC § 263A or materials and supplies subject to Treas. Reg. § 1.162-3.

     In contrast, the cost of handling coal at a power plant is not a cost of acquisition.
     

     See Treas. Reg. § 1.162-3. However, the Taxpayer's present method of capitalizing these costs is also a correct method of accounting under IRC § 263A. Costs associated with this coal do not enter into the computation of taxable income until the coal is consumed when electric energy is produced and sold. Handling costs, as a cost associated with property that is held for future production, must be capitalized in accordance with the requirements of IRC § 263A.

Application of IRC § 263A

IRC § 263A applies to the cost of handling coal, including transportation, used in the production of electric energy for sale to customers as follows: Page 3

(1) Producers of electric energy are subject to IRC § 263A. Generation of electric energy constitutes production of tangible personal property. See Helvey v. Wabash County REMC, 278 N.E.2d 608 (Ind. App. 1972);
Minnesota Power & Light Company v. Taxing District, 182 N.W.2d 685 (Minn. 1970); Curry v. Alabama Power Co., 8 So.2d 521 (Ala. 1942); State Tax Commission v. Marcus J. Lawrence Mem. Hosp., 495 P.2d 129 (Ariz.
1972). Thus, all direct and indirect costs attributable to the production of electric energy for sale to customers are subject to capitalization in accordance with the requirements of IRC § 263A and the regulations thereunder. See IRC §§ 263A(a) and 263A(b)(1); Treas. Reg. § 1.263A- 1(a)(3)(ii).

(2) The cost of coal becomes a cost of electric energy produced when the coal is consumed in the ordinary course of production. Treas. Reg.
§ 1.263A-1(e)(2)(i)(A) provides that producers must capitalize direct material costs, which include the cost of those materials that become an integral part of specific property produced and those materials that are consumed in the ordinary course of production and that can be identified or associated with particular units or groups of units of property produced.
Arguably, coal used to produce electric energy constitutes a direct material cost because it is consumed in the production of electric energy and can be directly associated with particular units of property produced (that is, there is a direct connection between tons of coal consumed and kilowatt-hours of electric energy thereby produced). However, even if the cost of coal was deemed to not qualify as a direct material cost under Treas. Reg. § 1.263A-1(e)(2)(i)(A), coal would still be subject to IRC § 263A as an indirect material cost. Treas. Reg. § 1.263A-1(e)(3)(i) provides that taxpayers subject to IRC § 263A must capitalize all indirect costs properly allocable to property produced or property acquired for resale, including indirect material costs (which include the cost of materials that are not an integral part of specific property produced and the cost of materials consumed in the ordinary course of performing production or resale activities that cannot be identified or associated with particular units or groups of units of property). Note: A cost described in Treas. Reg. § 1.162-3, relating to the cost of a material or supply, specifically is listed as an indirect material cost for purposes of IRC § 263A.

(3) IRC § 263A requires capitalization of coal handling costs. IRC § 263A requires accumulation of costs associated with the production of property until those costs can be attributed to property produced and matched with income from the sale of that property. See Preamble to § 263A; S. Rep.
No. 313, 99th Cong., 2d Sess. 140 (1986). Coal transportation costs (that is, those costs not already accounted for as an acquisition cost that is part of the cost of coal) and material handling costs must be accumulated until the Taxpayer is able to allocate those costs as a cost of the electric energy produced when the associated coal is consumed. Accumulating coal transportation and material handling costs until the coal is consumed is consistent with the rule for pre-production costs that appears in Treas.
Reg. § 1.263A-2(a)(3)(ii), which provides that if property is held for future Page 4
production, taxpayers must capitalize direct and indirect costs allocable to that property (for example, purchasing, storage, handling, and other costs), even though production has not begun.

Application of Treas. Reg. § 1.162-3

The cost of transporting coal from the place where title is obtained to a power plant where it can be used in the production of electric energy cannot be deducted until the coal is consumed even if coal is deemed to be materials and supplies subject to Treas. Reg. § 1.162-3. Treas. Reg. § 1.162-3 provides that taxpayers carrying materials and supplies on hand should include in expenses the charges for materials and supplies only in the amount that they are actually consumed and used in operation during the tax year for which the return is made. These charges include acquisition (transportation) costs.

Conclusion

Coal handling costs are subject to capitalization requirements and cannot be deducted until the associated coal is consumed and electric energy is produced. Treas. Reg. § 1.446-1(a)(2) provides that no method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income. See also IRC § 446(b). IRC § 446(e) and Treas. Reg. § 1.446-1(e)(2)(i) provide that a taxpayer must secure consent of the Commissioner before changing a method of accounting. In order to clearly reflect income, the Taxpayer must continue to capitalize coal handling costs and not include those costs in the computation of taxable income until the associated coal is consumed in the actual production of electric energy. Accordingly, permission to change to the proposed method of accounting for coal handling costs, which would not clearly reflect income, is denied. Similarly, permission for the Taxpayer to change to the proposed alternative facts and circumstances allocation method is denied. The alternative method would not clearly reflect income because it improperly accelerates the deduction of coal handling costs that are associated with electric energy that will not be produced until a subsequent tax year.

This letter is directed only to the Taxpayer and may not be used or cited as precedent.

Sincerely,
Office of Associate Chief Counsel
Income Tax and Accounting
Thomas A. Luxner, Chief, Branch 6 cc: